Finance directors might soon be attracted to some rather tasty bonbons being passed around the world’s boardrooms – permits to big carbon emitters involved in new cap-and-trade schemes. If the EU’s European Emissions Trading Scheme (ETS) is anything to go by, heavy industry could be reaping massive windfalls in the coming years. The EU’s ETS has found imitators in other parts of the world and carbon trading is catching on.
How industry fares depends partly on whether new trading schemes copy the EU template and, for instance, supply free emissions allowances in the first few years, and partly on whether emerging regional schemes link up.
In Australia, an ETS comes into force in 2015, preceded by a carbon tax introduced in July 2012 (see also article on page 38). Non-governmental organisations (NGOs) and other campaigners embraced this as a significant moment, but only a few weeks after the scheme began, the federal government approved a A$6.9bn plan for a new coalmine in the Galilee Basin, Queensland. The gassiest coal mines have also been given free allocations, allowing them to pass on costs to customers without losing money and becoming uncompetitive.
The mining plan is hardly the sign of an effective carbon penalty. Most emissions resulting from the new mines will not be covered, as James Lorenz, an Australian Greenpeace campaigner, points out: ‘The carbon price was a good first step in Australia, but it only covers domestic emissions. So the mines, which produce coal for export, will be largely unaffected.’
Nevertheless, investors who put a priority on environmental, social and governance (ESG)factors are given to making dark warnings of new carbon policies that turn positive investment ratios on their head. In a 2009 report, the bank Goldman Sachs, which has invested large amounts in environmental markets, indicated direct or indirect penalties (via subsidies for alternatives) for carbon emissions could grow steadily until 2020 and rise sharply thereafter. Using OECD data, it analysed the cost that needs to be applied to carbon emissions to provide an incentive to cut them in line with the path required to stabilise temperature change. It concluded that US$40 per tonne of carbon dioxide is needed by 2030.
The present carbon price is far below that at around €7 per tonne, due to a glut of carbon permits in the EU market. What is clear is that as the first two stages of the European ETS come to an end, the corporate lobbyists have had the upper hand. The aim of a cap-and-trade scheme is gradually to reduce the availability of carbon permits by tightening caps, ensuring scarcity, so that the market retains its value, while at the same time forcing a reduction in the overall level of pollution.
But political horse trading has weakened this ambition. Sandbag, an NGO digging out injustice in the EU’s ETS, identified 10 carbon ‘fat cats’ (all steel and cement companies) that could have made a combined profit of up to €4.1bn from free carbon permits negotiated between 2008 and 2010. One way they may have made money from the allowances is by selling them on to others more skilled at cutting carbon. Since they will not have paid for them in the first place, that is an attractive and easy bonus.
Caps were also set too high, so there was little motivation for saving energy in some industries. This has been partly responsible for the oversupply of emissions allowances. Change is on the way though. Francisco Ascui, director of the master’s programme in carbon finance at the University of Edinburgh Business School, points out: ‘Ten different schemes are expected across the world in the next few years and free allowances are one way of buying political acceptance.’
Three years after talks on a global agreement collapsed at the UN summit in Copenhagen, another deal is in the offing. Anti-carbon campaigners, including many ESG investors and progressively managed corporates, are starting to put the pieces back together. Meanwhile, Australia is to link its ETS to the EU’s by 2018. California has linked its own, starting up in 2013, to Quebec’s. Guangdong, China’s most heavily emitting province, drafted a pilot ETS in autumn 2012.
As activists weave this web of trading schemes and carbon taxes into place, it seems likely that companies will start to experience more carbon pricing over the long term as the policy holes are gradually plugged. Typically, they wriggle out of regional schemes by claiming they are being unfairly penalised.
Emma Howard-Boyd, sustainable investment and governance director at Jupiter Asset Management, argues: ‘The regulatory impact depends on how broadly a carbon price is applied. Policies are fragmented at the moment, but the unintended consequences [of investing in a particular area] are something to be concerned about, so as not to be caught out in different parts of the world.’ On the other hand, a global deal could create a much tighter brace.
Different companies would be hit to varying degrees with no escape funnel. The Goldman Sachs report says 15% of total cashflow could be transferred from high to low-emission companies at US$60 per tonne carbon prices. An even more significant cashflow transfer – nearly 20% – passes from the most to the least carbon-efficient companies in the most carbon-intensive industries. So who should be the most worried? Tony Campos, senior executive of ESG at index producer FTSE, explains two main ways companies can be disproportionately affected.
The first is by being among the heaviest emitters. FTSE’s carbon strategy index, launched across various regions of the world in 2012, gives different companies different weightings according to their carbon risks. ‘We take an approach focused on the potential impact of how we see further regulations. Those companies most materially affected are the ones most aggressively tilted in the index and can be the most heavily over or underweighted,’ says Campos.
Second, companies will be affected according to their operational impact rather than their products and services, such as budget airlines and national carriers.
Ryanair seems a pretty safe bet for shareholders at the moment. It was hardly touched by the financial turbulence of 2011 and its net profit rose 50% to €560.4m for the year to 31 March 2012, while easyJet’s profits climbed 32% in 2011. By contrast, International Airlines Group (IAG), owner of BA, reported a worse-than-expected Q1 2012 operating loss of €249m and expects to break even only in 2012.
But a glance at these companies’ carbon exposure reveals a different picture. Campos explains: ‘The airline industry is a stark demonstration of how some business models are better equipped to pass on additional carbon costs. Low-cost airlines struggle to pass them on because they are a greater proportion of the airfare.’ Hence, FTSE indicates the cost of carbon as a percentage of profits for easyJet could be around 15 times higher than for IAG, Lufthansa or Air France. The legal action many airlines have taken against the EU certainly shows they feel threatened. But this rebellion does put carbon risk in a different light.
How seriously the risk is taken depends on how effectively companies believe they can pass on the costs and on whether market leaders accept carbon as a competitive differentiator. Discretionary consumer industries or those with a ready substitute, such as from steel to plastics where steel is more carbon-intensive, will find it harder to pass on costs that seem inevitable – as climate changes become more severe, policy u-turns are unlikely.
After several years reporting on commodities for publisher Reed Elsevier, Elisabeth Jeffries became an independent writer on environmental, science and innovation issues. She focuses on clean energy and low-carbon issues.
This article first appeared in Accountancy Futures, Edition 6, 2013