Pricing Carbon: What Are The Options?

Frédérique Carrier 12 November 2021


Voluntary carbon offsets
Regardless of government mandated-schemes, an increasing number of companies wish to reduce their carbon footprint or accelerate the process of achieving net zero emissions. RBC Capital Markets estimates that over 20 per cent of global corporates are targeting net-zero emissions by 2050 or sooner.

Their motivation varies: management might be climate-conscious, or want their company’s shares to be appealing to ESG funds whose importance is growing and could represent as much as 60 per cent of mutual fund assets by 2025 according to PricewaterhouseCoopers.

Management may also want their company’s products to be appealing to consumers who are increasingly demanding greener product solutions. Green consumer preferences are well entrenched in Europe. A 2020 study by IBM and the National Retail Federation found that nearly 70 per cent of consumers in the US and Canada think it is important that a brand be eco-friendly.

Companies that are not in a cap-and-trade jurisdiction and wish to reduce their carbon footprint or accelerate the process of achieving net zero emissions can buy carbon offsets. They are certificates that represent one metric ton of CO2 equivalent that is either prevented from being emitted into the atmosphere or removed from the atmosphere as the result of energy efficiency projects such as reforestation or production of renewable energy. By using carbon offsets, a company can balance out its carbon footprint. Carbon offsets are also available to individuals: most airlines offer travellers the opportunity of offsetting the carbon footprint of their flight.

Reforestation is a common offset, as trees absorb CO2, they grow and store it, and makes up half the voluntary market. Other offsets include wind and solar farm projects that replace coal-fired power plants, thus preventing CO2 emissions, providing energy efficiency improvements.

McKinsey, a consulting firm, points out that though the voluntary carbon credit market is currently experiencing significant growth, it is still relatively small. It estimates that it could be worth some $50 billion by 2030 as demand grows.

Critics claim that many of these projects are ineffective, and do not reduce emissions as they claim to. Reforestation projects, for example, are often undertaken in faraway locations, where land is cheap and, if left unmonitored, may not be successful.

As a result, offsets are cheap compared with the price of carbon on cap-and-trade schemes, at a lowly $3 per tonne. Still, Easyjet, a UK low-cost airline group, which carried close to 100 million passengers before COVID-19, spent £25 million or six per cent of pre-tax profits to offset the carbon emissions from the fuel used on all its flights on behalf of its passengers.

Others point out that carbon offsets are less efficient at tackling climate change. Companies, they suggest, should focus on actively reducing emissions, not merely offsetting them. RBC Europe Limited, energy analyst Al Stanton thinks that to slow down and ultimately reverse climate change, technologies and solutions that actively remove CO2 directly from the atmosphere need to be deployed.

Peering into the future
Whether a country has a legally binding cap-and-trade programme in place or not, more and more companies are incorporating a cost to emitting CO2 as a way of measuring their climate change risk and putting their businesses in a better position for managing the transition to a lower carbon business model. A McKinsey study highlights that ‘some companies are setting an internal charge on the amount of carbon dioxide emitted from assets and investment projects so they can see how, where, and when their emissions could affect their profitability and investment choices.' Meanwhile, some US financial services companies are using internal carbon pricing to identify low-carbon, high-return investment opportunities.

The Sustainability Accounting Standards Board
Of the 2,600 companies that report their emissions to the Carbon Disclosure Project, 23 per cent were found to be using an internal carbon charge, and another 22 per cent plan to do so over the next two years.

French company Danone (Evian bottled water and Dannon yogurt), publicly reports its carbon-adjusted earnings per share, which has grown faster than its regular EPS because of the company’s reduced carbon intensity.

US companies using an internal carbon price, including Microsoft and Mars, say it helps them to drive low-carbon investment, energy efficiency, and seize low carbon opportunities.

Broad investment implications
Politicians of all factions are under increasing pressure to introduce green regulations. In 2020, the Grantham Research Institute at the London School of Economics counted close to 2,000 pieces of climate legislation across the world, of which two thirds were enacted since 2010. The Securities and Exchange Commission may not adopt Europe’s strict Sustainable Finance Disclosure Regulations, but it may choose to include relevant climate disclosure in its regulation.

Whether a company is bound by a mandatory cap-and-trade regulation, subject to a carbon tax, or whether it uses carbon offsets, more and more companies will incorporate the price of carbon into decisions about the way they operate and invest for the future.

RBC Global Asset Management’s head of global equities, Habib Subjally, observes that, in his experience, companies that understand how they may be exposed to or affected by climate change and have planned to deal with or take advantage of that exposure (or with other ESG issues) are usually better managed in most other respects and are superior creators of long-term value for their shareholders.

We suggest that there are two useful paths for investors. They could seek to manage risk by developing an understanding of how individual companies in a portfolio may be exposed to carbon pricing or climate change in general. It should be possible through stock selection and diversification to manage the associated risks down to acceptable levels.

In almost every sector, US companies using an internal carbon price, including Microsoft and Mars, say it helps them to drive low-carbon investment, energy efficiency, and seize low carbon opportunities. In almost every sector of the equity market, companies that develop solutions to reduce carbon emissions or in some other way enable other businesses or consumers to mitigate this issue are likely to emerge.

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