Lex in-depth: how carbon prices will transform industry
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With freak weather, crop failure and forced migration, climate change is imposing ever-higher costs. Governments, businesses and investors are belatedly trying to work out how to impose a proportionate monetary cost on those responsible.
More than ever, that makes putting a price on carbon one of the most important financial questions the world has to answer. Carbon pricing is essential because it creates incentives for decarbonisation, by incorporating the cost of greenhouse gas emissions into the price of goods and services.
The expected level of carbon prices is going up. Energy giant BP is planning for a carbon price of $100 a tonne of CO2 by 2030. It reckons that is what is needed to drive a rapid and sustained fall in carbon emissions. Central bankers are now telling other businesses to do the same. The Bank of England will examine how well banks and insurers would cope in June. Other regulators in Asia and Europe are planning similar climate stress tests.
The $100 price would be more than four times the average figure employed internally by companies using carbon pricing to manage risks and reduce emissions, according to CDP, a non-profit. It is 10 times higher than the 2019 global average of governments’ pricing initiatives.
That carbon prices might reach $100 by 2030 is far from fanciful. The Bank of England last month cited that figure as plausible if efforts to limit temperature rises to 2C above pre-industrial levels proceed in an orderly fashion. The price could go even higher if the transition is abrupt, the bank said.
A $100 price would supercharge investment in low-carbon technologies but it would also cripple businesses that could not adapt or secure government support. About $2.1tn, or 3.7 per cent, might be wiped off the market capitalisations of the 1,000 largest listed companies globally, according to calculations for Lex by consultancy Planetrics, part of Vivid Economics.
The 100 least resilient companies would lose just under half their market value. The best performing 100 would rise by 28 per cent.
Given the stakes around what carbon price is used and how, there are a series of questions that need to be answered. What is the best way to arrive at a good estimate of a carbon price? How should governments go about implementing a price on carbon? What will the impact be on competitiveness? And which companies and sectors are likely to be most affected?
How prices are set
Policymakers have two ways to think about prices. The first considers the carbon price needed to induce changes in behaviour — particularly those driving technology investments — that would deliver on the 2015 Paris accord pledges to keep the global average temperature rise well below 2C. A 2017 World Bank-backed commission chaired by economists Joseph Stiglitz and Nicholas Stern sifted the evidence from numerous models and concluded carbon prices might need to be as high as $100 a tonne by 2030.
Such an approach is inherently uncertain. Even optimists failed to predict a fall in offshore wind power costs of more than 30 per cent in 2019 to a level where it is unlikely to need subsidies. But the alternative approach — putting a monetary value on future environmental damage — is no less sensitive to the assumptions used.
That was illustrated when former US president Donald Trump’s administration revised down the estimated cost to society of putting carbon dioxide in the air. This change was used to justify the repeal of the Obama-era restrictions on the power sector. One difference was that the Trump administration only considered domestic climate damage. That resulted in a social cost of carbon seven times lower than the previous estimate which was based on the global impact.
If all countries took such a narrow approach, just a tenth of the costs of future climate damage would be reflected in carbon prices, according to Kate Ricke of UC San Diego and colleagues. Big emitters are not necessarily the most vulnerable to climate change, with some cold countries receiving offsetting benefits from warmer temperatures.
The discount rate used to convert future costs of climate damage into a present value matters too. Long-term interest rate forecasts have declined, which is likely to prompt President Joe Biden’s administration to adopt a lower rate, weighing future costs more heavily in today’s money. That issue will be examined by a working group re-established by one of the president’s first executive orders. Switching from a 3 per cent discount rate to a 2 per cent rate would increase the “social cost of carbon” — the net present value of the impact of putting an extra tonne of carbon into the atmosphere — from $53 to $125 in 2021 dollars, says Richard Newell, president of environmental economics think-tank Resources for the Future.
The resulting number will be used by the Biden administration for setting fuel economy guidelines and power plant regulations: examples of carbon pricing in its very broadest sense. It would also be relevant for a tax or trading scheme, were one to be adopted, though the rate would probably be much lower.
Winning congressional approval for a tax or trading scheme would be a stretch, although companies are coming round to the idea. The Business Roundtable, representing more than 200 big US businesses, threw its weight behind the suggestion last September. The US Chamber of Commerce announced a similar shift in January.
Implementing carbon pricing
About one-fifth of the world’s emissions are now covered by either carbon taxes or cap-and-trade schemes — where companies can buy and sell emission permits.
A nationwide carbon trading scheme covering China’s power sector, due to launch this year, will be the world’s largest. It will overtake the EU’s emissions trading scheme, though that uses a much higher carbon price and is being expanded to include the maritime sector.
Businesses often prefer trading schemes to taxes. They argue that permits amount to legally-defined property rights, making a strong basis for investment decisions. But politicians often bow to pressure from incumbents to overissue permits, greatly reducing the impact of some such schemes. Critics also dislike the administrative complexity and a lack of certainty over prices. Carbon prices in the EU emissions trading scheme collapsed after the financial crisis, though they recovered to reach record highs of more than €33 a tonne in January.
Conversely, taxes directly impose a price on carbon but do not guarantee the level of resulting emissions. The main disadvantage of such taxes — usually imposed on the transport and energy sectors — is that politicians, subject to enough pressure, sometimes buckle. That makes it hard for businesses to plan. Australia’s 2014 reversal of its carbon levy after an “axe the tax” election campaign is one example. More recently, France’s gilets jaunes protests forced Emmanuel Macron’s government to cancel planned fuel tax rises. It was billed as an environmental policy but seen as a revenue grab.
The IMF has estimated that household electric bills would rise 43 per cent on average over the next decade if carbon was taxed appropriately. Rises would be steeper in countries that rely heavily on coal. A backlash in some places would be likely.
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One way to reduce opposition is by recycling revenues from carbon taxes or the sale of emissions permits in benefits or tax cuts. This concept of “carbon dividends” has attracted bipartisan support in the US, including from Treasury secretary Janet Yellen.
But governments have so far channelled most of the funds they collect from taxes and trading schemes into the general budget or environmental projects. In 2019, little more than a tenth of the $45bn collected from taxes and trading schemes went on tax cuts and direct transfers, according to the World Bank.
The impact on competitiveness
The impact of high carbon prices on business competitiveness is a big stumbling block. Carbon-intensive companies such as steelmakers could be put at a severe disadvantage if their local carbon tariff was higher than that of foreign competitors.
ArcelorMittal intends to cut its emissions in Europe by 30 per cent by 2030, over 2018 levels. Even so, its European carbon costs might come to nearly $6bn, or more than its global 2019 ebitda, if it were subjected to a $100 carbon price. Were foreign competitors exempt, the carbon price would effectively be an export subsidy, encouraging production to switch abroad.
The EU is pushing the idea of a carbon frontier tax or other carbon “border adjustment” mechanism to create a “green level playing field” as it ratchets up the carbon price. “It’s a matter of survival for our industry,” said European Commission climate chief Frans Timmermans in January. The EU hopes to find common ground with Mr Biden, who has said he will impose carbon tariffs or quotas on goods from countries that do not meet their climate obligations.
Some World Trade Organization members have already voiced suspicions that the EU has protectionist economic motives. Blocking carbon-intensive exports from developing countries might spark protests, given they are subject to less stringent emissions curbs under the Paris accord.
Even a border tax set far lower than the European one would be controversial. If, for example, the embedded carbon in China’s exports to the EU was priced at $35 a tonne, that would imply a tariff of about 3 per cent, according to a rough calculation by Lex using OECD data. That would roughly double average tariffs on non-industrial goods.
Decarbonising economies may have egalitarian benefits but the financial impact will not spread equally. Some industries, usually those which are energy intensive, will shoulder heavier cost burdens than others.
In Europe, companies have reported their carbon dioxide emissions annually for some time. At some point they are likely to be forced to recognise the cost of these emissions. That could be a big number for those sectors which have higher emissions: steel, utilities, cement and power.
On the basis of reported emissions one can make a decent estimate of the cost of carbon to specific companies. It enables the calculation of the potential expense (liability) of emissions for industries. Just focusing on the emissions from the 29 largest European companies in the relevant sectors gives an indication of what lies ahead. Their direct and indirect emissions totalled 965 megatons in 2019. At $100 a tonne that equals $96bn, or 45 per cent of total 2019 ebitda.
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Within these sectors, steelmakers such as ArcelorMittal and utilities such as Germany’s RWE have the most to lose. In terms of CO2 intensity per tonne of production, Anglo American is high among steel and mining groups at 7.7 tonnes of CO2, according to Deutsche Bank. Among miners alone, Glencore has the largest footprint for direct and indirect emissions, worth a quarter of 2019 ebitda.
These figures give an indication of what to expect — some of which investors have priced in. Other sectors bear consideration, such as oil refining, basic chemicals and paper. These too have high energy intensity and will too have large carbon liabilities at $100 a tonne. However, their direct costs look unlikely to be proportionally as high as steelmakers and smelters. BASF’s 19.4mt of CO2 translates into just over a fifth of its ebitda earnings.
Winners and losers
In practice, the impact of carbon pricing on companies’ valuations will depend on how far they can pass on the extra costs to customers. For example S&P Global Trucost estimates the cost of the utilities sector’s carbon emissions to be twice its earnings, were the carbon price to rise to $120 by 2030. But less than 40 per cent of the sector’s valuation would be at risk because it could raise prices without suffering a large drop in demand, according to its tool for assessing carbon pricing risk.
Another crucial factor is the availability of low-carbon technologies. In some sectors, such as aviation and agriculture, those are some way off, minimising the impact of the carbon price signal. Ultimately there might be a need to rely on “negative emissions” technologies that remove greenhouse gases from the atmosphere. Those range from cheap-but-controversial forestry schemes to plants that suck carbon dioxide from the air. Costs of such “carbon capture” schemes could fall below $100 a tonne.
Conversely, the power and road transport sectors should be the most responsive to higher carbon prices, as low carbon alternatives have already been developed. Ratcheting up the cost of carbon makes it easier for those technologies to compete on price.
There will be winners and losers within sectors, the Planetrics analysis found. Among the utilities, for example, some coal-based businesses could lose as much as 90 per cent of their value, while renewable specialists might more than double theirs.
Overall the energy sector would be the worst hit with a mean impact of nearly 40 per cent, Planetrics found. It took a bottom up approach to analysing the impact on individual companies of changing prices. The baseline was a business-as-usual forecast expected to lead to more than 3C of warming.
It then drew on central bank scenarios to consider the impact of carbon prices rising to $100 in 2030 and $350 by 2050. Each company’s ability to pass on costs to customers, become more energy efficient and adopt low-carbon technologies was taken into account. The effect on earnings was discounted back to 2021 to calculate the impact on valuations.
Some regions will be more affected by higher carbon prices than others. The companies analysed by Planetrics based in Canada and Australia — both tilted towards extractive industries — declined by an average of over 8 per cent. By contrast those based in the US fell by just over 1 per cent, reflecting the relatively modest impact of high carbon prices on tech companies.
Calculations of this sort are based on the premise that governments will follow through on their promises. Many companies and investors are wary of pre-empting lawmakers’ decisions. Counting on a sharp increase in the carbon price is not without risk. If politicians fail to follow through on their rhetoric, investments may well not pay off. Speculative bubbles are possible.
But the climate crisis cannot be solved without effective carbon pricing. If governments delay, it could well result in higher prices. Making companies bear the full cost of their emissions will have a big impact on their long-term value. If companies and investors fail to factor them into their financial calculations, they are flying blind.
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