The importance of carbon pricing

In the wake of the recent climate change conference (COP26), the enormity of satisfying The Paris agreement – which aims to keep global warming well below 2°C and preferably below the safer limit of 1.5°C - is largely apparent and requires us to tackle key issues like reducing emissions head-on. Climate analysts estimate the world is on track for about 2.4°Cⁱ of warming, with a best case estimate of a 1.8°C temperature rise if countries manage to meet all their 2030 promises, as well as pledges to cut their emissions to net zero by 2050. To reach the 1.5°C goal, the consensus is that reaching it would require global emissions to halve by 2030.

With this in mind, the importance of understanding and grappling with how we can help control or reduce the level of carbon emitted is high. As a result, the conversation around taxing companies on carbon and the associated pricing mechanisms continues to gain pace.

So, what is carbon pricing?

Carbon pricing is the umbrella term used to describe a set of tools that can be used to achieve decarbonisation goals by placing the cost of emissions on the polluters. The aim is to place the price on the emitter to capture and connect the negative externalities created by greenhouse gas (GHG) emissions. An example would be the human health impact and healthcare costs created due to air pollution. Carbon pricing mechanisms can take the form of carbon taxes, emission trading systems (ETS) or carbon offsets, amongst other mechanisms. According to Bernstein analysis, there are roughly 64 carbon pricing initiatives globally (covering only 22% of global emissions)ⁱⁱ. 33 involve carbon taxes and 31 involve emissions trading systems, and these figures continue to increase as countries launch new initiatives. Additionally, experts estimate that a carbon price of $50 - $100/tCO2e is needed by 2030 to meet Paris Agreement goals, whereas the UN Global Compact had already called for businesses to adopt an internal carbon price of at least US$100/tCO2e by 2020.

Carbon pricing mechanisms explained

An ETS is where emitters can trade emissions units to meet their targets with the carbon price being determined by the market. The EU ETS is probably the most well-known system covering 41% of EU emissions. It works by setting a cap on the total amount of allowances which is then reduced over time to incentivise companies to decrease their total emissions. The system allows companies to trade emission allowances to ensure they have enough allowances to cover their annual emissions or roll over to offset future emissions. There is a dual penalty for failing to deliver sufficient permits to cover emissions; a penalty of €110 per permit as well as a requirement to make good on the permit shortfall in the following year. The cap is then reduced over time so that emissions fall by a linear reduction factor which in turn means the annual supply of allowances is reduced every year. The EU ETS is a key tool for reducing GHG emissions cost effectively from power stations and other energy intensive industries such as cement production. The objective of the system is to reduce net GHG emissions by at least 55% by 2030 (compared to 1990 levels).

There are other systems around the world like the two regional systems in the US (RGGI for utilities in Northeastern states and the California Carbon Market) which cover roughly 6% of US emissions. China also initiated a new national emissions trading market in 2021 which will initially cover the power generation industry and then be extended to other industries such as construction, oil, and chemicals. The UK was part of the EU ETS until 2020 and has recently launched a separate UK ETS which started trading in May 2021. The scheme works in a similar fashion to the EU ETS, a cap-and-trade system where a cap is set on the total amount of GHG that can be emitted by certain sectors. These sectors include energy intensive industries, power generation and aviation.

Alternatively, there are voluntary carbon markets. In this case, corporates can buy carbon offsets where prices vary between $3 - $5/tCO2e. There are continuing arguments surrounding offsets given the lack of transparency and quality. High-quality offsets adhere to a strict set of standards, and there are several internationally recognised verification standards including those from the United Nations Framework Convention on Climate Change. The carbon credits come from projects that reduce carbon emissions through reforestation or renewable energy. Once the credits are issued, corporates purchase them and retire the credits, so they can’t be offset against other emissions. The issuance and use of carbon offsets has grown rapidly as they have become a requirement for a credible and science-based net-zero commitment. As demand increases so will the prices and research conducted by UCL and Trove Research shows that this could see carbon credit prices rise to US$20-50/tCO2e by 2030ⁱⁱⁱ.

Many companies use little to no offsets whereas others believe it’s an important part of their climate strategies. Taking Unilever as an example, they believe the focus should be on emissions reduction rather than simply offsetting and will therefore not seek to meet their emissions reduction targets through the purchase and retirement of carbon credits. Conversely, Procter & Gamble have pledged $100m to spend on carbon offsets in a bid to neutralise a portion of their GHG emissions. This highlights the importance of monitoring offsets across companies given how the different use of them as a tool can affect both net zero commitments and decarbonisation strategies.

Another mechanism is an internal ‘shadow price’. An internal shadow carbon price creates a theoretical or assumed cost per tonne of carbon emissions and is often used as a capital allocation tool for firms to make decisions about projects alongside other objectives. Most companies use internal carbon pricing to achieve one or more of three key objectives: driving low carbon investments, driving energy efficiency, and changing internal behaviour. Additionally, some companies will also use it for supplier engagement, by using a shadow price to attach a hypothetical cost of carbon to each ton of CO2 as a way to reveal hidden risks and opportunities. The Carbon Disclosure Project (CDP) estimates the median internal price to be $25/tCO2, and this will look to increase as carbon prices continue to soar. Additionally, CDP’s data from 2020 shows that nearly half of the world’s 500 biggest companies (by market cap) are putting a price on carbon or are planning to do so in the future^iv.

As an example, an internal fee mechanism will impose an internal fee on GHG emissions which can be applied to operational decisions, and revenue from the fee can be used to establish a low-carbon fund or be redistributed. An example of this is Microsoft, who use a company-wide internal carbon fee set at $15 a metric ton, to fund carbon neutrality through green projects whilst driving accountability with internal stakeholders thereby ultimately taking responsibility for reducing their own carbon footprint. This fee mechanism was also extended in late 2020 to include Scope 3 emissions beginning at a lower rate of $5 per ton.

Carbon tax, what is it and what’s out there?

Arguably, the simplest system proposed is a carbon tax, where governments levy tax on GHG emissions directly on companies or the emitter. A carbon tax fixes the price rather than the quantity of emission reduction and as a result carbon taxes are easier to administer. Current carbon taxes operating across the world vary widely from between $1/t to $133/t. Notably, the High- Level Commission on Carbon Prices estimated that the carbon price needed to be at least $40-80/tCO2 by 2020 and $50-$100/tCO2 by 2030 to reduce emissions in line with the Paris Agreement.

As an example, in 2019 South Africa became the first country in Africa to put a price on carbon. Additionally, Canada had a federal level fossil fuel charge CAN$20/tCO2 in 2019 set to increase by CAN$10 per year to CAN$50 in 2022. A uniform global carbon price delivered through a carbon tax could also be an ideal way to reduce GHG. However, gaining consensus on the price, on what would be a highly politicised issue, will be difficult.

The overall idea of a carbon tax is that it encourages companies to adjust their investment away from intensive technologies and towards greener alternatives. An additional benefit of a carbon tax is that it is somewhat easier to implement and will also help incentivise reduction. However, many sceptics highlight that the actual amount of reduction is not guaranteed unlike a cap-based system. Additionally, ‘carbon leakage’ can also occur whereby the carbon in one jurisdiction could lead to emission increase in another (pollution havens). Finally, another argument is that the companies or emitters would simply pass through the carbon cost to customers through the means of higher prices. Therefore, the true bearer of the cost is the consumer and the company itself has lower incentive to reduce internal inefficiencies and emissions. This is compounded by the current cost of living crisis.

What does that mean for the Evenlode portfolios?

So, what does that mean for the companies we invest in on behalf of our clients? We can already see that many companies are using internal or shadow carbon prices for scenario analysis purposes and this in turn will help drive improved (and hopefully greener) investment and capital allocation decisions. Some are even going as far as modelling the effect of a carbon tax in anticipation of future changes. As an example, LVMH has looked at calculating the financial impact of a carbon tax using its carbon emissions from upstream and downstream transportation for all its business segments, i.e. Maisons. The company has considered several scenarios compatible with a 1.5°C world and this in turn has helped inform their process, create realistic emissions reduction goals as well as show the impact a carbon tax may have. We view this sort of analysis as incrementally positive in terms of the company making sure they are prepared for and target both positive and negative outcomes relating to carbon emissions reduction and related pricing mechanisms. As far as our analysis goes, we don’t know yet how this could affect the companies we invest in. As a result, we will be running a project in the coming year after our annual carbon emissions analysis to see how a carbon tax would affect the companies we invest in and hence the Evenlode portfolios as a whole. This sort of analysis is in our view, extremely valuable for not just us and our clients but also in terms of the feedback we can provide to our investee companies.

Bethan Rose, Stewardship Analyst
2021

Please note, these views represent the opinions of the Evenlode Team as of 2021 and do not constitute investment advice. Where opinions are expressed, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This document is not intended as a recommendation to invest in any particular asset class, security or strategy. The information provided is for illustrative purposes only and should not be relied upon as a recommendation to buy or sell securities. Every effort is taken to ensure the accuracy of the data in this document, but no warranties are given.