Since my last piece on carbon pricing, significant changes have occurred, highlighting the growing importance of carbon pricing mechanisms and policies globally.
To update on recent shifts in the market, as of 31 March, 2023, Uruguay has held the highest carbon tax rate worldwide, with a charge of $155.87 US dollars per metric ton of CO2i. The carbon tax in the country was first established in January 2022 however, while Uruguay currently has the highest carbon tax, it’s important to consider the variations in tax coverage from one country to another. In the case of Uruguay, their carbon tax only applies to gasoline. In contrast, a country like Singapore utilises a carbon tax of SGD5/$4 but this covers 80% of their national greenhouse house (GHG) emissions, vastly different to that of Uruguay.
Further, Singapore is set to raise its carbon tax to SGD25/$20 starting in 2023, with the goal of reaching SGD50/$40 to SGD80/$60 by 2030. Liechtenstein is also a good example of a country which maintains a robust carbon tax rate of $130, covering a significant 81% of their GHG emissions. This indicates that while a higher carbon price is beneficial, it is equally important to consider the proportion of a country’s emissions covered by the carbon price.
It is generally accepted that carbon prices need to grow over the long-term, to drive investments at the necessary scale and pace. To keep global warming below 2C degrees the consensus suggests that prices must reach $50/tCO2 to $100/tCO2 by 2030.ii
As of April 2023, less than 5% of global GHG emissions were covered by a direct carbon price equal to or higher than the suggested range for 2023 (USD value). Although globally there are currently 73 carbon taxes or Emission Trading Systems (ETS) currently in operation.
Total carbon revenues from ETS and taxes saw a 10% increase in 2022, reaching €95bn, with ETS revenues in the EU alone amounting to $42bn in 2022. This increase can be attributed, in part, to higher prices.
In terms of how governments spend carbon revenues, it is estimated that on average 46% of revenues are allocated to specific policies, 29% to the general budget, 10% to direct transfers and 9% to tax reductions.iii
Revenue allocation
National and sub-national governments continue to implement direct carbon pricing instruments with several policy design specifications, reflecting different political and institutional standpoints. Governments also continue to apply indirect carbon pricing through excise taxes on fossil fuels and subsidies worth more than $1 trillion annually. These measures impact the underlying incentive, even though they are not primarily adopted as climate change mitigation policies. Additionally, fossil fuel subsidies still exist in many countries, impeding efforts to tax carbon emissions.
This complexity of tracking carbon pricing trends highlights the importance of understanding the interaction between direct and indirect pricing mechanisms to achieve wider climate and policy objectives.
The collected revenues from carbon taxes and ETS systems are used in various ways. According to data collected by the Institute of Climate Economics, approximately 40% of revenues from carbon taxes and ETSs were earmarked for dedicated purposes in particular green spending and 10% for direct transfers to vulnerable households and firms. Most revenues from indirect carbon price systems (fuel excise taxes) are not set aside for specific purposesiv. New research from the OECD indicates there is greater public support for climate policy, including ETSs and carbon taxes, only if the revenues are used to fund green infrastructure and low-carbon technologies or redistributed to low-income households or those most affected by the policy.
The carbon taxes that currently exist in the UK only contributed 5.3% (£47.4bn) of total tax revenue in 2022. Since 2002, there has been a 7.7% decline in revenue, mainly because of the lack of direct carbon taxes. Most carbon taxes are implemented implicitly, based on activities like fuel usage rather than being directly linked to emission levels. Approximately 75% of the revenue from environmental taxes comes from fuel duty and energy taxes, while the remainder is derived from other transport taxes (such as vehicle registration tax) and taxes on non-carbon related pollution (including landfill taxes or fishing licenses)v.
It is difficult to create a uniform carbon pricing model across industries due to their own unique characteristics and supply chains. The emissions levels are extremely varied for a company operating in the Consumer Staples industry versus a services-based industry. Creating a consensus will be challenging. Carbon pricing across sectors will be more effective if it is accompanied by complementary government policies that create some common ground. UK government allocated £5.5bn to its core net zero spending for 2022/23 which was less than the amount raised by the UK ETS in the same period. The current political sentiment towards carbon taxes could also further threaten the level of spending in the UKvi.
Evenlode portfolios
We looked at the ten highest emitters across the Evenlode portfolios to test the financial impact of a uniform carbon price. We also looked at which carbon pricing mechanisms companies are currently exposed to. Procter & Gamble’s (P&G) operations are regulated by three carbon pricing systems. The California Cap-and-Trade (CaT) ETS, the EU ETS and the UK ETS. The California model is a cap-and-trade system which applies to emissions that cover approximately 80% of the state’s GHG emissions. The EU ETS is a well-established emissions trading system, and the UK ETS replaced the UK’s participation in the EU ETS in 2021.
For P&G 14.6%, of scope 1 emissions (314,364 t/CO2) are covered by the CaT ETS , 1.5% (13,922 t/CO2) by the UK ETS and only 0.4% (8,922 t/CO2) are covered by the EU ETS. Their strategy is to purchase enough allowances, to match their annual compliance obligations.
P&G has also set an internal carbon (shadow) price, which covers scope 1,2 and 3 emissions (including upstream emissions, i.e. purchased goods and services and capital goods). They have aligned this with the cost of allowances within the EU ETS. The price ranges from $8 to $110 a tonne.
Rounding up the information
Eight out of the top ten companies are already exposed to some kind of carbon pricing mechanism, usually in the form of an ETS. However, it often only covers a small portion of scope 1 emissions with the occasional inclusion of scope 2 emissions. For pricing mechanisms to fulfil their intended purpose, they must cover a larger proportion of company emissions.
On a positive note, if you look at the generally accepted carbon price range needed of $50 - $100, six of the eleven of the highest emitting companies are using an internal shadow carbon price of at least $50 or more. This highlights the readiness of a carbon pricing regulation being imposed on certain companies. The risks are higher for companies not currently utilising a shadow carbon price, necessitating closer monitoring and a more targeted engagement strategy. Such companies may find themselves financially unprepared for the implementation of a mandatory carbon tax.
Uniform global carbon tax
Using our most recent carbon emissions analysis, we took the top ten emitters, on an absolute basis.
We used their emissions data for scope 1, 2 and scope 3 upstream to calculate what the financial impact of a carbon price at £50, £75, and £100. This is roughly in line with the general consensus in the scientific community of needing a carbon price of between $50 - $100 by 2030 (currency considered). We have used pounds given our funds’ denomination and the report of our portfolios’ emissions intensity. As a result, any calculations relating to revenue have been converted using the appropriate exchange rate.
We then calculated the proportion of revenue which would be taxed and how it would affect the operating income and margins (i.e. the bottom line) of the most emission intensive holdings in our portfolio(s). What would this mean for the consumer? Will the costs be merely transferred to the user of the product? Additionally, larger companies often incur other significant costs that demand greater attention, such as employee expenses.
What are the initial outcomes?
If P&G’s scope 1 emissions were taxed at £50 per tonne of CO2 this would amount to £112m, and for scope 2 this would cost £7.8m. Worth noting that scope 2 emissions are generally the lowest for companies, this is because the category is measuring just the electricity or energy they buy for heating or cooling and often organisations can purchase renewable sources of energy. Finally, if you were to calculate scope 3 upstream emissions, this would equal approximately £1bn. This sounds like a lot in practice, however, if you look at the carbon liability as a proportion of revenue, it’s only 2.14%. For operating income, it is considerably higher at 7.89%. This is not insignificant. If a carbon tax was imposed tomorrow, this would mean a $7bn hit to operating income, in total, up until 2030. The cost of inaction in P&G’s case is much higher than the cost of action.
This is at a carbon price of £50 per tonne which is at the lower end of our assumptions. Currently P&G are using an internal shadow carbon price of between $8 - $110. Through their reporting, it is unclear how this works in practice. If we were to use a carbon price of £100, this would be a liability of just shy of £240 million for scope 1 and 2 emissions and just over £2.1bn for scope 3 upstream emissions. That’s a total liability of 4.32% as a proportion of revenue, and 15.78% as a proportion of operating income.
The complexity of taxing scope 3 emissions makes the proposed P&G scenario unlikely, but it highlights the significant financial liability that could be imposed on the company.
Taking a deeper look
We also looked at the different ranges of internal prices that the companies set and what the difference in liability would be in practice.
So, as an example, P&G uses a carbon price of between $8 (£6.57) and $100 (£90). That would mean that for scope 1, 2 and upstream scope 3 emissions the liability could range from anywhere between circa £156.5m to £2.15bn. For context, that is a liability of anywhere between 0.28% of revenue (or 1% of operating profit) and 4% of revenue (14% of operating profit). It’s an even bigger issue for Henkel, who use an internal carbon price range of between €1 - €118 which if applied across all scopes would create a liability of anywhere between £11.2m to £1.32bn. Again, that could create a revenue liability of 7.9% or 71% of operating profit. This scenario could negatively affect the company’s investment case.
These carbon prices, presently serving as theoretical internal shadow prices, guide capital allocation decisions; however, if these prices were implemented, the financial liabilities on the company could be significant.
What are the experts saying?
Planet Tracker’s Climate Transition Fast Moving Consumer Goods (FMCG) report studied the financial implications of a carbon tax being imposed on Unilever, Colgate and P&G’s scope 1, 2 and 3 emissions. Planet Tracker estimated that by 2030 Unilever could face an annual cost increase of $1bn, and P&G up to $6.7bn based on future predictions. This was calculating only the upstream scope 3 emissions.
For Unilever, they used an implied cost of carbon at $58 per tCO2e by 2030. They will need to reduce 32.4m tons of CO2e by 2030. This is only if you calculate scope 3 emissions. If using an absorption ratio of 80%, the financial impact would be £1.5bn or 14% of Unilever’s annual operating income (averaged between 2020 – 2022). It is unclear exactly what the research means by absorption ratio, but we have assumed this means the cost the company would be able to take before incurring the extra financial impact. For P&G they used an implied cost of carbon at $62. They will need to reduce 135.3m tons of CO2e by 2030. This would result in a financial impact of $6.7bn or 51% of annual operating income (averaged between 2017-2021). They appear to be forecasting future emissions, applying a price, and estimating the annual cost relative to today’s (last 5 years) operating income. While this is an estimate, it provides an upper bound on the potential trajectory of carbon pricing liabilities.
This demonstrates the various methods available for conducting a carbon pricing scenario analysis. Nevertheless, the overarching message is clear: the potential future carbon cost or liability could be significant and should not be underestimated.
Revenue, margin, pass through
In the absence of a co-ordinated approach, businesses subject to carbon prices could be at risk of being undercut by competitors which are operating in countries with fewer environmental regulations and could be tempted to move production abroad. This effect is known as ‘carbon leakage’.
Firms can determine the extent to which they wish to pass the costs onto their customer base. Consequently, if the costs are absorbed upstream, incentives to change consumer behaviour are diminished. The costs passed on are difficult to determine as certain industries included in the EU ETS do not pass on significant costs with their final product. This can partly be explained by concerns around competitiveness and maximising market share. Passing on carbon prices and other related costs could also have an impact on labour costs as taxes often play a larger role in determining product pricevii.
Separately, if not carefully designed, a carbon price tax can hit lower income households disproportionately because spending on carbon intensive goods such as heating, and transport is a larger proportion of their expenses. They may be unable to afford the upfront investment in lower carbon alternatives, like home insulation or electric vehicles.
How are companies responding?
Carbon offsetting gets discussed a lot in conjunction with carbon pricing. There are lots of different versions including carbon compensation credits and carbon removal credits (neutralisation). Carbon offsetting does have a part to pay in the transition especially for hard to abate sectors. Some companies have indicated that they will not use emissions offsets as part of their transition plan, while others will.
According to research by Trove Research and University College London, by 2030 carbon credits are projected to cost between $20 - $50 per tonne of carbon. They can currently cost anywhere between $1 - $100 per tonne. It may be tempting for companies to pay the lowest possible carbon price for an offset but in reality, companies need to be paying for the high-quality offsets so that they can continue to operate. It is worth noting as per my previous piece on carbon pricing that a higher price for offsetting also doesn’t necessarily mean higher quality.
What investments in climate mitigation are being made?
Unilever have a €1bn Climate & Nature fund. They note in their annual report that natural climate solutions could provide up to 37% of emissions reductions the world needs by 2030. The fund invests in projects that positively address climate change and protect nature through protection and regeneration. Unilever has stated that some projects might generate carbon credits, supporting claims of carbon neutrality for consumers. However, this occurs in addition to, not as a means of, achieving emissions reduction - a crucial distinction.
Unilever make it very clear that credible net zero strategies must lead with science-based emissions reductions pathways, complemented with carbon removals when all feasible reductions have been implemented. This is a statement that all firms should be leading with. It’s not an either/or question. Companies must be reducing emissions whilst also investing in carbon sink projects.
P&G have partnered with Conservation International and the World Wildlife Fund (WWF) to identify and fund a range of projects designed to protect and restore ecosystems. One example is their Philippines Palawan Protection Project with Conservation International which aims to protect and restore Palawan’s mangroves. They are going beyond their targets of reducing scope 1 and 2 emissions by 50% by 2030, by also advancing a portfolio of climate solutions that will deliver a carbon benefit equal to any scope 1 and 2 emissions they have emitted between 2020 and 2030. This would amount to 30 million metric tons of carbon.
Engagement
An important outcome of the analysis will be a more targeted engagement strategy towards the most emission intensive holdings in the portfolio. As an example, P&G are currently using a carbon price of between $8 - $100 which could result in a carbon liability of billions of dollars over the next couple of years. The potential financial liability will be discussed with the management team to better understand the severity of the risk. Companies need to be adequately accounting for carbon when making financial planning decisions and consequently their long-term GHG emissions reduction targets. This aligns well with the Net Zero Investment Framework which we strongly advocate for in our long-term net zero transition strategy. This would mean companies can reach their carbon reduction targets and that the capital is being funnelled in the right direction.
Looking forward we will continue to monitor the portfolios’ emission intensity as well as any carbon pricing mechanisms that they may be subject to. We will continue to assess whether companies are aligning their future capital expenditures with their long-term GHG emission reduction targets. Additionally, we will focus on companies that are openly committing to investments in climate solutions and demonstrating their potential to become part of the solution.
Bethan Rose, Stewardship Analyst
2023
Please note, these views represent the opinions of the Evenlode Team as of 2023 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.