An excellent article at the HBR by Robert Eccles and John Mulliken on the necessity to consider a “shadow carbon pricing” when making investment decisions. This is especially true for developing countries like Ukraine where energy prices are subsidised and therefore distort investment decisions with the long-term implications.
Through some combination of government intervention and the development of carbon trading markets, it seems inevitable that a price will eventually be put on carbon around the world. Underscoring this, a carbon price has been proposed as part of several bills before Congress, but other mechanisms like a cap on emissions in a sector or geography would achieve the same effect. Economic models and the experience of the EU Emissions Trading System suggests that a price could likely be between $50 and $100 per ton of CO2 in the near term and rise from there. At $100 per ton that would represent five percent of the global economy. Five percent of the global economy is a huge number. But where does this liability sit? With the world’s corporations.
A sad joke for corporate climate activists is that acting on climate plans is always “the next CEO’s job.” But every company has an uncovered “Carbon Short” position based on their emissions, and it needs to recognize this hidden liability today. This short position arises from the carbon emissions produced by their own operations (Scope 1 and 2, in the argot of climate accounting), and their products and services (Scope 3). Most companies don’t recognize this liability because these emissions are priced at zero today, were priced at zero last year, and so it seems natural to assume that they will be priced at zero in the future. One could say that companies are engaging in the carbon futures market, assuming that this fundamental “input cost” will never change. Anyone who works in commodity markets knows that uncovered positions can turn from profit to significant loss in the blink of an eye.
As Nicholas Kukrika, Partner at Generation Investment Management, puts it, “Companies need to manage their carbon exposure, and there is just about enough time if companies start mitigating these risks today. Corporate executives might be tempted to wait for ‘cheaper technologies’ to come, but there are projects that make perfect economic sense even at today’s relatively low carbon prices.”
To see the implications for one company, consider the example of ExxonMobil. The company recently had three board members replaced by a small activist investor, Engine No. 1, as a result of its failure to recognize that the energy transition requires some fundamental changes in its strategy and capital allocation decisions. Why were investors so incensed? In 2020 ExxonMobil released 112 million metric tons of CO2 “equivalent” (along with carbon, they also released other greenhouse gasses such as methane). At $100/ton, they would owe $11B annually on their own emissions. Since the company has earned only $8 billion on average over the past five years, this means they would rapidly be bankrupt. That surely is a good way to finally get the attention of their board. Add in the company’s share of the annual $60 billion from pricing the roughly 600 million metric tons of its Scope 3 emissions (it’s not clear how much they could pass on to purchasers) and the situation is even more dire.
Some companies, however, are already choosing to act now. Take Ryanair, the European low-cost airline. Like all airlines, Ryanair is an “existential emitter,” meaning that there is no readily available substitute to fossil fuels that they use to conduct their core business of flying passengers. Listen to their FY2021 earnings call on May 17, 2021, and you’ll hear a vision of the future. The carbon they emitted in 2020 cost them €150 million last year. Since that time the EU market price per ton of CO2 emitted has doubled. However, they’ve already purchased CO2 options to hedge that exposure so that it doesn’t reach the ~10% of profit that it might have by one analyst’s estimate.
Ryanair aims to develop a competitive advantage due to their fuel-efficient fleet and focus on operational efficiency. They claim that any passenger who flies with Ryanair instead of a legacy carrier is lowering his or her environmental footprint by 50%. So as the price of carbon rises, they believe they will steal market share through price competition and branding. Group CEO Michael O’Leary said on the earnings call that they aim to “get to zero carbon emissions by 2050 and also to continue to reduce our fuel consumption and make flying with Ryanair ever more green.” They are managing their climate risk as financial risk.
Companies need to start covering their carbon short today and they can do so with these five simple steps:
- Measure the position in carbon terms. Calculate the total emissions and carbon intensity (number of tons per dollar of revenue) of the company’s operations and supply chain. Use the Scope 1, 2, and 3 emissions’ calculations that will likely soon be part of reporting requirements.
- Absent any capital projects, determine if carbon intensity will increase or decrease as revenues increase and model all future emissions.
- Determine a set of prices to use and the timing of putting them into place. A basic approach would be to start with assuming prices of $50 in 2022, $100 in 2024, $200 in 2026, and $300 in 2028. This is one example of a forward price curve; scenario analysis could use several.
- Price the forward emissions by multiplying the forward price by the emissions amount in each year to determine a total annual cost.
- Discount the “carbon cash flows” by using your company’s cost of capital to discount the future carbon prices and determine a total economic impact in today’s dollars.
Based on the total economic impact, the company can assess the set of possible capital projects that will enable it to decide which carbon emissions to avoid now. Some will be pure efficiency projects that make sense with even a low carbon price. Some will be low capital-intensity projects with long lead times which can be started now to ensure that emissions are lower in the future as prices likely rise. Some will be higher capital-intensity projects that can be planned now but only triggered when the timing and level of carbon pricing is clearer. Some companies will choose to use offsets, though these are unsettled and the risks remain substantial.
The price of carbon may be zero in many places today, but it’s unlikely to remain zero for long. Recognizing each company’s carbon short position in a variety of carbon prices is a powerful tool. Following this recipe will drive the attention of management and the board to necessary changes in strategy and capital allocation in the transition to a net-zero world. It will be even more powerful if the company discloses to its investors how it is doing so. This begins by articulating its approach to the five steps above and then describing efficiency and capital expenditure projects. Done right, these steps will lead to a reduction in both carbon intensity and absolute carbon emissions as well as a protection of shareholder value in a decarbonizing world.
This progress each company makes toward managing its “Carbon Short” should be reported on a quarterly basis during the earnings call. Yes, companies must have a long-term plan for covering their carbon short by being net-zero by 2050, but they should provide short-term updates on the risks they face and the progress they’re making on their plan. It’s no longer the next CEO’s job.