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The Polluter Pays ― If They Want To

Current carbon-offset arrangements are complex, inefficient and, for most companies, voluntary. Companies should start preparing now for a tougher regime.

We all know where we need to get to. Net zero. Over the past two years only COVID-19 has pushed aside these two words as the most pressing item on the global agenda. It is extraordinary that it is only couple of years ago that Theresa May was the first leader of a leading economy to commit to net zero by 2050.  Since then over 100 countries, countless cities and great swathes of global market indices have followed her lead. Accurate market data is difficult to come by, particularly given the fast-moving take-up of net zero commitments. However, analysis of our own fund holdings suggests a stark difference by geography, with the EU and its Green Deal leading the way while Asia-Pacific companies bring up the rear.

At whatever level of the economy, be it a country, town or company, what does all this furious net zero target setting actually amount to? Beyond sounding good, what will it change? Well, if these targets are not joined to another buzz phrase, “the polluter pays”, they won’t do much more than sound good. The evidence for that comes from any passing acquaintance with human nature and what is currently happening at the company level.  Yes, target setting is a good thing; it may be something that companies aspire to, a dream in effect. In the words of a head of investor relations I talk to: “Without a dream, Columbus would never have set sail nor Neil Armstrong stepped onto the moon”.

Targets lead to action, but there is nothing quite like a rising bill to hurry that action along. A simple global carbon tax would be ideal, but also unrealistic. In the absence of such simplicity, governments around the world have chosen complexity in the form of emission trading schemes (ETSs), the most venerable and until recently the largest of which is at Britain’s doorstep, the EU ETS. To date this is the best attempt at making sure that the polluter pays.

It works like this. The EU ETS covers industries – such as power generation, steel, paper and commercial flights within the EU – that collectively produce around 40% of the EU’s greenhouse gas emissions (GHG). When the EU ETS started 16 years ago, companies or industrial sites within the EU ETS were granted allowances under a cap and trade system whereby they could emit GHG up to a certain level. If they went beyond this level, they were committed to purchasing allowances, called carbon credits, from other companies in the EU ETS. They were therefore incentivised to reduce emissions in order to make money by selling their surplus carbon credits. Over the years a couple of things have changed: first, the proportion of free allowances has declined and been replaced by auctions. Secondly, as can be seen in chart 2, the price has considerably increased.  The pressure is on.

The trouble is that for most companies which have made net zero commitments, this rising carbon credit price is irrelevant because they are not participants in the EU ETS. For most companies, the polluter need only pay if they want to and, unsurprisingly, not many take up that offer. This brings us to a different and growing carbon credit market; not the regulated market of the ETS sprinkled around the world but the voluntary carbon market.

As I said, and as the name implies here, the polluter can choose to pay. The only ones who are currently choosing to pay are businesses that emit next to no carbon in the first place, for whom the bill to offset their mouse-sized emissions is tiny compared to the benefit they can gain by broadcasting to the world that they are  a “carbon neutral company”.

Real polluters, those that create inverted mountains by digging up copper from the bowels of the earth, are very coy about paying up for voluntary carbon offsets. Plans to purchase these are parked at the end of a multiple decade-long process of reducing their emissions. These credits will only be bought when they can literally do no more to reduce their own emissions. As things stand, and if they are not compelled to, that is 20 to 30 years away. So how does this voluntary carbon credit market work?

In the voluntary market a company seeking to offset its GHG emissions funds projects to reduce them. This offsetting comes in two flavours; GHG avoidance (typically investing in renewable energy) or GHG removal (reforestation, carbon capture technology). For example, an IT service company wishing to offset its carbon footprint may ask a consultant to recommend and run an offsetting project, such as funding solar powered cookers in developing countries to replace wood burning stoves. The consultant will select and run the project and have it accredited by an external body (the most well-known are Gold Standard and Verra), who will verify the GHG emissions avoided or sequestered. The value of such avoided or sequestered carbon makes up the carbon credit, the price of which depends on the demand for offsetting.

Now accrediting bodies will also certify carbon offset projects in the regulated market which are then auctioned off. The Clean Development Mechanism (CDM), a United Nations-run carbon offset scheme that enables countries to fund GHG-reducing projects in other countries and claim the saved emissions, has, until the last few years, been the largest certifier of carbon credits. But there ends the similarity with the voluntary market. Apart from the lack of compulsion, the real difference is the price of a carbon credit on both markets. Graph 2 shows that the EU ETS carbon credit price currently stands in the mid-US€50s. In the voluntary carbon credit market you can find carbon credits as cheap as US$2-3 per ton of CO2 avoided or sequestered[1].

If you combine low prices and no compulsion, this voluntary market seems to have few redeeming features. This, though, would be harsh. The number of such credits has grown rapidly in size over the past five years as companies the world over seek to burnish their ESG credentials. They are funding real projects that make real reductions in C02. They also have much better accrediting bodies, with Verra and Gold Standard being seen as far more credible than the accrediting bodies linked to ETS schemes. In ETS schemes, projects that would have gone ahead anyway may be approved, making a nonsense of the whole point of carbon credits which is to fund additional investments in carbon removal.

Is it feasible for this strange situation to persist, with some industries being compelled to pay for their pollution while others only need to pay if they so choose? It would seem heroically complacent to think so. And a growing number of companies are not showing such complacency. According to a World Bank study[2] published in 2020 (based on 2019 data), 1,600 companies worldwide had set an internal carbon price to help with budgeting. That number must have grown considerably since then. For many know that these shadow budgeted costs could easily become real ones that reduce profits. It’s best to be ready.

Take for example the EU ETS, which is undergoing a revamp that includes a tussle over who will fund its expansion to cover more sectors, including as autos and property. If their inclusion in the EU ETS leads to the cost of CO2 pollution being passed onto owners of older, more polluting vehicles and those in rented accommodation who can’t afford to upgrade their heating systems, then it will be as regressive as it will be unfair. Macron, for one, has no desire for a re-run of the “Gilets Jaunes” mayhem he had to endure when he upped green taxes.

But still, everyone knows that with every passing year carbon continues to be pumped into the atmosphere and that the simplest way to reverse that trend is to price pollution correctly. We need a price and we need a payer.  Net zero targets on their own are all well and good, but if the low prices of voluntary carbon credits are anything to go by, net zero will be little more than a catchphrase.

Companies know this. The mushrooming use of internal carbon prices suggests they know that the luxury of choosing whether to pay for their pollution may be taken away. Someone has to pay. It’s best to be prepared in case it’s you.

[1] Source: ClimateTrade, https://climatetrade.com/marketplace/

[2] Source: The World Bank,  “State and Trends of Carbon Pricing 2020”   https://openknowledge.worldbank.org/handle/10986/33809

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CLI01904
Expiry on 17/06/2022