Analyst, Governance and Sustainable Investment
- Tightening regulatory requirements paired with changing stakeholder expectations are altering the competitive environment of carbon intensive companies.
- We examined how companies in carbon intensive sectors have assessed the impacts of climate policies on their business and how these impacts are translated into corporate greenhouse gas (GHG) mitigation strategies.
- Our engagement identified significant discrepancies among company practices. This was particularly the case with regards to scenario planning and the use of mechanisms to incentivize energy efficiency strategies.
The past two years have witnessed a historic step forward in taking global action on climate change. In December 2015, the leaders of 195 countries adopted the first-ever universal, legally binding global climate agreement at the Conference of Parties (COP)21 climate change summit in Paris to keep the global average temperature increase to well below two degrees Celsius (2°C) and to pursue efforts to hold the increase to 1.5°C. Over the course of 2016, several major economies, including China, the U.S. and E.U., have ratified the agreement. For the agreement to enter into force, 55 parties needed to ratify it. The threshold was surpassed and the agreement entered in force in early October this year, a month before the COP22 summit in Marrakech.
For the corporate sector, this policy change comes with growing pressure to address and disclose climate change management strategies and related metrics, as well as action to help nation’s meet the carbon reduction targets reflected in Nationally Determined Contributions (NDCs). In this context, carbon pricing schemes and Emission Trading Schemes (ETS) in particular are gaining traction as the preferred policy instrument for many governments. At the time of writing, about 40 national jurisdictions and over 20 cities, states, and regions are putting a price on carbon. This translates to a total coverage of about 13% of global GHG emissions. These numbers are expected to increase, with 101 countries accounting for 58% of global GHG emissions considering the use of carbon pricing, according to a recent survey conducted on behalf of the World Bank.1
Most ETS currently being implemented focus on the most energy intensive sectors such as power generation and industrial plants (in the EU, ETS also include airlines). For companies operating in these sectors, the inclusion under ETS directly increases operational costs and, therefore, impacts profitability and shareholder value.
The cost aspect constitutes the key driver for the corporate sector to meet carbon reduction goals in a cost efficient way, either by trading emission allowances or investing in carbon reduction strategies. However, it becomes increasingly evident that this aspect also triggers unintended, but foreseeable side effects, such as “carbon leakage,” i.e. the possibility that carbon intensive companies move part of their production to countries with less stringent climate measures, as this becomes economically viable. Steel, construction materials and chemical companies—the focus group of this engagement project—are potentially all exposed to carbon leakage.
We believe that a global carbon market, which facilitates cross border trading of carbon allowances and covers a critical mass of relevant markets (>80%) would largely eliminate the incentive to relocate carbon intensive business segments. Such a market allows those who have the financial responsibility for reducing emissions to purchase emission reductions wherever this is most cost-effective. In particular, it would eliminate the allocation of free allowances to sectors deemed to be exposed to a risk of carbon leakage. This has been proven to harm the efficiency of the EU ETS to an extent that it even provided significant windfall profits to certain cement and steel companies, including Lafarge (€37 million of sales in 2014) and ArcelorMittal (surplus of 7 million European Emissions Allowance (EUA) in 2015, worth around €40 million at current prices). While Article 6 of the Paris Agreement provides the basis for facilitating international recognition of cooperative carbon pricing, the political hurdles, including the recent U.S. election outcome, are likely to be too high to expect an agreement in the near future.
For carbon intensive companies to better assess and understand the economics of climate change, it is vital to assess and compare different adaptation strategies and their economic viability under different policy scenarios. Issues to consider include the pace of technological innovations, demand pressure stemming from product substitution and cost pressure due to carbon pricing. It is becoming increasingly important for Corporates to consider these aspects in conjunction with current and expected carbon pricing liabilities.
Our engagement targeted steel, construction materials and chemical companies worldwide. While we believe that key risk drivers and corresponding best practice management standards are equally applicable among companies operating in all three sectors, our engagement also considered sector specific aspects, including opportunities. Biofuels used by cement and steel companies to replace fossil fuels in the production process for example, constitute an opportunity for chemical companies such as Novozymes, who specialize in the development and production of these substitutes.
Our project followed a two-step approach. In Phase 1, we contacted companies with relatively strong GHG management programs, substantiated with quantifiable improvements of key carbon metrics in recent years. In Phase 2, we reached out to lagging companies to express our concerns and requested the company assess its climate change approach and practices against those of more advanced peers we identified in the first phase. Advanced practices include:
- Board oversight: Dedicated board resources and expertise on climate change economics and effective oversight to ensure that business models are resilient to rapid energy transition pathways.
- Scenario planning: The use of scenario planning to understand how the likely direction and speed of an energy transition, as reflected in the COP21 agreement and national carbon reduction commitments, will impact future profits and shareholder value.
- Emission reduction targets: Defining suitable long-term reduction goals in line with anticipated regulatory requirements, market trends as well as overarching corporate climate commitments.
- Mitigation strategies: Group-wide mechanisms to incentivize energy efficiency strategies, underpinned by a carbon shadow price is one example. The implementation of a carbon shadow price helps to prepare for the impact of tightening regulatory requirements on operations or the company’s value chain as well as to align incentives to meet the company’s GHG reduction targets. We also encourage companies to allocate and report on dedicated research and development expenditures for low-carbon solutions along the product life-cycle.
- Transparency and commitment: Public disclosure of detailed information on the management of carbon related risks, opportunities and metrics. We also encourage companies to have the systems and processes in place to monitor and respond to tightening carbon reporting requirements.
Following our initial outreach to 64 companies, we had comprehensive engagement with 19 and received written responses from an additional 18.
Generally, our engagement revealed that climate change related issues receive significant management attention across these companies, which is unsurprising given the carbon intensity of their operations. Out of the 37 companies we engaged, no fewer than 30 (81%) had direct or indirect (through sub-committees) board responsibility for climate change. Also, most carbon intensive companies transparently disclose their Scope 1 and 2 carbon emissions (97%) and set emission reduction targets and deadlines (82%), albeit with varying quality.
Larger performance dispersion is evident in relation to the target setting process, as well as the underlying considerations and assumptions used. Only a few companies have compelling rationales and even fewer consider climate change scenarios—such as a 2°C pathway—when setting the magnitude of these targets. Finally, only a few use a science-based approach to target setting.
With regards to scenario planning and the use of mechanisms to incentivize energy efficiency strategies we see widespread discrepancies among company practices. While an increasing number of companies are starting to use carbon pricing to factor in the cost of carbon in their capital expenditure (CAPEX) and operational expenditure, we note that the proportion of companies is still relatively small compared to other carbon intensive sectors such as oil and gas and utilities (see chart).
CRH – Best practice example
CRH is considered a leading construction materials company in terms of carbon management and is recognized for its strong carbon metrics. Our engagement with the company largely confirms this view. Unlike many of its peers, the Irish company’s carbon management strategy considers both tightening regulatory requirements, reflected in the NDCs submitted by countries as part of the COP21 Paris Climate Agreement, and the broader Sustainable Development Goals. The company aligns its carbon reduction targets with these standards and conducts sensitivity analysis to stress test its business model against different climate scenarios. In terms of emission reduction, the company collaborates with different industry bodies in order to research and develop mitigation strategies which help the company meet its carbon reduction target to reduce emissions by 25% by Financial Year (FY) 2020 relative to FY1990 levels, one of the strictest carbon reduction targets in the construction materials industry.
To assess and prepare for tightening regulatory requirements, companies implement different strategies with varying degree of quality and suitability. Less than one third (27%) of the companies engaged use scenario planning to assess their exposure to various climate change outlooks. Others, such as Voestalpine take a more practical approach and make sure to have the technological solutions on hand to compile with even the most stringent emission reduction targets, once they materialize. Similarly, Vale is developing a so-called marginal abatement cost curve (MACC), which helps the steel company prioritize emission reduction projects. Most carbon intensive companies we engaged, however, follow a more regulatory driven approach. They focus their efforts on monitoring and complying with prevailing regulatory requirements, rather than assessing and preparing for potential tightening of such regimes. Our engagement did not reveal any concrete plans to relocate carbon intensive operations to jurisdictions with less stringent carbon regulation. Companies exposed to carbon leakage, however, signalled they are considering such moves if the financial exposure increases due to tightening regulations and if carbon policy is not harmonized across geographic regions.
From an opportunity perspective, companies appeared to be better prepared to capitalize on the potential stemming from climate change.
Chemical companies in particular develop and market a multitude of products that—compared to conventional alternatives—make a positive contribution to reducing GHG emissions in their applications. Examples of such products include lighter material, catalysts for light and heavy duty vehicles, wind turbines, chemicals needed to produce solar panels and Lithium-ion batteries used in electric vehicles. Also, many construction materials and steel and aluminium companies anticipate changing market trends and devote increasing CAPEX to the development of climate-friendly products that are in line with sustainable mobility or the green building concepts.
Growing cost pressure to comply with climate change related regulation across the globe, coupled with changing stakeholder expectations are altering the competitive environment of carbon intensive companies, and are revealing both opportunities and threats.
For companies in carbon-intensive sectors to better assess and understand the economics of climate change, it is vital to assess and compare different adaptation strategies and their economic viability under different policy scenarios.
Our engagement revealed that compared to their peers in the energy and mining sectors, companies operating in the steel, construction materials and chemicals industry are less advanced in modeling and managing their climate change exposure. Especially with regards to scenario planning and the use of mechanisms to incentivize energy efficiency strategies. We identified widespread discrepancies among company practices, ranging from purely regulatory-driven approaches to forward-looking exposure assessments based on scenario modeling.
We expect engagement around emission management in carbon intensive sectors to grow. We are positive that the increased pressure will help raise the bar and encourage more companies to strengthen their practices and disclosure.
1 World Bank Group “State and Trends of Carbon Pricing” October 2016.