New horizons: Carbon pricing

Today, more than 9,600 of the world’s largest companies, representing 50% of global market value, disclose information on climate change, deforestation and water security through the Carbon Disclosure Project. They do so at the request of 590 investors with $110trn in assets.

The internal pricing of carbon is a risk management tool; government carbon pricing regimes are underway. Carbon pricing provides an understanding of a company’s vulnerability to increasing carbon costs. Carbon pricing is of particular importance for long term investment strategies as it presents a new strategic risk and opportunity. Carbon pricing is also increasingly playing a role in scenario planning, forecasting, sensitivity analyses, and valuations.

Professor Gianfranco Gianfrate, Climate Finance Lead and Professor of Finance at the EDHEC-Risk Institute, says carbon pricing is happening and managers need to prepare.

The Drawdown (TDD): How close are we to really having to consider carbon pricing?

Gianfranco Gianfrate (GG): Short answer; this is happening. It’s not yet standard practice when it comes to modelling but it is gaining momentum in the market.

For example, the US market is probably the most sceptical on ESG and climate, even if most investors and investment banks are speaking about it, it’s still not common practice. However, Biden and Janet Yellen want a national carbon price. In one of Yellen’s first interviews she was fully supportive of carbon pricing.

So for a PE fund that is looking at US companies, and knowing the Biden administration is going to do this, when you prepare the discounted cash flow, you are aware of these risks. If the company is exposed to these risks, if it is a fossil fuel producer or relies on external energy, then when modelling the cashflow you have to take into account a form of carbon pricing.

It no longer depends on a willingness to show off one’s green credentials or because LPs are pushing ESG considerations.

TDD: What’s the difference between carbon pricing and a carbon tax?

GG: The main difference is volatility. Tax is a measure that governments take on the medium horizon, for example $30/tonne, which is unchanged for two or three years. Whereas carbon capture systems change; it is a market. In terms of modelling - if you are an analyst - it is easier to work with carbon tax because it’s more stable.

TDD: What’s your advice for private equity CFOs?

GG: There is another channel becoming more urgent for CFOs; this is that central banks are incorporating these elements into their policies. The European Central Bank and The Bank of England are far ahead in their thinking, including the greenness of assets, for securities, or the supervision of banks. For example BOE has already implemented a new regulation whereby every bank board includes a member responsible for looking at climate risks. This will impact the cost of capital.

For the CFO, it’s not just what price to pay for a company, you also need to think about what kind of interest rate is going to be applied depending on the greenness of the asset. The question is: what is the rate of interest going to be for future investments? And am I climate resilient? Am I ready?

TDD: How can private equity firms answer these questions?

GG: There are two things to consider. First, to what extent the portfolio company is exposed to climate risk? Is it in the energy industry with direct exposure to fossil fuels, or where is the company purchasing the energy?

The second question is harder: what are the future possible scenarios to consider - this is risk management practice: there are scenarios for the interest rates and for the exchange rates, and now there are scenarios for the cost of carbon as well. The CFO probably needs to work on those scenarios and think of hedging strategies. Carbon is already emerging as a cost and sometimes as a revenue on income statements; if the price per tonne increases, what is the impact on the cashflow?

TDD: What about carbon credits as an offsetting or hedging strategy?

GG: Yes, this makes sense in certain industries such as aviation. But there is some concern around offsetting as there is not very much transparency. There are not many certifications for the entity purchasing the offsetting security - this market is very much in its infancy.

Mark Carney recently put out a whitepaper on how it could work, but it’s not there yet. For now, it’s not a structured market, nothing is standardised, no audits, no verification. Companies are mentioning it in their company reports, but for now it’s more wishful thinking.