The sweeping 1,400-page energy bill passed by the House of Representatives in late June, and now on its way to the Senate, contains the makings of a new asset class for affected companies: carbon emissions allowances. Further, the proposed legislation, dubbed the American Clean Energy and Security Act of 2009, would also create new liabilities for companies that are unable to comply with the new proposed carbon emissions rules.
If the bill becomes law, whether a company winds up on the winning end of the new emissions rules will be a function of how its management tackles the issue of carbon risk. However, one thing is clear: Chief financial officers will be more engaged in energy management than ever before, with the legislation having a direct, and possibly material, affect on corporate financial results.
Emissions allowances are the centerpiece of the bill’s so-called cap-and-trade system for carbon dioxide, the greenhouse gas thought to be most responsible for global climate change. In general, the proposed cap-and-trade system is designed to reduce economy-wide CO2 emissions in the United States by 17% by 2020, and by 83% by 2050, compared to 2005 levels.
To do that, the government will either give away or auction off carbon allowances, which are permits that gives U.S. companies covered by the program the right to emit CO2 into the air. One allowance is the equivalent of one-ton of CO2, and the bill will cap or limit the total amount of allowances released in a year to acheive the overall emissions reduction. As a result, affected companies — big carbon emitters such as utility, chemical, oil and gas, and other large industrial companies — may use the allowances to offset what they spew into the air while running their plants and factories. It is still unclear under what circumstances free allowances will be doled out by the government.
“The Europeans very famously gave away allowances [in the European Union's cap and trade program] and produced a huge windfall to polluters,” says Philip Adams, president of World Energy Solutions, which operates online exchanges for energy commodities. He says Congress will likely scrutinize any free allowance allocations in light of the European giveaway.
Companies that wind up with more carbon allowances than they need because they shuttered older plants, switched to low-carbon electric generation, or ramped up efficiency efforts will have the option to sell excess allowances to companies that have a shortfall. Independent exchanges will be set up to facilitate trading of federal allowances. Currently, several regional exchanges already exist in the United States, based on state mandates and voluntary emissions reduction programs.
One working model for a federal cap-and-trade system is the Regional Greenhouse Gas Initiative, the first mandatory effort in the country to reduce CO2 emissions. The 10 Northeastern and Mid-Atlantic states that belong to RGGI have pledged to reduce CO2 emission from the power sector by 10% by 2018. Currently, RGGI allowances are trading in the $4 to $5 range (see the chart at the end of the article).
For factories and plants that pump out more CO2 annually than they are permitted, owners will be forced pay penalties equal to twice the most recent clearing price for a ton of CO2 emissions, says the bill.
Slated to begin in 2012, the federal cap-and-trade program will likely yield an average market price of $28.24for a ton of CO2, says environmental research and benchmarking firm Trucost. That price could drop depending on supply-and-demand scenarios and the final program rules. Still, by using the Trucost estimate, the average overall carbon cost for S&P 500 companies would total $93 billion, which is more than 1% of the revenue generated by those companies in 2007. That same price point would also depress earnings before interest, taxes, depreciation, and amortization by 5.5% for the S&P 500.
The affect on financial results will likely cause investors to demand more information about carbon-related risk — and regulators may push for the same thing. In March, the U.S. Environmental Protection Agency issued for public comment proposed rules that would require the largest 13,000 facilities that emit greenhouse gasses to measure and report emissions levels starting in 2010. The draft rule would also force suppliers of fossil fuels and industrial greenhouse gasses to do the same, and would requuire car and engine makers to report to EPA the emission rates associated with their products.
Further, according to a recent report by PricewaterhouseCoopers, a securities rule known as Regulation S-K already addresses the disclosure of environmental liabilities, and U.S. generally accepted accounting principles require disclosure of significant risks and uncertainties that could have a material effect on the financial condition of a company.
“As issues surrounding climate change become increasingly material to investors, and therefore, to a company’s value, [the issues] can be expected to have a considerable impact on financial reporting,” notes the PwC report. In addition, as investors’ interests are piqued, it will start a cycle of disclosure, say the authors, Scott Gehsmann and Rob McCeney, partners in PwC’s transactions services group. “As the impact of climate change on financial reporting rise in significance, investors, stakeholders, and regulators will demand greater transparency and comparability of companies’ financial information.”
Companies may also find investors clamoring for disclosures related to carbon intensity — the amount of greenhouse gases emitted by a company relative to the revenue it generates. For S&P 500 companies, carbon intensity ranges from a low of 11 tons of CO2 per $1 million of revenue for insurance companies, to 4.2 billion tons for utilities, according to TruCost.
Other situations may warrant disclosure of carbon-related risks, as well. Companies that rely heavily on carbon-intensive industries and supply chains could be “most exposed to carbon liabilities,” says the Trucost report. For instance, construction and engineering firms may feel the squeeze as cost for building supplies rise — for example, as cement and steel producers pass on the higher cost of goods sold. Meanwhile, direct emitters such as utility, chemical, oil and gas, and metal manufacturers that produce CO2 emissions by fueling combustion and industrial processes may just see profits tumble.
Other companies will watch supply chain costs swell when higher-cost electricity increases the prices of chemicals, packaging, transportation, and outsourced logistics. Service-based and retail organizations will feel the crunch of carbon-related risk too, when they are forced to pay higher electricity bills for real estate holdings and swallow price hikes for business travel expenses.
On a more optimistic note, carbon pricing could create opportunities for low-emission companies in carbon-intensive sectors, says Trucost, adding that “the cost of capital … will likely be influenced by the ability of a company to reduce its carbon intensity and exposure to liabilities under future carbon constraints.”
Nevertheless, materiality may guide many corporate reporting practices. That is, if the overall cost of carbon is low compared to a company’s total revenue or profits, many companies may choose not to disclose much information at all. According to Trucost, 66% of the S&P 500 companies do not publish adequate data on direct emissions from operations — and therefore could be unprepared for mandatory reporting requirements.
For example, disclosure levels among S&P 500 companies are “low” in the travel and leisure and industrial goods and services sectors, says Trucost, given their relatively high carbon intensities. Only 25% of the companies in the travel sector reported carbon risk exposures adequately, while 28% in the industrial goods and services sector reported the risks in an appropriate manner.
Meanwhile, nearly 90% of the 34 utility companies in the S&P 500 — which account for 59% of the direct CO2 emissions in the U.S. — disclose carbon data for operations. Consider that Edison International, which based on the Trucost estimated price of $28.24 per emissions allowance, would report carbon costs equal to 13% of the company’s annual revenue. In contrast, Allegheny Energy, the most carbon-intensive company in the S&P 500, would report carbon costs equal to 43% of its revenue, using the same allowance price.
Technology companies were more transparent than other non-utility companies. More than one-third (35%) adequately disclosed their direct carbon emissions. Tech companies are generally low carbon producers, but Trucost posits that the disclosure activity may reflect the industry’s hope that it can help other businesses lower their carbon risk through more energy-efficient technologies.
CFOs may have a change of heart regarding energy costs, now that carbon emission allowances may soon become a new company asset. “Energy costs used to be a big zone of mystery for CFOs,” says Adams, noting that it was a cost left to the company’s energy manager — who was usually not the same person as the procurement manager. Before electricity deregulation in 2000, companies just “paid their energy bill, while the energy manager looked to reduce usage to control costs,” notes Adams. But deregulation gave companies the opportunity to shop for better electricity prices and resulted in “more energy purchasing oversight.”
Adams believes that the cap-and-trade system may be the “tipping point, the fundamental calculus that makes managing energy strategy more complicated” and therefore a more dynamic part of the budgeting and planning process. “CFOs are turning the screws on everything else in the company, [why not emissions trading],” contends Adams.
The Fair Value of Clean Air
Sampling of recent RGGI auction prices for CO2 allowances.
|Auction number/date||Allocation year||Quantity offered/sold*||Clearing price per ton of CO2|
|*In these auctions, the amount of CO2 allowances offered and sold were the same.
Source: Regional Greenhouse Gas Initiative, July 1, 2009.