Carbon Seen as a Liability and How it Might Help Save the Climate (1)

Opinion, news, interview, analysis by Mathew Carr

Jan. 9, 2023 (LONDON): Accounting rules should require companies to disclose what portion of their emissions they will struggle to abate, immediately creating a “contingent liability,” according to a serial entrepreneur.

Failing to disclose to shareholders and potential ones a company’s future big risks when those risks are known — including whether its able to operate under a regime of high effective carbon prices in whatever form — amounts to fraud, according to Tim de Rosen, president of ClimaFi Ltd. and serial board director.

Failing to disclose “could amount to misrepresentation or even a fraud on their shareholders because there’s no liability number in the balance sheet,” de Rosen said. “There should be now a contingent liability figure in the balance sheet representing that part of the emissions that they will never be able to reduce.”

“If the directors anticipate that they may be unable to reach net zero, they should state this categorically as a contingent liability.”

What Is a Contingent Liability?

A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. Contingent liabilities are recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met. (Investopedia)

While businesses don’t immediately need to deal with contingent liabilities, they could begin to hold on account emission credits to match that figure, beginning say in 2026 or 2030. That could limit risks for the company as carbon pricing is introduced into the national laws in countries in which they operate. Only about one quarter of emissions are currently priced around the world, according to the World Bank.

CarrZee: This carbon pricing coverage is changing rapidly even if it is hidden in inefficient and anticompetitive climate policy such as the U.S. Inflation Reduction Act.

Companies could and should assess what portion of their emissions are seen as impossible to abate. Over time, as new technology is developed, that portion of emissions might reduce. That would mean the company could hold fewer carbon credits, potentially even selling them for a profit. Such a system may help spur market buying right now.

EU carbon allowances, for example, could also be seen as a high-quality carbon risk offset. They are trading today at €80 per metric ton on ICE vs $5.67 for nature-based carbon on CME.

By buying carbon assets, purchasers would encourage further projects that cut emissions and save the climate.

While offsetting carbon dioxide emissions is not seen as the main way to tackle climate change yet, ultimately emission-removals and avoidance are seen as being needed for the world to keep temperatures from rising above 1.5C above pre-industrial levels, however unlikely keeping increases to that level actually is.

“Certain industries will get to the point where they cannot do anything else — it’s not possible to avoid the emissions,” de Rosen said. “To be honest, I’m not sure net zero is even possible in some cases.”

These IOSCO consultations through next month below asks questions about how companies should communicate around the use of carbon credits, and allowances (voluntary and compliance markets) ……………………please respond to the consultations if you can.

(Adds links, IOSCO reports, more to come)

See this article from the Harvard Business Review from 2021:

Carbon Might Be Your Company’s Biggest Financial Liability


October 07, 2021

Yaroslav Danylchenko/Stocksy

Summary.   The price of carbon may be zero in many places today, but it’s unlikely to remain zero for long. That means that many companies have hidden liabilities on their books. To cover their carbon short position, executives can take several steps: Measure the position in…more

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:

  1. 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.
  2. Absent any capital projects, determine if carbon intensity will increase or decrease as revenues increase and model all future emissions.
  3. 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.
  4. Price the forward emissions by multiplying the forward price by the emissions amount in each year to determine a total annual cost.
  5. 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.

Read more on Government policy and regulation or related topics Social and global issues and Sustainable business practices

  • Robert G. Eccles is a visiting professor of management practice at Saïd Business School, Oxford University, and a senior adviser to the Boston Consulting Group.
  • John Mulliken is the founder of and was the CTO of Wayfair.

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