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Carbon Indulgences

At their origin, indulgences were a way through which remission of the punishment of sin could be obtained under the Roman Catholic Church. In the Middle Ages, individuals could purchase indulgences from ‘pardoners’ and pay for their sins in monetary terms. Unsurprisingly, the scheme proved more and more popular. The building of cathedrals and crusades were financed to a growing extent by indulgences. But this degenerative trend contributed to the Reformation and the advent of Protestantism in the 16th century.

Today, the analogous notion that one can pay for the right to pollute is one of the principal ethical objections to carbon credit schemes. Yet, pragmatism has prevailed. ‘Cap-and-trade’ systems represent a central market-based tool to tackle environmental issues.

This year, the EU Emissions Trading System (ETS) – the most extensive scheme in the world covering c.45% of EU emissions at present – is switching to its fourth and highest gear. Over the next decade, it foresees an acceleration of the reduction in annual carbon credit allowances and a decline in the number of free allowances. (1)

Naturally, the price of emitting one ton of CO2 or equivalent (CO2e) has recently risen to more than Euro 50 after languishing below Euro 20 for most of its history. The recent move by the Biden administration to set the social cost of carbon (‘SCC’) at $51 per ton supports that evolution too. The current market price is consistent with the widely publicized 2017 report from economists Joseph Stiglitz and Nicolas Stern: they foresaw a price of $40-$80 per ton by 2020 and expected such price to rise to $50-100 by 2030.

Investors have been able to assess companies’ carbon intensity for years, relying on information from the Carbon Disclosure Project, for example. The tons of emitted CO2e per million of revenue is an imperfect but widely accepted metric. (2) As a benchmark, the MSCI World Index generates a ratio of about 160. (3) Based on that approach, each Euro 25 of increase in the price of a carbon credit generates a negative operating margin impact of 40bps for the MSCI World Index – all other things being equal. (4)

But things do not tend to stay equal. Companies can increase output prices to compensate for the incremental costs, adding that demand elasticity will determine the negative impact on volume. Then, firms can invest in new technologies towards greater sustainability. It takes a wide range of heroic microeconomic assumptions to form a view as to the net impact of climate change on a company’s future bottom line. (5)

Since responsible for financial stability, central banks must build robust frameworks to assess the value at risk from climate change. The European Central Bank is doing just that with the first-of-a-kind 2021 stress test (approach and first results here). Following their work and integrating it in capital allocation decision-making processes will undoubtfully represent a source of competitive advantages.

Managing the social implications from carbon credit-induced price increases will be a tremendous challenge. The ‘unfair burden argumentacknowledges that wealthy individuals will be more financially affected than the less affluent but argue that they will be less burdened since they can more easily afford to pay for their polluting sins.

Given the fragile socio-economic situation, the pressure for governments to implement a more comprehensive redistributive policy is set to rise. Otherwise, mirroring the events of the 16th century, the risk of protests – or worse – will soar.

(1) Where the risk of shifting production to a jurisdiction unaffected by the EU ETS was high, the EU decided in the first three phases of the EU ETS to grant free carbon credits to avoid over-penalizing its domestic industries. With the number of free credits declining, various sectors will see their cost of doing business increase. To avoid some offshoring or ‘carbon leakage,’ the EU will need to introduce a carbon import tax (‘Carbon Border Adjustment Mechanism’) without falling into unfair and unjustified protectionism

(2) Most calculations (including that of MSCI) are focused on company-specific direct (Scope 1) and indirect (Scope 2) greenhouse gas emissions data from company public documents and the Carbon Disclosure Project. Scope 3 emissions (indirect emissions resulting from activities such as business travel, distribution of products by third parties, and the use of a company’s products by customers are excluded due to insufficient data). The comparison between companies is thus imperfect as it depends upon their business model (e.g., manufacturing outsourcing vs. insourcing)

(3) The production of certain building materials and metals, fossil fuel extraction activities, and utilities generate vastly higher ratios

(4) 160 * 25 Euro/1 million of Euro revenues

(5) Without forgetting the balance sheet impact given the need to assess the physical risk from global warming (fires, floods, droughts)

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