Climate change policy presents investment risks, opportunities

Published February 1, 2001

The Kyoto Protocol was signed at the 3rd Conference of the Parties to the U.N. Framework Convention on Climate Change, held in Kyoto, Japan, in December 1997. The world’s first binding agreement on greenhouse gas (GHG) reduction, the agreement commits developed countries to reducing their GHG emissions by an average of 5.2 percent below 1990 levels by the years 2008 to 2012.

The Clinton administration, whose representatives at the Kyoto meeting signed the agreement, agreed to pursue a reduction of 7 percent, compared with 8 percent for the European Union and 6 percent for Japan. The U.S. Senate has not ratified the Kyoto Protocol, a move required by the Constitution before the treaty binds the U.S.

Economics of climate change policy

There is much uncertainty as to the macro-economic consequences of achieving the Kyoto Protocol’s targets. Authoritative estimates put the cost to the U.S. alone at between $100 and $300 billion a year in lost GNP. Profitability and relative competitive advantage will be affected differently from company to company and industry to industry.

In the U.S., the Clinton-Gore administration has estimated the costs of implementing the Kyoto Protocol at between $14 and $23 per ton of CO2 emitted, assuming reductions are made in response to a tax on the carbon content of fossil fuels. According to Arthur D. Little, the automotive, chemicals, coal, electric power, manufacturing, oil and gas, refining, steel, and consumer goods businesses all stand to be hard hit by climate change policy. The effects will ripple throughout virtually all sectors of the economy.

According to a PricewaterhouseCoopers study issued in October 1999, the impact of climate policy on future shareholder value will depend largely on decisions taken in the months to come. PWC has calculated that for each 1 megaton of reduction in CO2, a forward-thinking strategy could produce savings of more than $100 million over a wait-and-see attitude, and nearly $50 million over a reactive stance.

Incentives for voluntary GHG cuts are under development. The Clinton-Gore administration allocated $4 billion in spending and tax breaks for early GHG reducers in its 2000 budget, and Congress is considering the Credit for Voluntary Early Greenhouse Gas Emission Mitigation Action Act. A successful “credit for early action” program would likely spur more aggressive emissions reduction initiatives by U.S. industry.

However, opposition to even voluntary GHG cuts remains strong, and it seems likely the Senate will not ratify the Kyoto agreement—or any legislation deemed to have a similar effect on the U.S. economy—without substantial commitments from developing nations. Without U.S. ratification, the Kyoto agreement is likely to fail.

High cost of direct taxation

Vulnerability to GHG emission restrictions varies. In the electric power industry, a sector that stands to be most affected by climate change regulation, most U.S. companies oppose the Kyoto agreement, saying compliance could require early retirement of coal plants, assuming emissions trading is limited in the near term.

Carbon emissions from U.S. electric generators are projected to increase by 28 percent from 1996 to 2010, and coal is projected to represent 83 percent of the emissions. Reversing this trend to comply with Kyoto is projected to increase utility sector fuel costs by $10 billion annually as gas plants replace coal and the gas fuel mix rises to 57 percent in 2010.

Experiences in countries where energy taxes are already in place (e.g., Finland, Denmark, Norway, the Netherlands, and Sweden) indicate that direct taxation is more damaging to the economy than emissions trading, although it has achieved some success in reducing emissions.

The Norwegian government estimates that CO2 emissions in certain target areas were 3 to 4 percent lower than they would have been absent the country’s CO2 tax. The price of heating oil and gasoline in that country rose roughly 15 percent and 10 percent, respectively, as a result of the tax.

Promise of emissions trading

The specific means and timing by which GHG emissions reductions will be achieved have yet to be determined, but of the mechanisms proposed, emissions trading is the most likely to garner the necessary widespread support. While direct taxation leaves little room for gaining competitive or commercial advantage, the use of permit trading or similar mechanisms can create opportunities for companies to benefit using superior organizational or strategic positioning.

Leading petroleum companies have already begun to explore the opportunities created by emissions trading. BP Amoco, for example, has developed an internal emissions trading scheme in partnership with the Environmental Defense Fund.

Royal Dutch/Shell, which aims to develop a similar pilot trading system, has also begun to factor the effect of a carbon price penalty into its investment calculations for new projects and existing major assets. In addition, Shell’s reforestation activities in Costa Rica could generate emissions credits that could be held, used to offset emissions from facilities in the U.S. or Europe, or traded with other companies in need of offsets.

Companies may also seek to position themselves advantageously by teaming up with large-scale fuel consumers, such as energy firms, in a bid to trade credits on a micro scale. In March 1998, for example, Calgary-based Suncor Energy Inc. and Syracuse-based Niagara Mohawk Power Corporation announced plans for Suncor to offset its own emissions by purchasing carbon dioxide emissions reductions resulting from Niagara Mohawk’s new renewable energy initiatives. At the same time, both companies agreed to work with Environmental Resources Trust (ERT) to develop comprehensive reporting and tracking of each company’s total greenhouse gas (GHG) emissions and GHG reductions portfolio.

The market responds: carbon funds

The emergence of investment funds that generate carbon emissions credits by financing clean technology or renewable energy projects—so-called “carbon funds”—is rapidly developing into one of the most remarkable sub-plots of the climate change story.

Since January 2000, at least six such funds have been announced with a combined total of just over $1 billion in actual and projected assets. Several others are known to be under formation, in addition to the growing number of private company carbon funds.

Funds range in strategy and style according to their breadth of holdings and, in particular, the emphasis they place on generating and trading carbon emissions credits. The first—and most controversial to date—is the World Bank’s Prototype Carbon Fund (PCF), launched on January 18, 2000. The PCF aims to offer investors independently verified and certified emissions credits by investing in renewable energy and related projects in developing nations.

The PCF has been heavily criticized in some quarters for potentially distorting the emissions market by arbitrarily fixing a price for its carbon credits. However, this does not seem to have deterred investors. Originally capped at $150 million, the PCF has been oversubscribed and is now expected to top $200 million. Participants include roughly 25 private-sector companies, including Daimler-Chrysler, Hydro-Quebec, Sumitomo Corp., Mitsubishi, Rabobank, and Royal Dutch/Shell, as well as six national governments. Approximately $135 million will be targeted at between 15 and 20 energy-related projects in the initial round of investments.

A private-sector version of the PCF is being developed by UBS, the Swiss bank. UBS hopes to raise $65 million, primarily from corporate sources, for its carbon fund. Like the PCF, the emissions credits would be distributed among investors or sold on the open market and the proceeds reinvested in the fund.

Several other funds under development also target energy-related projects or early-stage companies, but the overarching strategy of these funds is to generate minimum cash returns for their investors rather than the production of emissions credits. In these funds, credits are viewed mainly as a bonus that can either be sold to boost the account of the fund or distributed among investors. This more diversified class of funds includes:

  • D&B Capital’s Clean Energy Fund, sponsored by the World Solar Commission, which has set an initial target of US $100 million. It intends to invest in renewable power generation projects as well as the restructuring of existing power generation facilities.
  • the Dexia-FondElec Energy Efficiency and Emissions Reduction Fund, a 10-year limited partnership sponsored by EBRD and the Dexia Group. It aims to raise $150 million for investment in energy-sector projects. Primary investors pledged to the fund to date include Kansai Electric Power and Mitsui & Co. Europe.
  • a planned $400 million fund set up jointly by Credit Lyonnais and Arthur Andersen, which is reported to be aimed at energy infrastructure projects; and
  • the International Finance Corporation’s Renewable Energy and Energy Efficiency Fund (REEF), to be managed by the EIF Group. The equity portion of the fund is expected to top $100 million by the end of 2000, with a further $100 million available in debt financing. REEF’s founding investors include Dutch utility Nuon International Renewables, Alliant Energy, and Belgium’s VMH.

While Senate ratification of the Kyoto Protocol appears unlikely, some form of GHG emissions restrictions will probably be implemented in the next five to 10 years. Industries from petroleum to high finance appear to be bracing for the impact, positioning themselves to take advantage of whatever climate change policy might come their way.

Martin Whittaker is an environmental consultant and researcher and senior analyst with Innovest Strategic Value Advisors, Inc., in Toronto, Ontario. He holds a Ph.D. in environmental science from the University of Edinburgh.