One of the issues that has been thrust into the spotlight by invasion of Ukraine is the supply of fossil fuels. It is a systemic risk that has accumulated over many years and intersects with social factors, as energy prices soar in a way that the most vulnerable in society can scant afford.
Having minimal exposure to companies in the policy crosshairs is an important aspect of our active approach. Italy’s windfall tax on energy companies (which funds a 25 cents per litre cut in petrol and diesel prices until the end of April) highlights the significant squeeze on the profit margins of carbon-intensive businesses that can result from this process, and which may only intensify once the current crisis has faded, as part of the long-term policy response to both energy security and the path to net zero. Incorporating the cost of carbon into analysis is acutely important.
The pace of change in this area of regulation should not be underestimated. As recently as 21 March 2022 the US Securities and Exchange Commission proposed a major change in US climate regulation that would require corporations to disclose not only their current carbon emissions (Scope 1 and Scope 2, plus Scope 3 where material) but also their physical and transition risks related to climate change.
In the context of the historic approach to this topic in the US, the new proposals are very progressive. Initial support among politicians appears predictably split along party lines but, whatever form the regulation eventually takes, it demonstrates that the US regulators are beginning to act.
Across the pond, the European Union continues its march with an agenda that is progressive in its principles and aggressive in its timelines. As part of its previously announced plans to achieve climate neutrality by 2050, the EU has set itself a “Fit for 55” intermediate target to cut carbon emissions by at least 55% by 2030. Even assuming that such a target can be hit, however, it would have no material impact if those emissions were not reduced but simply ‘offshored’ by shifting carbon-intensive industrial processes to territories outside the EU with softer regulations. This process is known as ‘carbon leakage’, and it is what the EU’s carbon border adjustment mechanism (CBAM) is designed to address.
Recognising the global aspect of climate change the CBAM aims to equalise the price of carbon between domestic EU production and imported goods. Building upon the existing Emissions Trading System (ETS), importers will have an obligation to buy carbon certificates corresponding to the carbon price that would have been paid had the goods been produced under the EU’s carbon pricing rules (if carbon costs are paid at source, these can be fully deducted). Not only should this create a level playing field when it comes to carbon pricing for goods sold in the EU, it should also provide an incentive for countries outside the EU to reduce the carbon intensity of industries located in their territory in order to improve their global competitiveness.
These plans were first outlined in July 2021, with a phased implementation due to begin on 1 January 2023. Within nine months, the EU Council agreed a ‘general approach’. Given the urgent timelines, some important details are still being worked on, including the full scope of the sectors covered (although many highly carbon-intensive sectors such as iron, steel, cement and electricity generation are definitely in scope).
There has also been disappointment in some quarters as organisations such as the WWF have expressed concern that the regulations don’t go far enough. However, in the context of capital markets, it is notable how progressive the proposed rules are, and how committed the EU is to the timeline of 1 January 2023, indicating a determination to get on with action. This may well be an example of ‘do not let perfect be the enemy of good’. As with other recent policy progress, they can always go further.
As things stand, from January next year the phased implementation of CBAM will begin with a requirement for EU importers to comply with the reporting rules, with the actual payment for carbon via certificates to commence from 1 January 2026. This enhanced reporting – in concert with improved disclosures from US businesses – will provide investors with better quality data on carbon emissions across global supply chains, providing greater transparency around the challenges businesses face to achieve decarbonisation in the full extent of their operations.