One of the first lessons I learned at Business College was that companies always try to maximize economic profit. In those days, a profit and loss statement was basically made up of typical expenditure items: raw materials, salaries, debtors, insurance, taxes, etc. Carbon risk premiums were not in vogue, with few forecasting that carbon could be monetized and have a significant impact on a company’s performance.
The last two decades have taken us in a very different direction; one where carbon emissions have relevant importance for business management in the 21st century. Let’s recap the history of carbon and analyze the current state of carbon pricing to understand how we got here and what companies should prepare for in the future.
Contributed by: María Felez, Schneider Electric
A brief history of carbon pricing in Europe
In 1997, the Kyoto Protocol identified the need to reduce GHG emissions by 5% between 2008-2012, with 1990 emissions as the baseline. The execution of the Kyoto Protocol in Europe was formalized through the EU Emission Trading Scheme, also known as the EU ETS market. Without getting into the technical details of the scheme, the EU progressively applied tougher targets on emission reduction throughout a series of phases: 15% reduction by 2012; 20% by 2020; and, initially, a 40% reduction by 2030.
The first phase of EU ETS only captured electricity generation and some electro-intensive industries. These companies were required to buy carbon emissions rights to compensate for the emissions that could not be covered by free allowances. Consequently, these companies must either pay for emissions rights or invest in efficiency projects to reduce their emissions. This is when carbon first started to become an expenditure/investment.
Throughout the different EU ETS phases, more industrial sectors have been obliged to participate in this market (glass, chemical, cement, paper, glass, etc.). In parallel, free allowances have been progressively reduced. The EU ETS market refreshes daily, and for the last 5 years, its price has multiplied tenfold. In 2016, was valued at 5€/ton, at the end of May 2021 it broke the 50€/ton barrier, and experts forecast it will reach 100€/ton in the near future.
What is driving the increase in EU carbon prices?
The Paris Agreement in 2016 demonstrated the prevailing need to limit global warming to 1.5ºC by 2050, in order to avoid natural catastrophes that may trigger a social, economic, health, or food production crisis. The ambition of the Paris Agreement has been widely supported by sectors of private industry. Initiatives such as Science-Based Targets (SBTi) are encouraging corporates to make public commitments to reduce Scope 1, 2, and 3 emissions in line with the science outlined in the Paris Agreement. These corporates are also using climate action commitments to become more attractive for increasingly ESG-aware investment fund managers by applying sustainability and carbon neutrality criteria to their portfolios. There is clear evidence that ESG commitments are effective from a profitability point of view – during the COVID-19 pandemic, ESG funds proved to be one of the most stable and profitable.
Another price driver to the EU ETS market is the participation of hedge funds. Currently, there is no limitation to buying rights in this market, which means that carbon can be traded whether an entity needs them to compensate for its emissions or not. Hedge funds have discovered attractive profitability in speculating with emissions rights, much higher than traditional financial markets.
Phase IV for EU ETS is about to launch and will require a broader number of sectors to participate. The increased demand in the carbon market as a result of this shift will likely lead to higher prices.
For many of the corporates that have made public commitments on Scope 1 and 3 emissions, it will be very difficult to achieve those targets in the short- and medium-term. Many are facing the need to counterbalance their emissions to reach near-term goals while decarbonizing technology advances through investment in offsetting projects, such as reforesting, renewable energy projects, etc.
Between 2018 and 2020, the unit price of carbon offsets has doubled, mainly for all the reasons already discussed. Carbon is an expanding market, particularly to those corporates with ambitious carbon neutrality targets. Carbon price, once again, becomes a material part of the corporate P&L.
Carbon neutrality is the future in Europe
In December 2019, Ursula von der Leyen, the President of the EU Commission, announced an increase on the emission reduction target by 2030, from 40% up to 55%—10 times the objective set out by the Kyoto Protocol announced 20 years ago. Her words encapsulated the urgent need to accelerate climate progress: “Europe must be the first carbon neutral continent; the race has just started, and we cannot stop”.
The EU has planned the path to achieve its carbon neutrality target through the European Green Deal. The transposition of Green Deal objectives to national policies has granted billions of euros for projects such as increasing the electrification of transport.
The biggest lever to ignite the race towards carbon neutrality has been the COVID-19 crisis. The pandemic raised awareness of how vulnerable humankind can be in the face of a global crisis and catastrophes, and climate change is predicted to bring even worse episodes than what we lived in 2020. China, one of the main emission contributors on the planet, has committed to becoming net zero by 2060. On the other side of the Globe, President Biden’s first measure after taking office was to confirm the USA’s re-entry to the Paris Agreement.
To this end, Europe has approved the Recovery, Transformation, and Resilience plan with funding of 750 billion euros, which will be distributed according to fundamental pillars of the Green Deal, including digitization and sustainability. Digitization to innovate in processes and make them more efficient; data to accelerate decision-making processes; sustainability to shift toward low-carbon business models and economy.
Today, business schools around the world are studying this new economic model based on carbon neutrality. It is not an easy journey for corporates to achieve carbon neutrality or net zero, but it is a motivating challenge that will be more than worthwhile to achieve.
Schneider Electric, led by CEO and Chairman Jean-Pascal Tricoire, has taken an active role in this transformation. Sustainability is part of our company’s DNA. We are among the corporates committing to be carbon neutral by 2030. We lead by example, using our experience navigating the carbon neutrality journey to help our clients, suppliers, and partners to achieve their own carbon neutrality goals.
Watch our recent webinar to hear Schneider Electric’s European energy market experts discuss major energy-related policy updates and other trends and innovations shaping the market, and ask your own questions in a live Q&A.