Entry 01: What Chief Investment Officers Must Know About Carbon Risks
In today's rapidly evolving business landscape, the role of Chief Investment Officers (CIOs) has never been more critical. As the world grapples with the escalating climate crisis, CIOs must integrate carbon risks, compliance, and costs into their investment decision-making processes. Decarbonisation is now a key lever for value creation in today's transitional capital markets.
Regulated carbon pricing has a direct impact on profitability. For instance, the European Union Emissions Trading System (EU ETS) significantly affects energy-intensive sectors. Prices of EU allowances have declined since the beginning of 2023, averaging EUR 83 per tonne of CO2-equivalent emissions during the year and are currently at 66€. This decline is attributed to weaker industrial activity, lower natural gas prices, and the decarbonisation of the energy sector. Additionally, the implementation of the REPower EU plan increased the supply of allowances through auctions. Notably, around 10 participants buy 90% of auctioned allowances, indicating a high concentration in the primary market. Most operators, including energy and industry installations and airlines, opt for obtaining their units from financial intermediaries. The majority of trading in secondary markets is done through derivatives.
Internal carbon pricing (ICP) is the practice of assigning a monetary value to the carbon emissions a company produces. By doing so, businesses can incorporate the cost of their greenhouse gas (GHG) emissions into their financial decision-making, helping to drive investment in low-carbon technologies and assets. Firms may establish an internal carbon price based on future costs or net-zero commitments. If the baseline metrics covering the operational costs and liabilities are in place, they may offer a risk reduction tool for CIOs to use.
Here are some examples of companies that have successfully implemented internal carbon pricing:
Microsoft utilizes an internal carbon fee to finance sustainability initiatives. This internal pricing mechanism helps the company manage its carbon footprint and invest in renewable energy projects.
Mitsubishi has adopted internal carbon pricing to drive low-carbon investment and energy efficiency within the company.
Ørsted, a Danish multinational power company, uses an internal carbon price to guide its investment decisions and reduce its carbon emissions.
Tata Group, including Tata Steel, Tata Chemicals, and Tata Motors, developed its guidance on internal carbon pricing in 2015. This initiative helps the group manage its carbon emissions and align with global sustainability goals.
Yale University implemented an internal pricing mechanism for carbon, designed by Nobel Laureate William Nordhaus, to curb its carbon emissions and promote sustainability on campus.
The discussions around Article 6 at COP29 will be pivotal in shaping the future of carbon markets and regulations. Article 6 of the Paris Agreement enables international cooperation to tackle climate change and unlock financial support for developing countries. It includes mechanisms for the exchange of mitigation outcomes, the establishment of a new UNFCCC mechanism for carbon credits, and opportunities for non-market approaches.
ESG integration is also crucial. Investors use ESG scoring frameworks to evaluate investments, including metrics for carbon emissions. The MSCI ESG Ratings, for example, assess companies based on their environmental impact. ESG factors are integrated into due diligence and ongoing performance monitoring. Notably, BlackRock incorporates ESG criteria in its investment analysis processes.
Climate risk assessment is another key area. Investors measure and report climate risk exposure and develop mitigation strategies. The Task Force on Climate-related Financial Disclosures (TCFD) offers guidelines for reporting. Investors also engage with portfolio companies to promote low-carbon strategies and enhance climate resilience. For example, CalPERS engages with companies to improve their sustainability practices.
Decarbonization value creation involves companies transitioning to renewable energy to reduce carbon costs. Google's pledge to operate on 24/7 carbon-free energy by 2030 is a significant step. Companies also monitor their carbon footprint and advocate for clean energy policies. Notably, Unilever aims to achieve net-zero emissions across its value chain by 2039.
Financial incentives play a role as well. Investors may receive premiums for decarbonization efforts or face penalties for insufficient progress. Companies with higher ESG scores often receive improved financing terms.
Compliance and regulation are critical. The EU Green Deal, including the Corporate Sustainability Reporting Directive (CSDR) and Carbon Border Adjustment Mechanism (CBAM), mandates stringent reporting and compliance measures. These regulations compel companies to change their business models to avoid the risks of climate change legislation.
Chief investment officers must navigate the complexities of carbon costs and risks to protect their investments and drive sustainable growth. By understanding the key developments and leveraging strategic communications, CIOs can make informed decisions that align with their sustainability goals.
