Feature Stories | Feb 09 2007
By Greg Peel
There is no point in discussing the ramifications of climate change here. We have all read a great deal about the subject lately. Suffice to say Australia will be one of the worst hit countries. The “land of droughts and flooding rains” will be more so. Waterfront properties may soon boast indoor swimming pools as the norm.
This will have a material impact on the Australian economy, the global economy, domestic companies, international companies, and domestic companies that deal internationally. It will affect the price of everything from bananas to oil. Oh wait, it already has.
Information in this article is drawn from various sources, including extensive and comprehensive research by CLSA Asia-Pacific, Citigroup US, Citigroup Australia, Lehmann Brothers and the local press.
It is becoming inevitable that the only way to enforce carbon emission reduction in a free marketplace is to regulate, despite some corporations already taking the ball in hand as a matter of image as much as anything else. Even the Howard government now acknowledges this, although it took opinion polls to achieve such acknowledgement. The question thus becomes: How to regulate? For the investor, the question is: What companies or sectors will win and which will lose?
But the latter is twofold. For if you accept climate change as a reality, your first question must be: What companies or sectors will be adversely affected by climate change? Agriculture seems obvious, for example, and insurance. The mining industry does not seem obvious – more a case of damn the torpedoes, full steam ahead – but much production has been lost to flooding, landslides, hurricanes and other climatic anomalies in recent years.
There would also be winners under climate change. Persistent outbreaks of disease would not hurt the healthcare sector, for example.
Only then can you consider who would actually “win” and who would “lose” if there were some form of emission regulation. It is easy to say “coal bad, windmills good” but there are a lot of flow-through ramifications for almost every industry.
A carbon-traded world will be a very different one from the one we’re used to. It may even be that such a world (and resultant climate improvement) is an unattainable panacea. Certainly things won’t change overnight. The process will likely be slow, but there is no doubting the recent global shift into at least second gear. Australia is also responding.
So what exactly is carbon trading?
The story so far
As long ago as the 1920s, at the height of industrial explosion, pollution was recognised as a problem and ideas were floated as to how to curtail it. It was the sort of pollution that you could see and smell. The sort of pollution that caused obvious health problems.
By the 1960s, “clean air” had become a serious issue. By the 70s, a fledgling emissions trading system was introduced in the US and 1977 saw the Clean Air Act.
Along the way, the problem of “smog” was attacked. Cars manufacturers were forced to clean up their act. Lead was removed from petrol. By the time we got to the nineties, the latest problem was “acid rain” – a deadly mix of sulphur dioxide and nitrogen oxide combined with precipitation. In 1990 the US introduced the Acid Rain Program, on a quota/allowance basis, and the results were surprisingly good.
But this was localised pollution. A lot of the world might have been suffering the same problem, but it was a case of looking after your own back yard. China has fairly recently discovered the joys of localised pollution, and has been trying hard to rectify the situation while trying not to upset the economic boom.
Around about the late 70s the world discovered a new problem. Remember the hole in the ozone layer? We were all going to die from solar radiation. The northern hemisphere was less concerned, however, as the hole was over the Antarctic. This meant it was bronzed Aussies who would be the first to spontaneously combust.
Nevertheless, the hole was considered a global problem, not a localised one. The major culprit was chlorofluorocarbons, found mostly in spray cans and refrigerators, among other things. They were banned, the hole got smaller, and we all rested easy. Until…
The concept of greenhouse gases has crept up on us slowly over the last couple of decades. We all knew from biology class that (a) you can grow tomatoes in a greenhouse in winter by trapping the heat of the sun and (b) trees absorb the carbon dioxide we exhale to provide oxygen for inhaling. Now we know that burning fossil fuels turns the earth into a greenhouse, and that it’s not a good idea to cut down all the trees.
Carbon dioxide, a by-product of fossil fuel burning, is the king of greenhouse gases. This is the villain that has leant its name to the “carbon” in “carbon trading”, along with perfluorocarbons and hexafluorocarbons. But GHG’s (greenhouse gases) also include nitrous oxide and sulphur hexafluoride. And let’s not forget flatulent cows (methane). A cow’s emission may seem the most natural thing in the world, but methane boasts 23 times more global warming potential than carbon dioxide, and a growing global population likes to breed more cows (and clear more land in which to breed them).
The insidious thing about GHGs is that they affect every soul on this earth, regardless of their source. While once it may have been safe to sun one’s self in the Pacific paradise of Kiribati, free of smog, fumes and acid rain, soon Kiribati may not be with us.
Which brings us to the Kyoto Protocol.
The Kyoto Protocol
The expression “ratify the Kyoto Protocol” is bandied around at will these days, but how many of us actually understand what it means?
What most of us do understand, however, is that there are only two countries on this earth which haven’t ratified the Kyoto Protocol. They are the US and Australia. Australia hasn’t ratified as it takes its lead from America. America’s reason for not ratifying is straightforward.
While it surprises no one that the Bush Administration has no intention of ratify the Kyoto Protocol it might surprise some that it was President Clinton who originally wouldn’t. Secondly, the US and Australia are not the only countries on earth that haven’t ratified. They are instead the only signatories to the Kyoto Protocol that haven’t ratified.
The Kyoto Protocol actually came about as a result of the United Nations Framework Convention on Climate Change held in Rio de Janeiro, Brazil, way back in 1992. This became popularly known as the Earth Summit. Representatives listened intently to scientists and environmentalists, gravely discussed the problem at hand, pledged to do everything in their power to reduce GHGs, and then most left without ever giving the subject another thought. 150 nations, however, signed the “treaty”. Once 50 nations “ratified” the treaty, it came into force.
At the time, a distinction was made between “industrialised countries” and “developing countries”, such that industrialised countries would bear the brunt, and developing countries would need only try their best. Fair enough.
The “industrial” category included most of Europe (including Russia), the US, Canada, Australia and New Zealand. The “developing” category included mainly South East Asia (even North Korea). There was no signatory from south of the US-Mexican border, and none from Africa. The “developing” category included China and India.
By 1994, 50 nations had ratified. They had ratified something that was onerously described as a “voluntary, non-binding effort”.
It is thus no surprise that suddenly, nothing happened. The GHG problem only grew worse. The UN convened more meetings, but eventually it was decided that what needed to be ratified was not a voluntary agreement, but a legally binding one. After a lot of heated debate, agreement was reached in a meeting in 1997 – at Kyoto, Japan. The plan was to encourage programs that would result in noticeable GHG reduction between 2008 and 2012.
Since 1997, every one of the signatories has ratified, except the aforementioned two. The Clinton Administration chose not to ratify for the basic reason that the developing countries were not obligated to meet reduction quotas equivalent to those of the industrialised countries. And that meant China and India. As the world’s greatest producers of GHG, the US wanted China (now the second highest producer) to have the same obligations. Australia agreed.
Economic and Climatic Reality
An important element of the Kyoto Protocol is the “clean development mechanism”, or CDM. If you can prove you are taking steps to reduce GHGs then you receive a “credit”, known as a “certified emission reduction”, or CER. You can obtain a CER by actually doing something positive, like planting trees, or you can obtain a CER by ceasing to do something negative, such as replacing your coal-burning furnace with wind power. CERs can then be sold to other developing nations.
Two chemical companies in China produce hexafluorocarbon HFC-22 for refrigeration. The production of HFC-22 is currently regulated under Kyoto. But the by-product of the HFC-22 production is HFC-23, and it is 11,700 times more potent a GHG than carbon dioxide.
The two chemical companies were destined to shut down during the whole ozone layer scare, until Kyoto came along. They were then given a loan to retrofit their operations to capture the HFC-23, and to this day remain profitable (and producing HFC-22) simply because of the CERs they were granted to not release HFC-23.
China has collected so many CERs, it is today the world’s biggest seller.
The Clinton administration’s problem, which became the Howard government’s problem, and ultimately the Bush administration’s problem, is that unless the entire world addresses GHG reduction under the same rules, the whole concept breaks down. BHP could spend millions on reducing GHGs only to lose a major contract to China, or Bolivia, or Zambia, where lesser obligations lower unit costs of production. It makes no difference to the world’s demise from where those GHGs emanate. It does, however, make a difference to economies.
Hence the stand-off.
Of course, we all can see the final outcome in this stand-off, which is why property values are failing to hold up in Kiribati. Until the well-intended concept of Kyoto can be transferred into a global agreement that can achieve both an equitable environmental AND economic outcome, then The Day After Tomorrow may well arrive.
In 2003, the US was responsible for 24% of the worlds GHG emissions. China came in second with 15%, Japan 5%, India 5%, Korea 2% and Australia 2%. The UN predicts that by 2050, China will have stolen top place at a whopping 27%, the US will fall to 15%, India will jump to 9%, and Japan, Korea and Australia would fall to 2%, 1% and 1% respectively.
China is attempting to address the situation of its emission-spewing economic boom, but few outside China have faith in any meaningful results being achieved other than on paper (See “Reality Check: China’s Increasing Energy Intensity”, 30/11/06). If the US and Australia can lose their manufacturing industries to China and call centres to India then there’s no telling what economic shift might occur if , for example, the production of commodities became relatively a good deal more expensive in the West than the East or elsewhere due to a one-sided system of emissions penalties.
It does, however, seem that the Earth might quietly die while leaders stubbornly insist “We won’t if they don’t”.
Tilting At Windmills
To date, the US has made no binding national commitments to reduce GHG emissions. What the US and Australia have done, however, is create the Asia-Pacific Partnership on Clean Development and Climate, along with China, India, Japan, and Korea.
Citigroup notes President Bush proclaimed the goal of the partnership is to “develop and accelerate deployment of cleaner, more efficient energy technologies to meet national pollution reduction, energy security, and climate change concerns in ways that reduce poverty and promote economic development.”
While the agreement is a response to a supposedly unworkable Kyoto Protocol, with no binding targets or timetables it seems little more than a PR exercise.
There are emissions trading systems present in the US today, in a somewhat piecemeal set-up. Individual states are looking at what they can do on the GHG front – most notably California, the famous Governor of which has pledged to reduce emissions by 25% by 2020.
In stark contrast to the US, Europe has rushed to embrace emissions reduction and trading. The EU Emission Trading Scheme is the first international scheme and many times larger than the US Acid Rain Program. It addresses approximately 10,000 major emitters in the 25 EU countries and represents 44% of EU carbon dioxide emission. Participation is mandatory in various nominated industrial sectors, including power, metal production, cement, bricks, pulp and paper. It does, however, omit the emission-intensive industries of transport and building.
Europe has presented the world with a working model of a potential international carbon trading framework. But do you think the US will run with something Europe created?
Meanwhile in Australia, the Howard Government has “recommended” an international emissions trading scheme as the best solution for both Australia and the world. In so doing, Howard has dismissed the possibility of a go-it-alone national system which would undermine local industry. He has, importantly, quashed any fears of the imposition of a carbon “tax”.
Bravo. The reality is, however, that the scheme recommended included no target for reducing emissions, and Howard knows perfectly well that a fully international scheme is, at best, a long way off. Not a bad ploy to be seen to be doing something while effectively doing little. The government taskforce argued that such a scheme would create “an explicit carbon price signal which allows business to take long-term investment decisions” (Sydney Morning Herald). “Explicit” seems a bit ambitious. The five year establishment estimation may also be optimistic.
One thing Howard was very right about nevertheless, is that “market-based approaches will generally reduce emissions at a lower cost than other interventions”. Although regulatory consistency is an important part of any international scheme, it will be the market that will establish an emissions trading framework organically, probably long before governments agree. Already a combination of transparent social responsibility and preparation for the inevitable has led corporations to begin acting now. A fear of possible litigation in the future also helps.
A Scheme
There is as yet little consistency across the globe within various fledgling carbon trading schemes that already exist. However, there are consistent themes. The first element is the acknowledgement that as carbon dioxide is the most abundant GHG, trading of emissions should be based on carbon and other GHGs measured in terms of carbon equivalent – hence “carbon trading”.
Citigroup has provided figures from the World Resources Institute that estimate total tons of carbon equivalent emitted globally by different industry groups. At in excess of four billion tons, the two worst offenders by a long way are residential building and road transport (the two the EU has left off).
Emitting between two and three billion tons are the industries of oil and gas, agriculture, commercial building, livestock, and chemicals. Emissions then begin to diminish rapidly across remaining industry groups. It is surprising to note that coal mining emits only 575 tons by comparison. But then coal burning for power adds significant emissions to the score cards of many other industries.
The form of carbon trading that will most likely be globally adopted is the “cap-and-trade” scheme. Citigroup provides us with a succinct definition:
“A typical emissions trading system requires facilities to own permits for emitting GHGs. A government entity sets a “cap” on aggregate emissions, distributes an initial allocation of permits to regulated facilities, and allows those facilities to trade with others in the marketplace and buy allowances should their emissions exceed the number of permits held (hence the name “cap-and-trade” program). Conversely, if an entity possesses more permits than its emissions allowance, it can sell those permits in the market. (So, note that what is actually being traded is not a physical commodity but, rather, the certified absence of carbon emissions.) In most systems, fines exist for not owning sufficient permits, with those fines acting as a ceiling to carbon prices.”
The difficulty in the equation is where to set the “cap”, and, of course, reaching any international agreement on that cap. This is where regulation must be enforced upon the free market. If caps are set to prevent any increase in emissions, then we haven’t really solved the problem. Ideally, caps should be set as ultimate targets below current levels in order to affect actual reduction of emissions. But the more aggressive the system, the greater the cost.
While it might seem like a fair cop that obscenely profitable commodity-producing companies, for example, should be slugged for the emissions they create, the reality is that every person on earth will be affected by a carbon trading world. At the simplest level, petrol, power, water and food would become relatively more expensive.
This is a factor that governments appreciate, while electorates may yet be slow to realise. Saving the Earth is a popular notion, but paying for it individually is not so enticing. While the Howard government is concerned about job losses in the coal industry, for example, it is also concerned about just how the electorate will tolerate price hikes for daily essentials.
Nevertheless, while meaningful emission reduction will require some form of internationally regulated scheme, social conscience is still a very powerful market force. Citigroup notes that a coalition of global institutional investors, representing some US$31 trillion in assets, has formed the Carbon Disclosure Project, which requests emissions information from multinational companies.
In 2006, 72% of the Financial Times Global 500 companies responded to requests, up from 47% in 2003.
As more disclosure is demanded by investors, the more the focus will turn to those companies seemingly doing little about emission control. Investment allocations will be made accordingly. While such decisions will be based on a level of “doing the right thing”, economic reality suggests that if carbon trading is inevitable, large emitters are going to find their costs up and profits down some time soon – not a good long term investment.
Hence, why we may have to wait some time before a truly internationally standardised carbon trading system is in place, the market will have responded well before its official establishment.
Winners and Losers
On face value, and taking both the effects of climate change itself and the cost of carbon trading into account, Citigroup has provided a simple guideline of industry winners and losers:
Winners – Alternative energy; sustainable property; recycling; innovative financial institutions; and some healthcare companies.
At Risk – Emissions intensive companies; facilities particularly exposed to severe weather damage; agriculture and water intensive industry exposed to drought; and insurers that may misprice catastrophe risk.
In Australia, notes Citigroup, coal accounts for 54% of the country’s power, and gas 27%. Coal-burning is one of the greatest sources of emissions. Australia is also the world’s largest exporter of coal. Not only does the domestic industry need to consider its costs in a carbon-traded world, Australia’s customers will be forced to rethink their own coal consumption. While there have been a lot of motherhood statements made lately about “clean coal technology” and “carbon sequestration” (the latter being the burying of carbon underground), meaningful projects will need to be fast-tracked in order to head off forthcoming cost increases.
Transport represents 14% of Australia’s emissions (road 89% of that). Only now are low-emission or alternative energy cars being seriously considered, after a period where the market shifted to a larger vehicle preference.
Agriculture represents 17% (livestock 70% of that). This is a tough one. We can’t not eat. However there have been steps made in, for example, vaccines for cattle that reduce inevitable methane emission. Water use, as we know, is also a very urgent consideration.
Citigroup lists the big potential losers as coal and mineral miners, (eg BHP Billiton (BHP)), oil companies (eg Santos (STO)), steelmakers (eg OneSteel (OST)), builders (eg Leighton (LEI)), companies that suffer from higher fuel costs such as transport (eg Toll (TOL), or less fuel use (eg Caltex (CTX)), insurers who may bear the brunt of climate change catastrophes (eg QBE (QBE)), and any company exposed to severe weather changes, major water users (eg Coca-Cola Amatil (CCL)) and companies with agricultural inputs (eg Foster’s (FGL)).
Winners include alternative energy companies (eg Origin (ORG)), recyclers (eg Simms (SGM)), property trusts that actively manage property sustainability (eg Investa (IPG)), financial institutions who will benefit as intermediaries in a carbon marketplace, banks that acknowledge and adjust for climate change risk (eg Westpac (WBC)), and healthcare companies providing solutions against widespread disease (Eg Sigma (SIP)).
There will be, however, ramifications for every company, listed or unlisted. While the above summary by Citigroup is a simplified guide, it does not mean that companies that appear more benign on an emissions production/reduction basis will not suffer from higher cost of inputs, lower demand for products and so forth. An investor must also give consideration to just how much the market has already factored in to current prices. Clearly, for example, alternative energy companies will now be enjoying premiums previously not ascribed. Uranium miners have taken off. Agricultural stocks are improving due to higher grain prices driven by bio-fuel considerations.
By the same token, Exxon-Mobil just recorded the largest profit in the history of mankind. QBE Insurance has been re-rated for hurricanes that didn’t happen.
There will not be an overnight adjustment to the potential effects of valuations in a carbon-traded world. The process of establishing such a world will be slow and arduous. But investors now need to include the carbon factor in their long term investment decisions. To not do so would be to ignore the obvious.