Joel N. Swisher, PhD, PE, Rocky Mountain Institute
In 1992, the U.N. Framework Convention on Climate Change (UNFCCC) was adopted in Rio de Janeiro. The Convention entered force in 1994 with ratification by 186 parties, including the U.S. The 1997 Kyoto Protocol to the UNFCCC, which the U.S. signed but has not ratified, commits industrialized countries to reduce emissions of greenhouse gases (GHGs) including carbon dioxide (CO2), beginning in 2008, by an aggregate 7 percent from 1990 levels. The Kyoto Protocol will enter force if Russia (likely) or the U.S. (unlikely) ratify.
So, what is your power company’s strategy on the Kyoto Protocol and GHG reductions?
A. Ignore the agreement as lip-service to environmentalists that will never be enforced?
B. Mount an intense lobbying effort to convince Congress never to ratify the agreement?
C. Corner the nascent market in carbon emission credits to offset your firm’s emissions?
D. Offer to fund university research programs on relevant topics (or peripheral ones)?
E. Identify low-cost reduction options and explore ways to limit the risk of future limits?
F. Begin to invest massive resources in shifting technology to non-fossil energy sources?
Answering this question could involve the commitment of a significant share of a company’s resources over the next decade. The implications of that answer, right or wrong, could lead to continued growth and success, stagnation and decline, or perhaps complete demise. The right answer is not yet clear, and it is probably not the same for every firm that addresses the question.
An emerging scientific consensus holds that the global climate is warming and that most of the observed change is due to the increase in GHG concentrations caused mostly by fossil fuel combustion. In the U.S., power generation emits about 40 percent of all CO2, which translates to about 10 percent of global emissions. That is a huge environmental footprint for one industry in one country.
Meanwhile, European and Japanese leaders have accepted the need for CO2 limits, although it is already too late to achieve compliance with Kyoto Protocol commitments for 2008-2013. Nevertheless, emission reductions in subsequent years are likely. Whether implemented via emission charges or a cap-and-trade emission allowance market, CO2 limits would become mandatory and last-minute compliance could be very expensive due to the cost of capital replacement using low-carbon technology. Alternatively, potential legal action to require energy companies, such as in the coal industry, to indemnify customers against client liabilities would have similar impacts on the costs and profits of power generators.
While climate change and the potential costs of CO2 emission limits can impose risks to business performance and asset values, these concerns also present new business opportunities for proactive companies. These firms understand that the status quo is not risk free because emission limits, higher energy costs and market volatility could hurt business performance and lower asset values of carbon-intensive plants and equipment. They also understand that there is a significant risk in treating future energy costs and related emission control costs as a predictable, unavoidable expense.
Their goals are therefore to implement risk mitigation strategies at low-cost or at a profit and to help create emission regulations that are as flexible as possible regarding when, where and with which technologies reductions are achieved. To reach the second goal, companies need to demonstrate that they can realize significant reductions when allowed to choose their own strategies, even under voluntary programs. Proactive “early action” to reduce emissions can help influence the future regulatory structure in favor of flexible, market-based regulations. It is important to document any “early action” on emission reductions in order to ensure that reductions are credited against future emission limits, and to communicate about climate-related actions to employees, investors and the public.
If a firm wants to undertake early actions, or at least prepare to participate in the carbon market in the future, they can take the following short-term measures:
“- Develop an emission accounting, measurement and tracking system,
“- Begin to implement “no-regrets” emission reduction measures, and
“- Position themselves relative to the emerging carbon markets.
An emission accounting, measurement and tracking process requires detailed energy audits and metering, and it can employ one of several generic protocols now available. With an emission accounting and tracking system in place, firms can establish emission reduction targets, identify reduction measures and demonstrate progress achieved. Firms that use a tracking system to report emission reductions or offsets in an official carbon registry ensure they receive credit under future emissions regulations.
The basic options for offsetting CO2 emissions can involve developing offsets internally by producing low-carbon energy; developing external offsets by investing in renewable energy or carbon sequestration; and buying green power or carbon offsets from the emerging carbon market. At any given time, the best strategy for a firm is to implement emission reductions that are cheaper than the offset price, and to buy offsets to meet the remaining reduction level expected.
One of the most interesting prospects for offsets is carbon sequestration via sustainable agriculture or forestry practices. Although photosynthesis is a far more proven technology than any proposed geological sequestration schemes, it raises concern about the persistence of carbon storage. Nevertheless, there is huge potential, especially in the Midwest where generation is highly carbon-intensive, to store carbon and benefit farm incomes. One could imagine a transformed farm economy where carbon storage, biofuel production and wind power all provide revenues in a carbon-constrained world.
Looking forward, the offset price (or emission charge) is uncertain and, if it turns out to be low, less reductions or offset purchases will be justified. But if the potential cost is high, a prudent strategy is to have offsets (or options on offsets) to cover this potential liability. Holding forward contracts or options on future offsets is one way to lock in low-cost climate risk mitigation, and this may be the best strategy for reducing fossil-generation risk. Another approach is to begin reducing emissions via energy efficiency, renewable sources and cogeneration to create a physical, or “real option” that reduces risk from high future emission costs and increases flexibility in responding to them.
In the longer term, binding emission limits will be increasingly likely. Preparing for, and responding to, eventual GHG emission limits will involve substantial investments in:
“- Buying (and possibly selling) carbon offsets and “green power” certificates,
“- Implementing advanced technologies, and
“- Reorienting company strategy toward new processes, products and services.
New markets will emerge for products that combine advanced energy technology with services such as financing, carbon offsets, green power or ancillary services, tailored to improving performance while reducing GHG emissions. In a carbon-constrained world, there will be major changes to the value of different type of assets and liabilities. Carbon-intensive equipment such as coal-fired boilers will lose value, while processes such as controls manufacturing that produce emission-saving devices and intellectual property for developing low-carbon technology and reduction measures will gain value.
Skill in using GHG trading markets will provide a hedge against future regulatory risks, and land that can sequester carbon (and support renewable energy production) will gain value, while baseline emissions could gain or lose value depending on the allocation of emission credits. Financial reforms (e.g., Sarbanes-Oxley) that increase reporting and liability of executives for decisions affecting public welfare, will begin to include GHGs.
The bottom line in terms of a firm’s financial health depends on its relative risk exposure within its sector, which some call the “carbon beta.” We don’t expect climate risk to push industries completely out of business, hence this relative position is more important than the absolute climate risk in the sector as a whole. A carbon-intensive sector such as power generation will continue to emit CO2, but companies that outperform their competitors in managing climate-related risks will thrive and prosper.
Dr. Joel Swisher, PE is principal and team leader of energy and resources services at Rocky Mountain Institute in Colorado. This article summarizes “The New Business Climate: A Guide to Lower Carbon Emissions and Better Business Performance,” available at www.rmi.org.