For most of manufacturing industry, the growing pressure to reduce greenhouse gas emissions has become an important and accepted part of the landscape. The City has also shown an increasing interest in climate change - but, until recently, the main players have been the "usual suspects" in the socially responsible investment (SRI) community.
Much of the financial community's early interest in climate change was driven by insurers' concerns about growing exposure to extreme weather events. But in truth, the line between increased insurance premiums as a result of global warming and direct pressure on an individual company's emissions was always rather tenuous.
The City's engagement has moved onto a much surer footing during 2003. One of the most significant developments is the emergence of the Carbon Disclosure Project, a joint project involving the world's leading institutional investors.
Last year, the CDP - backed by 30 investors wielding funds worth $4.5 trillion - wrote to the biggest 500 global companies asking for information on their emissions and how they are managing the risks to their operations. The responses, published in February, led to a ranking of corporations' "carbon risk profiles" by financial analysts Innovest (ENDS Report 337, pp 3-4 ).
In November, the CDP repeated the exercise - and the list of signatories has swelled to 87 investors with assets of over $9 trillion. Companies which responded to the earlier questionnaire are asked to report on progress - and there is growing pressure on the substantial minority who failed to respond last year. The results will be published in May.
"It is time for shareholders to improve their understanding of climate change risks and opportunities," says project coordinator Paul Dickinson. "This exercise is aimed at encouraging the development of a common emissions measurement methodology and to facilitate its integration into general investment analysis."
The project does not just seek information on emissions. Investors also want to know about the potential for low-carbon technologies, products and services. They are also alert to shifts in consumer sentiment due to a corporation's stance on climate change - with ExxonMobil being in the front line (ENDS Reports 333, p 5 and 330, pp 25-28 ).
Another example of the growing interest in companies' carbon exposures is a new report for the World Resources Institute by Sustainable Asset Management. This warns that constraints on vehicles' CO2 emissions could reduce the earnings of some car manufacturers by 10% by 2015 - although the best positioned companies could boost their earnings by up to 8% (see box ).
Putting a price on emissions
However, the main driver behind the radical shift in the City's view of carbon finance is the EU emissions trading scheme, which is due to open for business in just over a year (ENDS Report 341, pp 18-22 ). For the first time, an environmental market is set to have a profound impact on the bottom line and competitiveness of major companies.
In late October, Prime Minister Tony Blair hosted an "environmental breakfast" with senior executives from ten major investment banks to discuss the impact of the trading scheme, and the potential for the City to become the focus for carbon finance services.
In recent months, a stream of reports from analysts, investment banks and rating agencies has explored the scheme's impact. Most of the names involved - such as JP Morgan, UBS, Citigroup, Deutsche Bank and Credit Suisse First Boston - are not normally associated with environmental initiatives.
To date, the focus has been almost exclusively on the European power industry. The sector is first in line because it is by far the biggest source of CO2 under the trading scheme - and also because it is dominated by a few large listed companies operating in a market well-known to financial analysts.
"The move to a carbon-constrained world is happening faster than people realise. This has moved out of the SRI agenda - and it's not going back," says Chris Rowland, head of utilities research at Dresdner Kleinwort Wasserstein.
Companies and investors are both on a steep learning curve. Last spring, Pricewaterhouse Coopers found that only 58% of European electric utilities had climate policies fully or partly in place. And in November, a report by Innovest for environmental group WWF warned that some companies are still "unprepared" for the trading scheme.
Analysts' efforts to evaluate the scheme's impact are hindered by several large uncertainties. EU Member States are still deciding how to allocate emissions allowances (see pp 5-6 ) - and the carbon price will be strongly affected by decisions on the treatment of "hot air" from Eastern Europe and project credits from the developing world (ENDS Report 344, pp 29-34 ).
Another dash for gas?
It is clear, however, that the scheme is likely to trigger a significant switch from coal to gas. Innovest says that even low carbon prices of €3-5 per tonne of CO2 would be sufficient to prompt a significant level of fuel switching, provided the coal-gas price differential remains less than €4/MWth.
Innovest's report forms part of WWF's Power Switch campaign, which is calling for the power sector in developed countries to be CO2-free by the middle of the century. The group's immediate focus is on the need to move away from coal.
The report includes an assessment of the options for carbon abatement in the UK generating market at different carbon prices (see figure). The assessment was provided by Climate Change Capital, a new UK-based merchant banking firm set up by some of the leading figures in the world of carbon finance.
"Lots of people assume companies can do nothing except build new combined cycle gas turbines," says Tony White, head of research at Climate Change Capital. "But there are lots of ways of skinning the cat using existing assets."
Chris Rowland of Dresdner Kleinwort Wasserstein offers a similar view. The main option for reducing CO2 emissions under the EU trading scheme is to boost the output of "under-utilised CCGT capacity," he says. This alone could reduce the EU's annual emissions by 50-55 million tonnes - broadly equivalent to the expected shortfall in 2005-7 - at a price of €12-17/tCO2e.
DKW reckons that life will get tougher in 2008-12, the second phase of the trading scheme. Meeting anticipated CO2 constraints for this period would need new CCGTs, Mr Rowland says, pushing the carbon price up to €28/tCO2e.
Most analysts broadly agree with this outlook. For example, JP Morgan and UBS Warburg both expect carbon prices to rise from €6-7 initially to €25-28 by 2010. Most also agree that this will have a highly significant impact on wholesale electricity prices, particularly in the UK.
Chris Rowland of DKW says that UK wholesale power prices are already on course to rise by 45% by 2008-12. The trading scheme could mean that prices rise by 80% or more. "The biggest effect is in the UK and Germany, where power prices are close to cash costs," he says. "Many large users will get a shock - but they may not realise how good they've had it historically."
The analysis is sensitive to several key assumptions. Many in the City do not expect project credits from the Kyoto Protocol's flexible mechanisms to make much of an impact - but the European Commission claims that they could reduce the carbon price to less than €13 per tonne.
Moreover, the next dash for gas in power generation coincides with the depletion of North Sea gas supplies and revived concerns over security of supply in the wake of a series of power outages in Europe and the USA. Policymakers may respond by finding some way of shoring up coal-fired generation, putting more emphasis on renewables - and even revisiting the nuclear question.
Impact on companies
The details of the EU trading scheme may remain unclear, as indeed are the prospects for carbon constraints in developed countries outside Europe.
Innovest argues that regulation of CO2 emissions from the US power sector is "plausible" within a few years, despite the Bush administration's stance. It points to initiatives in the US Congress, comments by leading Democratic presidential candidates and initiatives at the State level - and notes that some US corporations such as AEP are exposed because of their operations in the UK.
Innovest is clear that placing a value on CO2 emissions "promises to fundamentally alter the economics" of the power sector - and threatens "to have a similarly disrupting effect" to power market liberalisation.
The report assesses the financial impacts of global and national climate policies on 14 major utilities, including eight European companies. Even under "conservative scenarios", Innovest says, the additional marginal generation costs could exceed 10% of earnings in 2002.
Companies are exposed to differing extents, depending on the stringency of the CO2 constraint, the relative price of coal and gas, the nature of the existing generation portfolio and their ability to switch fuels. The main influences on the cost burden are the way in which emission rights are allocated and the extent to which costs can be passed on to consumers, Innovest says.
According to Innovest, the most exposed companies are Scottish Power and German corporation E.ON, which owns Powergen. At a carbon price of €20 per tonne of CO2, they face costs equivalent to 9% of their earnings. Not surprisingly, firms with the highest carbon intensity tend to face the biggest potential cost burden.
However, all companies stand to reduce their potential losses, or increase their cost recovery, if they switch from coal to less carbon-intensive forms of generation. AEP and German firm RWE, which owns Innogy, could make annual gains of up to €50 million while others, including E.ON, could save perhaps €20 million.
Waiting for a windfall?
Despite all this, Innovest believes that the net financial impact of carbon costs will be positive for many firms. Other analysts put it more bluntly - referring to the potential for a huge windfall.
Investment bank UBS Warburg says the total windfall for EU energy utilities could be worth more than €27 billion - and asks "whatever happened to the principle of 'polluter pays'?"
The main reason for the claimed windfall is that emission rights will be "grandfathered" on the basis of historic emissions. However, wholesale prices are driven by marginal generation - provided across much of Europe by old coal stations. Operators of lower-carbon technologies, including gas, nuclear and renewables, stand to benefit handsomely from higher electricity prices.
At a recent conference, Kim Keats of ICF Consulting explained that even coal-fired stations could become more profitable. "Production is curtailed by the carbon price," he said, "but the price of electricity goes up, keeping revenue roughly the same, while the generator frees up allowances for sale. Coal has a problem - but coal-fired generation will make a lot of money."
A large windfall for utilities would be politically embarrassing - especially as it would coincide with a steep hike in electricity bills for industrial and domestic consumers. JP Morgan believes that Governments are unlikely to let this happen, and will step in with a windfall tax or by clamping down on the power sector in their allocation plans.
Both JP Morgan and UBS say that Scottish and Southern Electricity and Spanish generator Iberdrola are best placed because of their relatively clean generation mix - including a substantial contribution from hydro - and capacity flexibility.
German giant RWE is in a more uncertain position. UBS says that its share price could increase by 57% or fall by 22%, while JP Morgan says it is the most exposed utility because of its high emissions and lack of alternative clean capacity.
The City's growing interest in the impact of carbon finance on power companies is an important new factor in the climate debate. Companies will not merely need to develop a sound carbon management strategy - it seems they will also be asked to defend their stance to an increasingly well-informed financial community.