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An approach to valuing decarbonisation: Identifying the leaders and laggards

11 April 2024

For sectors with material CO2 emissions, carbon pricing will present a significant challenge and reveal companies to be either leaders or laggards.

By Jags Walia,

Van Lanschot Kempen

Global CO2 pricing is on its way: just a decade ago 8% of the planet’s emissions were priced while today, this is closer to 25%.

In the past decade, CO2 pricing has not been material, however across the US, European Union and China – the three biggest CO2 emitting areas – we are now seeing a broader adoption of CO2 pricing and increasing CO2 price levels.

We expect this to be the new regime for the coming decades. This change will make a company’s decarbonisation trajectory more financially material for generating alpha, since the costs of CO2 will weigh on the valuation of companies that have not decarbonised.

For sectors with material CO2 emissions, material CO2 pricing will present a significant challenge and reveal companies to be either leaders or laggards.


The US utilities problem

Amidst the global economic downturn, utilities offer a safe haven for those looking to position their portfolios defensively. However, the sector in the United States is responsible for 25% of total greenhouse gas emissions and the introduction of global CO2 pricing will have a marked impact on valuations.

The winners will be those companies which decarbonise the fastest and hence minimise the impact of carbon emissions pricing schemes. The losers will be those that decarbonise the slowest and hence will be most exposed to these costs.

The question for investors going forward will be how to meaningfully identify which is which.

With so much carbon data available, it is essential to apply strict goal setting and to plan execution criteria. Without doing this, investors are left potentially susceptible to greenwashing by giving companies more credit than they are due.


Dig into the detail

The ability to forecast carbon emissions and carbon costs is a critical piece of the puzzle.

The approach we take is to analyse publicly available information, such as the US Energy Information Administration (EIA)’s overview of all US power generation facilities (via S&P Capital IQ).

From this data set, it is possible to construct a comprehensive picture of all US announced coal and gas plant decommissions, coal to gas conversions, and gas plants being built in the US over the coming three decades – and then to estimate the future greenhouse gas (GHG) emissions of planned power plants, and forecasting the change in GHG emissions from each facility.

An informed, granular approach provides a more reliable estimate of decarbonisation pathways to better inform investment decisions.


The future is already here, it’s just not very evenly distributed

Incorporating the future matters. Were we to only examine a screenshot of the present, we would importantly miss out on relevant information regarding the environmental trajectories of companies.

For example, a utilities company which has disclosed the decommission date of a significant number of coal power plants clearly has a more credible strategy than a competitor which has communicated the ambition to phase out coal but has yet to announce when and how this will be done with any meaningful detail.

What’s the cost?

To estimate the financial impact of a carbon pricing scheme on US utilities companies, there are two key factors to consider: allowed emissions and emissions cost.

In Europe, carbon allowances represent about 50% of the total carbon emissions, above which the companies will be priced. Using Europe as a proxy, it is reasonable to estimate that half of the total emissions a US utility company produces will be subject to a cost.

By modelling higher climate scenarios against carbon price estimations and forecasts, it is possible to measure the relative impact these changes would have on each company’s market cap. This approach also preserves the valuation of companies which have already decarbonised and hence do not show a declining carbon emissions pathway.


A robust approach that informs valuations

On the positive side, the more credible and material a company’s decarbonisation plans are, the more they will be rewarded by investors. All things being equal, this will increase valuation upside and hence more capital will be allocated.

However, when the decarbonisation pathways do not fulfill the required criteria, the company is more likely to be penalised in the investment process.

This shortfall in commitment can often become a trigger for engagement, where investors actively raise the issue with management and set expectations for a change which is to the benefit of shareholders, and wider society.


The polluter pays

Pricing externalities adheres to the ‘polluter pays’ principle and is an efficient manner to reallocate capital towards sustainable economic activities. Carbon pricing schemes will therefore play a key role in the decarbonisation of companies.

This has already happened in Europe, where companies are only permitted to emit up to a certain threshold of carbon, above which they have to buy carbon credits to offset extra emissions. Furthermore, the price of European carbon credits has been rising – from around €20 per ton of CO2 in 2020 to around €90 per ton of CO2 in 2023.

In the US, there is an active debate to initiate a similar policy and other countries, such as China, are following as well.

This represents a foreseeable expense in the near to medium term for utility companies, making it all the more important for investors to adopt frameworks that allow them to effectively identify those which are materially decarbonising. Ultimately, investors need to be able to cut through a company’s stated sustainability ambitions and uncover its credible ambitions. This will protect from claims of greenwashing and more broadly, help separate the leaders from the laggards over the coming decades.

Jags Walia is head of infrastructure at Van Lanschot Kempen. The views expressed above should not be taken as investment advice.

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