The facts about emissions trading and company performance

Recent media reports including the Herald article Top companies leaders in pollution, too (SMH 1 February) focusing on the greenhouse gas emissions of ASX200 companies raise the serious question of how to meaningfully assess the impact of the introduction of a carbon price on Australia’s biggest companies.

Investors are already seeking greater disclosure of the risks and opportunities presented by the Government’s proposed Carbon Pollution Reduction Scheme. Reports are being commissioned and released but there has been little scrutiny of whether the information being presented is meaningful and accurate.

It is becoming clear that much of the analysis of how an ETS will impact industry is overly simplistic and does little to enhance understanding of how particular companies will perform in a low carbon environment.

Many of the measures presented such as emissions per million dollars of turnover or emissions per EBITDA are great for grabbing headlines but of little or no use to investors. These types of arbitrary measures do not provide investors with any real analysis of the actual change in a company’s expected profitability as a result of the introduction of emissions trading.

The first step in assessing the impacts of an ETS on a company should be to determine its Scope 1 and Scope 2 emissions. Scope 1 emissions are emissions produced directly by the company in producing its good or services. For example, a power generator produces Scope 1 emissions when it burns coal to create electricity. Scope 2 emissions are those emissions associated with consuming energy that has ‘embedded emissions’. This measure provides a good indicator of the increased energy costs likely to be experienced by a large energy consuming company.

Once Scope 1 and Scope 2 emissions are known, it is relatively easy to determine the increased costs likely to be experienced by a company based upon an assumed carbon price. For example, if we assume that a coal-fired generator produces 20 million tonnes of Scope 1 emissions, a carbon price of $10 will result in increased costs of $200 million. Similarly, in the case of a large energy user with 20 million tonnes of Scope 2 emissions, a carbon price of $10 will result in increased energy costs of $200 million.

However, increased costs are only one side of the equation. The ability to pass costs through to customers will vary across industries and companies. It is critical that analysis include some discussion and quantification of the ability of the company to pass these costs through to consumers. Critical questions that require consideration are: what is the elasticity of demand for the product (i.e. does it have substitutes); are there substitutes for emissions producing inputs (e.g. can gas be substituted for coal?); how trade-exposed is the industry; and is the company likely to receive free emission permits through transitionary assistance from the Government.

The answers to these questions will differ across industries and specific companies. However, it is clear that without considering these issues, analysis is at best partially complete and at worst misleading to investors. A company with significant emissions operating in a non-trade exposed market where demand is highly inelastic may actually not be impacted at all by the proposed Carbon Pollution Reduction Scheme. A simplistic measure such as emissions per EBIT or million dollars turnover would fail to consider these issues and should not be relied upon when considering the financial impacts of emissions trading.

There is one further aspect of an individual company that will need to be considered by investors. Some companies will have ‘early mover advantage’. For example, a company with that has already invested in lower emitting production equipment will experience a cost advantage relative to its competitors. As prices rise to reflect the costs of its competitors, the company will increase its profit as revenues increase by more than costs. Again, simplistic measures will fail to pick up these types of market dynamics.

AGL is one of the few companies to fully disclose the expected impacts on earnings as a result of the introduction of the Carbon Pollution Reduction Scheme. Since 2007, AGL has included forecasts of the impacts of emissions trading on its earnings. This has been done to specifically overcome much of the misunderstanding created through the use of simplistic measures that do not consider the market dynamics of specific industries and companies.

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