It's time to measure the real impact of a carbon tax
There has been a great deal of debate about what it will take for individual companies to reduce their carbon dioxide (CO2) emissions. Many argue that either a carbon tax or cap-and-trade program is the most viable option. Some even maintain that such policies should include all greenhouse gases (GHG), including methane and nitrous oxide.
In any case, it is difficult to form thoughtful views on emissions taxes because much of the debate is highly politicized, with assumptions that carbon taxes would be harmful to companies and economies. These assumptions ignore the external impacts, such as rising food prices and health care costs, that carbon emissions have on economies, which seems increasingly illogical in this day and age.
KBRA believes meaningful reductions in carbon emissions will require that a price be assigned to the impact emissions have on the economy.
Politicization of carbon pricing clouds the reality that many companies can easily absorb or pass through the cost of emissions.
Transparent carbon pricing schemes would likely accelerate the development of technologies that reduce emissions or remove carbon from the atmosphere.
As KBRA discussed in Carbon Pricing and Its Potential Credit Impact, any policy that introduces a price for carbon’s environmental impact would incentivize more dramatic, scalable technologies and processes that reduce emissions. Most experts argue that without a financial quantification of this impact, progress toward meaningful reversal of centuries of CO2 accumulation in the earth’s atmosphere will remain elusive.
While we acknowledge the complexity and politics associated with attempts to implement a carbon pricing scheme, the sheer data helps us conclude that all other actions combined will lead to slow progress, at best. Creating a more direct financial impact, however, would create a stronger incentive for companies to change their business practices. According to the High-Level Commission on Carbon Prices, an effective carbon pricing scheme—pricing carbon between $40-$80 per metric ton (or tonne) of CO2 (tCO2) by 2020 and $50-$100/tCO2 by 2030—would reduce carbon emissions in line with the targets of the Paris Agreement. However, given the limited markets and the constrained incentives for trading carbon credits, the median global carbon prices are currently about $15/tCO2. While some companies may be willing to reduce emissions for environmental reasons or in response to stakeholder pressure, others will only do so if it impacts their financial performance, which is unlikely given current incentive systems.
The Problem With Internal Carbon Prices
While many companies now report internal carbon prices, there is no agreed upon accounting or regulatory standard guiding their methodology or measurement techniques. Some companies have relied on a theoretical price of carbon, while others have determined what it would cost to offset its emissions. Meanwhile, it appears that internal carbon pricing exercises are sometimes more linked to public relations efforts than to meaningful changes in operations or technologies. KBRA believes that it is a step in the right direction for companies to report internal carbon prices; however, the inconsistent approach makes it difficult to compare exposures across sectors.
A standardized approach for calculating internal carbon pricing would provide investors with insight into a company’s exposure to emission regulations, while also allowing them to compare prices across industries. Prices that are consistently updated could also provide insight into a company’s ability to reduce its emissions and achieve its stated goals. KBRA believes companies will eventually need to provide this level of reporting to gain the broadest and most efficient access to capital markets as investors shift to environmentally focused companies. Companies that have significant exposure to carbon will likely need to execute on a public strategy to reduce emissions by a given date to maintain strong relationships with its stakeholders. We believe these companies can illustrate the progress they have made by publishing carbon prices that reflects their true cost of carbon.
Below are some techniques that companies use to report internal carbon pricing:
Implicit Price: Applies a tax on certain carbon-intensive activities (e.g., transportation and heating) to measure the potential regulatory impact. This strategy also considers how much it would cost a company to switch its electricity consumption to renewable resources.
Internal Fee: Applies an internal price to penalize different divisions for their carbon emissions. This strategy is usually implemented to incentivize business lines to reduce their carbon footprint.
Shadow Pricing: Applies a theoretical price of carbon. This is the most common form of carbon pricing.
Offsets: Applies a price based on how much it would cost a company to offset its carbon emissions. This could be done through purchasing carbon credits or changing business practices.
No matter what approach a company uses to calculate its exposure to future regulations, the first step in the process is to determine its emissions, categorized into three scopes: Scope 1, direct emissions or emissions produced from corporate activities; Scope 2, indirect emissions from electricity, heating, cooling, and other modes of energy consumption; and Scope 3, all other indirect emissions that occur throughout the value chain. Once these values are known, a company could utilize one of the methods outlined above to assess its financial exposure to carbon regulation.
For example, in 2019, Exxon reported that its Scope 1 and 2 emissions totaled 120 million t/CO2e. Based on these levels and a shadow price of carbon set at $100 t/CO2e, the company would have paid around $12 billion in taxes. This conservatively assumes that there were no allowances and that the company did not purchase any offsets. While a carbon tax of $12 billion is substantial, Exxon generated around $264 billion of revenue and $39.8 billion of EBITDA during this period. Given its strong cash flow position, it could have easily paid the carbon tax from its cash flow from operations. However, the same might not be true if the company had to pay a similar tax in 2020 when its EBITDA fell to $18.3 billion. During this period, the company’s debt-to-EBITDA ratio was around 3.7x, which would have increased to over 10x if it had to absorb a $12 billion carbon tax. While these are extreme scenarios, it illustrates the impact a carbon tax could have on the credit quality of an individual company.
Figure 1 and Figure 2 compare Exxon’s financial metrics pre- and post-carbon tax:
Reducing Carbon Emissions
While using theoretical prices can help companies prepare for what lies ahead, a price based on how much it would cost a company to reduce its emissions would provide greater insight into its true price of carbon. However, most companies are relying on external sources to determine an internal price of carbon. According to the Carbon Disclosure Project (CDP), about half of the companies (approximately 430) participating in a recent study on carbon pricing suggested they were relying on a shadow price. KBRA believes this is a flawed strategy, as most companies should understand the trade-off between paying a carbon tax or taking measures internally to reduce emissions, which, depending on the appraisal process, may not be fully reflected in a shadow price. In certain cases, it may be more cost effective for companies to implement a capital expenditure program, switch to renewable energy, or eliminate certain business lines rather than pay a carbon tax.
Ultimately, it will be governments, not corporations, that own the task of designing and implementing a carbon tax. This fact introduces considerable uncertainty, given the disruptive (potentially highly disruptive) nature of such a top-down energy transition. Setting a carbon price at a relatively low rate will not fulfill the long-term goal of having companies reduce emissions. Conversely, a price that is set too high could have a significant impact on the global economy, as higher costs will likely be passed on to the consumer. Although there are many different approaches to reduce carbon emissions, most economists and policymakers agree that the best way to shift away from fossil fuels and reduce emissions is to put a price on carbon. There is no uncertainty that there will be further emission regulation, but questions remain about what the policies will entail and what their impacts will be on corporate credit.
Andrew Giudici, Global Head of Corporate, Project, and Infrastructure Finance
+1 (646) 731-2372
William Cox, Global Head of Corporate, Financial and Government Ratings
+1 (646) 731-2472
- ESG Global Rating Methodology
- Carbon Pricing and Its Potential Credit Impact
- Credit Ratings Deserve ESG Risk Analysis, Not ESG Scores
- Corporates: KBRA’s Framework for Incorporating ESG Risk Management in Credit Ratings
- Midstream Energy Companies: KBRA’s Framework for Incorporating ESG Risk Management in Credit Ratings