Climate change and sustainability concerns are slowly but surely evolving from a niche concern to a mainstream business, economic and political issue. In recent weeks there have been some clear signals that this evolution in business perspectives is reaching a critical mass.
On the corporate front, the Carbon Disclosure Project – a global initiative to encourage and measure the adoption of greenhouse gas emissions reporting – published the 2011 global survey, which found that 68% of respondents are integrating climate change initiatives into their overall business strategy, up from 48% in 20101.
The issue is similarly gaining prominence with investors. On 19 October, a group of 285 investors2, which together manage assets worth more than US$20 trillion, issued a new report and statement to G20 governments calling for an urgent acceleration in the development of domestic and international low carbon policies. The group is calling for the creation of “investment-grade policy” based around government incentives and stable policy frameworks that serve to reduce the risks associated with investing in low carbon projects.
Sustainability is therefore emerging from the corporate responsibility department to becoming a core business issue embedded throughout every department and role within an organisation. The treasury function is no exception and this article explores some of the implications that treasurers should consider. First, however, it is worth giving some thought to the concept of sustainability and the current state of play in the global sustainability policy landscape.
International Initiatives on Climate Change
One way to consider sustainability from a business perspective is to separate it into two fields. On the one hand, the underlying economic impacts of unsustainable businesses practices (e.g. depleting a water basin used as an input to manufacturing or energy production); and the other, the impact of the government responses to sustainability challenges (e.g. increasing taxes on fossil fuels, such as a carbon tax, to discourage their use).
Sustainability is often used synonymously with ‘green’ issues, although it is fair to say that the primary sustainability concern for businesses most often relates to climate change. The same can be said for the policy response. However, natural resource depletion, financial sustainability and wider social impact measurement are increasingly finding their way onto the boardroom agenda. Treasurers will have particular interest in the concept of long-term sustainable financing. It’s a broad concept that is in a sense intrinsic in all treasury activities and beyond the scope of this article or the author’s expertise. But it is worth mentioning because the financial piece should be integrated into a broader overarching sustainability strategy, albeit one that primarily focuses on the ‘green’ issues at this point in time.
Politicians worldwide recognise that while some public opinions on climate change remain heated and diverse, the weight of evidence is that taking action now will be cheaper than dealing with the consequences later. However, policymaking – particularly when it needs to be internationally co-ordinated – is notoriously challenging. The global policymaking effort is underpinned by an UN-led international conference. The 2011 conference will take place in December in Durban, South Africa. The Copenhagen conference in 2009 had the intent of triggering a new era of global collaboration, but the negotiations stuttered due to basic disagreements over responsibilities for cutting emissions. Progress since has been mainly limited to the macro level but advances have been made in some detailed components, such as reducing emissions from forestry and funding for climate change adaptation in developed countries.
In the vacuum created by the lack of progress towards a global framework, some governments are realising unilateral action is the only way forward for now. China’s large population will suffer acutely if climate change reduces domestic agricultural productiveness. The government is starting to take action. For example, there are plans to introduce a fossil fuel based tax in China from 1 November 2011.3 The Chinese are also progressing broader discussions on emissions policy and actively encouraging new clean technology sectors, such as electric cars and solar and wind power generation equipment.
Meanwhile, the UK presses ahead with policies to price UK emissions not already covered by existing policies such as the EU Emissions Trading Scheme (ETS) (through tax and the allocation of emissions trading permits) and set legally binding targets for emissions reductions. The UK government has, however, stressed that green policies will not be introduced at the cost of UK competitiveness, and there are signs that rebates and incentives will be used to mitigate the impact on trade exposed industries. This is evidence of the greatest challenge of unilateral green policymaking – if other countries don’t follow suit the emissions will simply be diverted elsewhere – no net benefit to the planet but a reduction in national competitiveness which can be ill-afforded in the current fragile global economy.
The Sustainability Currency
Firstly and most tangibly there is the emergence of new ‘currencies’, the foremost being greenhouse gas (GHG) emission permits, commonly referred to as carbon permits. A carbon permit gives the owner the right to emit a set amount of GHG, usually one tonne.
The principles of both emissions trading and project-based carbon credits were established by the 1997 UN Kyoto Protocol: a binding legal agreement under which developed countries accepted targets for limiting or reducing GHG emissions. Countries with targets were given an assigned amount of emissions units for the period 2008-12. Those countries with surplus units during that period can sell them to those with a shortfall. In addition to emissions trading, the protocol established two ‘project based mechanisms’ which provide an incentive for investment in low carbon projects:
- Clean Development Mechanism (CDM): the CDM seeks to encourage low carbon investment and sustainable development in developing countries by permitting industrialised countries or companies to finance GHG emissions reduction projects in those countries in return for offset credits.
- Joint Implementation (JI): JI works in a similar fashion to CDM, except that the projects are between two developed countries. By putting a price on carbon, carbon markets such as these help stimulate investment in low carbon technologies and reduce emissions.
Outside of the regulated markets there also exists the voluntary carbon market. This has emerged to enable businesses and individuals to offset their emissions on a voluntary basis. The voluntary market accounted for less than 1% of the volume of carbon credits and allowances traded in 2009. However, for the majority of consumers, voluntary offsetting is their only interaction with the carbon market and so the voluntary market receives a considerable degree of media attention.
In order to achieve its target under the Kyoto Protocol, the EU has established a number of policies to tackle emissions growth. The EU’s flagship climate policy is the EU ETS, which covers approximately 11,000 installations across Europe or half the EU’s GHG emissions. The EU ETS is by far the largest scheme in the carbon markets accounting for over 80% of the volume of carbon units traded in 2009.
Each year, all companies in the scheme must surrender a number of EU Emission Allowances (EUAs) equal to their independently verified, annual emissions for the previous calendar year. Installations emitting more than their allocation must purchase additional EU allowances and those that emit less can sell their excess allowances.
A treasurer may encounter carbon permits and it could fall under their remit to manage how they are purchased, held and sold/surrendered. For cap-and-trade participants, some larger groups with many qualifying facilities have explored ‘pooling’ structures where they transfer all of the freely acquired and purchased permits across Europe into one entity for ease of management and possibly tax efficiency.
Another technique that was observed in the midst of the 2008/2009 financial crisis was for cash-constrained corporates to immediately sell the free permits that they received (probably late February) to raise cash with the intention of rebuying them in time for surrender (April one year later). Derivatives could be used to fix the repurchase price. The same selling strategy has been employed recently in the public sector – treasurers desperate for cash in the Greek government have arranged an auction of carbon permits.4 This auction has contributed to the recent fall in EUA prices – so awareness of this approach is not only important for a treasurer considering their strategic toolkit, but also to improve their understanding of the key price influencers in the market.
Although carbon permits could be seen as a new ‘non-cash currency’, as the paragraph above shows, they are readily convertible into cash and this can make them a versatile tool in treasury management. For example, they could be used as unconventional collateral for raising conventional financing. This would need careful negotiation and management with the finance provider as cap-and-trade permits only typically stay within a corporate for up to 14 months. The financier would need confidence and possibly contractual guarantees that there would be a guaranteed rolling pool of permits made available.
As ever, tax is an important factor to consider in treasury management activity. For emissions permits it will be necessary to consider the direct taxes on any profits made and within this the transfer pricing policies which determine where within the group these profits arise. VAT on carbon permits has been a contentious area as they were used in a bout of carousel (missing trader) VAT fraud that was identified in 2009. The EU has issued a reverse charging directive since, but not all countries have adopted this so VAT on any purchases, transfers or sales will need careful consideration. In general, the tax rules for carbon permits are not well established. The OECD5 has a programme looking at establishing some standardised principles in the hope that this will give national policymakers the confidence to clarify domestic tax rules.
Carbon permits are the most established ‘sustainability currency’, with the global market expected to be worth US$107bn in 20116, but permits for natural resource degradation (sometimes referred to ecosystem or biodiversity permits) or for water use are also expected to emerge. One report estimates that biodiversity loss could be worth US$2.2 trillion annually7. Responsibility for these permits or other types of asset/liability management in relation to these markets may fall to the treasurer. They will at least be expected to be equipped with a reasonable level of awareness.
If you are a treasurer within a business that is providing products and services that are contributing to a more sustainable/low carbon economy, there could be new sources of finance available to you or variations to the terms from existing sources. Policymakers are acutely aware of the vast sums needed to provide more sustainable energy, industrial, buildings and transport infrastructure and steps are being taken to oil the financial wheels. Policies include tax breaks for lenders, loan guarantees and specific financing vehicles such as the Green Investment Bank in the UK or the Clean Energy Finance Corporation in Australia. It would be worthwhile keeping your finger on the pulse of developments in this area so that you can help your organisation prepare and possibly even help shape the policy.
Reducing Operational and Counterparty Risk
Financial risk management is core to the remit of a corporate treasury role and an increasingly important component of this is assessing counterparty risk throughout the entire financial supply chain. Climate change in particular has the capacity to deliver significant shocks to the global financial system. Short-term risks are presented to insurers and other businesses by an increased chance of more extreme weather events – in the longer term, the patterns of economic activity are expected to shift and natural resources are expected to become more valuable and national rights to using and taxing these resources will become increasingly contested.
These risk factors are relevant for every business and, particularly for treasurers, should be given some thought in respect of how they will affect financial counterparties. For businesses considering project financing, management of environmental and social risk should be part of the assessment. A treasurer could learn more by reviewing the Equator Principles8 – a set of broadly adopted social and environmental principles that can be used to form a credit risk management framework.
Operational and counterparty risk considerations should be part of the broader analysis of financial sustainability mentioned earlier in this article. As part of an organisation’s embedded sustainability strategy, the treasury department should have an answer to the question of just how sustainable the business’ financial arrangements and relationships are. Forming an internal view on this would be the starting point, possibly to be followed by some benchmarks with key competitors and consideration of external reporting options. In a world where economic and financial challenges are starting to dominate the headlines once again, corporates that can demonstrate thoroughly considered sustainable financing strategies will stand out favourably from their peers.
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