Thursday, 15 January 2015

Taking the carbon out of economic growth – how to regulate financial institutions - Prof Colin Haslam, Professor in Accounting and Finance at Queen Mary

Image: Rochester Factory Credit: Ben Reierson License: CC BY 2.0

Reducing carbon emissions is a major global challenge. Over the last four decades the amount of carbon dioxide equivalent (CO2e) emitted annually into the atmosphere has increased from 32 billion tonnes to 45 billion tonnes and CO2e concentrations in the atmosphere are increasing at an annual rate of 1 part per million. If these trends continue, scientists expect that surface climate temperatures will increase to levels exceeding 2 degrees Celsius (2oC) above pre-industrial levels. In turn, this could contribute to accelerate melting of glacial ice, higher tides, additional flooding and a host of other volatile climate related events.

Reducing CO2 emissions has been a legal obligation for governments under the Kyoto agreement, which has recently been extended from 2013 to 2020. It is a major challenge because, at a global level, although we are reducing carbon intensity per financial unit of GDP by about 1 percent per year, global GDP itself is growing at over 3 percent. So it is reasonable to expect that carbon emissions will continue to grow at 2 percent per annum. Any growth in emissions risks inflating temperatures closer to and even above the + 2oC target, which governments have set in the climate negotiations at the UN.

There are significant challenges associated with decarbonising the capital stack position of FIs in the corporate sector(s) of the advanced economies, which account for over two-thirds of carbon emissions. The challenge is to align measurement, disclosure and behavioural change. On measurement, the greenhouse gas protocol (GHG Protocol) classifies carbon emissions into three ‘scopes’:

So, the challenge is to decarbonise GDP at a faster rate than 1 percent per annum. Yet even this will only move us towards holding the line! The United Nations Environment Programme and Greenhouse Gas Protocol (UNEP/GHG-Protocol) agencies have combined with other key stakeholders to establish a global project that has set itself the objective of widening carbon disclosure and design of financial toolkits to decarbonise GDP. These toolkits will help inform finance industry (FI) analysts about carbon-risk embedded in capital investment allocations the so-called the “capital stack”.

The UNEP/GHG-Protocol carbon disclosure risk project is motivated by a general observation that ‘the world's financial institutions are there to finance a growing, sustainable economy, but the evidence suggests that, today, the industry performs that task poorly’.

Financial Institutions (FIs) could play a key role in modifying corporate behaviour towards decarbonising their business models. As key bodies in allocating debt and equity among firms, these financial organisations need to increase the visibility of carbon risk attached to their current and future investment positions. Funding allocations made by FIs could progressively be diverted towards firms which operate with lower carbon emissions per financial unit of output. Metrics such as carbon emissions per unit of sales revenue or cash earnings could be employed to redirect investment flows into firms which are decarbonising their business model. Moreover, because they are deemed to present a lower investment risk, they would also benefit from a reduced cost of capital. Portfolio decarbonisation can be achieved by withdrawing capital from particularly carbon-intensive companies, projects and technologies in each sector and by re-investing that capital into particularly carbon-efficient companies, projects, and technologies in the same sector.

·         Scope 1: emissions that are direct emissions from owned or controlled sources;
·         Scope 2: indirect emissions incurred in the supply of purchased electricity; and
·         Scope 3: comprising all other indirect emissions occurring in the reporting company’s value chain, including both upstream and downstream activities.

The science of translating different types of emissions into carbon dioxide equivalents (CO2e) is now relatively stable. By contrast, accounting boundaries used to capture carbon are much less stable. This is because they are affected by assumptions about which carbon generating activities are located inside or outside the responsibility and control of a reporting entity. When firms restructure, outsource and off-shore business processes or carve up asset ownership, they change their operational responsibilities in ways that quickly affect their reported carbon emissions.

Mandatory carbon reporting is necessary if we are to determine whether companies are changing the intensity and trajectory of their carbon emissions. From October 2013, the UK Companies Act 2006 (Strategic and Directors’ Reports: Regulations 2013) requires that companies listed on the London Stock Exchange make carbon disclosures in their directors’ reports. These include the annual quantity of greenhouse gas (GHG) emissions stated in tonnes of carbon dioxide equivalent (CO2e) from activities for which the company is responsible, and at least one carbon intensity ratio. Until recently, no country had imposed regulations regarding emissions reporting on all companies, irrespective of their size, industry, number of employees, etc. The United Kingdom is the exception.

Changing behaviour requires that we embed carbon-intensity metrics into executive remuneration packages to change corporate governance. Executive remuneration is already linked to financial performance metrics such as Earnings per Share (EPS), Return on Capital Employed, and Economic Value Added (EVA™). We could, for example, embed carbon emissions per employee, carbon per unit of sales revenue, cash earnings or profit into senior executive bonus packages.

UNEP needs to encourage FIs to decarbonise their capital stack. But to do this, FIs need to be subject to mandatory carbon emissions disclosure duties. Mandatory disclosures would reveal both the nature and extent to which intervention(s) are decarbonising value chains.  Disclosures need to be converted into carbon-financial risk metrics and embedded into executive remuneration packages so as to modify corporate governance. The political and practical challenge for UNEP is to deliver alignment between carbon emissions measurement, disclosure and changes in behaviour. UNEP must now encourage FIs that have power and influence over the corporate sector to decarbonise economic growth.

Colin Haslam is Professor of Finance and Accounting in the School of Business and Management at Queen Mary University of London. He is an adviser to the UNEP/GHG Technical Working Group 5 (Carbon-risk metrics) and has recently been involved in the European Financial Reporting Advisory Group (EFRAG) ‘Towards a Disclosure Framework for the Notes in Financial Statements’ and ‘The Role of the Business Model in Financial Statements’ and has given presentations on these issues to the European Parliament in November 2014.

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