Carbon Emissions Move up the Board Agenda

[Derek_Parkinson]

The international community is moving closer to agreement on a climate change treaty, China and India have signed a five-year climate change agreement and the US looks set to pass its own climate change legislation within months. There is little doubt that climate change is becoming a key corporate risk, in terms of both financial and reputational risk.

One thing remains clear however, and that is the failure of many corporations to understand how soon carbon legislation will have a direct financial impact on their operations. In November 2008, Low Carbon Board Report undertook a survey of readers, finding that over 50% of respondents didn’t see an increasing cost of carbon as a threat to their business.

It may not be a threat, but carbon emissions and their management are set to become a business critical issue as carbon accounting moves from a voluntary reporting process to a legislative compliance regime. Companies and organisations will be obliged to measure and publicly disclose and report their energy use and related emissions. Soon there will be financial penalties for failing to do so, underpinned by government legislation. The end result is to put carbon emissions, their management and their mitigation, firmly on the agenda of finance directors

The UK was the first nation to pass climate change legislation, with the Climate Change Act 2008, creating a legally binding long term framework to cut carbon emissions. The Carbon Reduction Commitment Energy Efficiency Scheme (CRCEES), formerly the Carbon Reduction Scheme, lies at the heart of government plans to encourage organisations that fall outside the EU Emissions Trading Scheme to play a full role in contributing to emissions reductions.

Carbon costs

CRCEES has gone through some changes, and is still under consultation due to issues surrounding accounting for renewable energy, but it effectively ensures a direct link between corporate carbon emissions and the financial bottom line.

Beginning in April 2010, CRCEES requires every company with half-hourly meters to register, but only those firms with annual electricity spend of £0.5m or more will be subject to the scheme. They will have to calculate their energy footprint for 2010-2011 using a Government methodology and report that to the Environment Agency (EA).

The following year, from April 2011, organisations will have to purchase allowances to cover their projected emissions for year two of the scheme. There will be no cap at this point but, as the Government has already set a price of £12 per tonne for carbon credits for the scheme, the cost will be immediate. It’s been anticipated that the CRCEES alone could add 12% to energy costs, even without further costs increases in fuel or other inputs. The additional cost to a £0.5m energy bill will be just under £50,000.

The second phase of the scheme will begin in April 2013 where, following advice from the Committee on Climate Change, the Government plans to cap the number of allowances within the scheme, with participants bidding in a blind auction. By April 2014, when credits equivalent to emissions must be surrendered to the EA, it seems likely that there will be a dearth of available emissions credits, and the requirement to purchase them could increase costs significantly.

Of course, that’s not the only problem. In order to support companies in their transition to the new system, the Government has decided to create a league table for performance on cutting emissions, and this starts in 2011. Under the rules of the scheme, money spent within the CRCEES will be returned to industry but the top performers will receive a 10% bonus, while the worst performers will receive a 10% penalties. Fines and penalties will both escalate over time.

Financial risk

This means that even if you don’t think your company has much to worry about in terms of emissions management and the need to purchase carbon credits, you do need to worry about how you’re going to be benchmarked against your competitors. A finance director could forecast the purchase price of necessary credits and then find out, after the fact, that the company is liable for a penalty.

The financial risk of failing to forecast exposure, cash flow, and the use of allowances against actual budgeted allowances will become significant. The fines for inaccurate reporting under the new programme are like to be far more aggressive than the initial capped cost of emissions credits. The penalty for a 10% inaccuracy in reported emissions has been estimated as being as much as £150,000 under the scheme for a medium-sized company.

On the upside, there is significant potential in terms of cost savings. The Government estimates participants could save around £1 billion per year by 2020 through cost effective energy efficiency measures that are not yet being taken up. Cost analysis for the implementation of energy savings measures versus potential carbon credit and penalty costs is critical.

Energy efficiency savings are fairly low hanging fruit and relatively easy to achieve. One key energy solution for buildings, especially in the commercial sector, lies in lighting and temperature controls, as well as the technology that enables companies to track what’s happening in their buildings.

Building management systems (BMS), when working together with a network of sensors, can manage lights, heat, ventilation and air conditioning (HVAC) systems, fire safety and security equipment and even communication networks. According to McKinsey research, in the US alone using such tools could cut the commercial-building sector’s energy bill, and associated emissions, by nearly 30% a year.

Early action

Estimates of the potential savings vary but, in some cases, energy costs can be cut by up to two-thirds. Of course, even if the cost of introducing energy efficiency technology can be quickly repaid in savings, it is still a cost, and at the moment, many companies are keen for obvious reasons to cut costs and avoid capital expenditure. There are a range of loans and capital allowances provided by government to support the transition to a more efficient corporate framework. Whichever way you look at it, capital outlay, managing operational costs, budgeting for credits, penalties or bonuses, financial forecasting is set to be significantly affected by the scheme.

The financial and reputational cost is potentially huge. One of the biggest issues is the short time-frame which remains within which to act. In order to support those companies which have already taken action, the Government has introduced the Early Action Metric, to reward those who have already made strides towards cutting emissions. This will be taken into account when identifying their position in the first league table in October 2011.

For the larger companies whose finance directors have not yet acted, it may be too late to achieve top of the league table, but there’s still the fight to avoid relegation. The short, medium and long term impact of carbon pricing is set to transform the economic risk factors of a broad range of businesses. There’s a direct financial cost to acting slowly, and that makes carbon measurement and management a critical issue for the Board. Whether threat or opportunity, the UK’s finance directors are going to have to learn a lot more about carbon management, and soon.

Felicia Jackson is an author and analyst focused on the low carbon economy. Her new book ‘Conquering Carbon’, is published by New Holland Publishing this month.