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Asset or liability? What carbon means for corporate balance sheets

August 30, 2022
Carbon: Asset or Liability?
Carbon: Asset or Liability?

As private organizations face rising ESG-related pressures, the medium- to long-term cost predictions for carbon is going up. Whether due to carbon taxes, cap and trade systems, or even voluntary commitments, large corporations will soon be adding carbon to their balance sheets.

Forward-thinking companies are doing this already, and in doing so, they are transforming carbon from liability to asset.

A brief primer on mandated carbon pricing

What does it mean to put a price on carbon? A carbon price simply means that it will no longer be free for companies to release CO2 into the atmosphere. To hit the Paris targets limiting global warming to 1.5-2°C, the IPCC says we’ll need to stop putting carbon into the atmosphere once we reach 430-450 ppm. In 2021, we hit 414 ppm.

There’s a pretty clear gap here between supply and demand. The supply of remaining atmospheric space for CO2 is rapidly disappearing. Meanwhile, demand for carbon-intensive activities remains. With limited atmospheric space for additional carbon particles, every extra ton is going to cost emitters.

What’s the current state of carbon pricing?

Around the world, there are at 68 direct carbon pricing mechanisms in place, 36 of which are carbon taxes, and 32 of which are Emissions Trading Systems (ETSs) such as the EU’s ETS, which is the largest in the world by value; by coverage, China’s ETS is larger.

But many parts of the world (including many parts of the USA) aren’t subject to carbon pricing, which means the price of carbon is yet to feature on many corporate balance sheets. This is a mistake, because it’s becoming increasingly clear that a price on carbon is coming — soon.

What will carbon cost?

Right now, mandated carbon price estimates vary widely. Reputable estimates suggest an initial global carbon price is likely to be somewhere between $50-100 USD per ton. (Compare this to the currently unregulated voluntary carbon credit market, where prices can range from a few cents to $2,000 per ton).

What’s important is that carbon prices won’t remain static. Though an initial price may be set at approximately $50 per ton, we can expect this to increase dramatically as atmospheric real estate for carbon dries up.

Voluntary climate commitments

Mandatory carbon prices aside, even voluntary commitments (such as net zero or carbon neutral targets) can become liabilities. Across industries and around the world, more and more firms are setting voluntary commitments as a result of stakeholder, consumer and peer pressure.

Many of these commitments involve highly ambitious emissions reduction targets that will almost certainly require the use of carbon offsets. With increasing legislation and accountability around public climate targets (including the SEC’s new climate disclosure rule), even voluntary commitments put companies at risk of fines and legal trouble if they fail to meet them.

The price of voluntary carbon offsets is on the rise

The supply of carbon offsets supply isn’t keeping up with the demand. This means the amount companies need to pay for a single carbon credit (one ton of carbon avoided/removed) is going up, fast. In our 2022 Carbon Credit Crunch Report, we reported that voluntary carbon credit inventories fell by 50% in 2021, which was likely the result of an explosion in demand, and constrained supply that can’t respond elastically to rising prices.

Carbon is your firm’s imminent liability

Firms that aren’t yet factoring in the price of carbon or carbon credits to their balance sheets are playing with fire. In their article on carbon liability for Harvard Business Review, Eccles and Mulliken give the hypothetical example of ExxonMobil. In 2020, ExxonMobil produced 112 million tons of CO2 equivalent (without factoring in their Scope 3 emissions). If a carbon price were to enter the picture at $100 per ton, that’s an annual carbon fee of $11 billion. The problem? Their earnings averaged $8 billion annually over the previous five years.

So carbon is a clear financial liability (for some firms more than others), but financial liability isn’t the only carbon-related risk for companies. In an increasingly regulated environment, the legal liability is significant for exceeding emissions caps and allowances (which can also lead to fines and financial consequences), falling short of public climate commitments (or even the ESG performance required for Sustainability Linked Loans), or failing to accurately disclose carbon data. And since the news media doesn’t miss a beat with corporate scandals, any carbon risk also threatens brand image and corporate reputation.

But with the right approach, carbon is an asset

Mandated carbon prices and voluntary decarbonization commitments create financial liabilities for companies, but smart leaders are hedging their bets by treating carbon as an asset class, and securing long-term carbon offset arrangements and power purchase agreements to combat carbon’s rising value.

In our Sustainability Leaders panel at our 2022 Carbon Markets Summit, Torsten Lichtenau of Bain & Company spoke about the financial role of carbon credits. “Carbon credits are an asset, and should be treated as such on the balance sheet,” says Torsten. The more expensive carbon becomes, the more smart firms will do to radically reduce emissions, and thereby create a competitive advantage. And with carbon prices rising, the longer a company waits to decarbonize, the more expensive it will become.

“The most progressive players probably have a balanced view,” Torsten says, “managing liability but also investing in a growing asset that is needed for the world to decarbonize.”

In proactive firms, conversations about decarbonization and carbon credits are increasingly moving from the domain of Chief Sustainability Officers over to Chief Finance Officers. For sustainability teams yet to see this shift, calculating your company’s carbon liability can be an effective way to get C-suite buy-in on decarbonization strategies.

The other types of carbon assets

Credits aren’t the only carbon assets available. Smart firms are also capitalizing on allowances, grants, and tax incentives for green business initiatives. Additionally, a genuine commitment to decarbonization is itself a strategic marketing and business asset. As ESG markets boom and conscious consumers command more influence, an aggressive commitment to environmental sustainability scores points with consumers, investors, employees, and stakeholders everywhere.

Three ways to turn carbon liability into carbon assets

1. Price carbon internally

Forward-thinking firms are putting their own price on carbon internally, ahead of legislation, and/or factoring in the cost of carbon credits required to hit decarbonization targets. Your internal carbon prices should reflect the dynamic nature of carbon pricing mechanisms. Eccles and Mulliken recommend determining a set of prices to use and forming a forward pricing curve that might look something like:

2022 - $50/ton

2024 - $100/ton

2026 - $200/ton

2028 - $300/ton

2. Avoid, reduce, offset

In a carbon-priced world, emissions reduction is cost reduction. The companies that can decarbonize most aggressively will reap the competitive cost advantages (not to mention the benefits of a stronger brand image and corporate reputation). Far from the traditional understanding of green being the ‘expensive’ option, reducing emissions will soon be a crucial cost-cutting exercise for all firms.

We recommend that firms follow the mitigation hierarchy: First, focus on avoiding the creation of future carbon emissions (for example, by building green, self-powered facilities). Then, look to reduce existing emissions across Scope 1, 2, and 3. Most firms won’t achieve 100% emissions reduction, so offsetting is crucial for mitigating the impact of inevitable emissions that remain after avoidance and reduction efforts.

3. Optimize for quality

Not all green initiatives, suppliers, and offsets are created equal. Although it can be tempting to optimize for cost, the risks associated with poor quality projects, suppliers, and carbon credits are substantial. As with any market, the cost of carbon credits often rises with quality, so aim to invest as much as you can afford into high-quality offsets. With a third-party verification tool like Sylvera, you can ensure you’re mitigating that risk and investing in high quality offsets at least cost to meet your targets.

The time to decarbonize is now

Rising carbon prices send a clear message to companies: the longer you wait to decarbonize, the more expensive it will become. The companies that start their decarbonization journeys now — accounting for the true cost of carbon and investing in high-quality suppliers and partners — will win out in the end.

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