Next month we will be celebrating World Environment Day on 5th June. While the theme this year is Biodiversity, Covid-19 and Carbon will no doubt remain topical. Covid-19 and Carbon overload (resulting in climate change) are similar in that they are now both Known Unknowns. We know they exist but their eventual impact and damage is still Unknown. However, they are also different, in that Covid-19 arrived unannounced with no one ready for it. Carbon overload on the other hand is well known and has been around, we just consider it a problem beyond our personal, professional and portfolio time horizon. A potentially expensive mistake indeed.
Today, in the spirit of the upcoming World Environment Day, I will highlight why carbon is important for companies and portfolios. I will also share one tool that we use when assessing our companies and portfolio’s financial vulnerability to this risk. That is - Carbon Adjusted Financials.
Climate Change and Carbon
Climate change and associated impacts are just some of the many environmental externalities (others being plastics, water usage, waste, etc) that companies will have to internalise in coming decades. Carbon and carbon equivalent emissions have been indiscriminately released by companies with impunity, making carbon the single biggest and most important issue relating to climate change. This will no longer be tolerated. Legislation, litigation and broader stakeholder pressures are planning for a decarbonising world, one where carbon cost will have to be borne by companies. The EU is leading this effort to decarbonise.
The European Green Deal will work through a framework of regulation and legislation setting clear overarching targets – a bloc-wide goal of net zero carbon emissions by 2050, and a 50%-55% cut in emissions by 2030 (compared with 1990 levels).
Financial Risks of a Decarbonising World
Companies face a multitude of financial risks associated with a decarbonising world, such as stranded assets, lack of access to financial capital, increased insurance costs, potential lawsuits, loss of customers base and revenue to name just a few. Today, we are only focusing on the potential impact of regulated carbon costs on companies.
According to the World Bank, there are about 45 jurisdictions which have instituted a carbon tax on emissions, transport fuels, and other fossil fuels. Figure 1 below demonstrates the price difference in carbon tax between these countries. Companies operating in these jurisdictions are already factoring in carbon costs, especially related to transportation. Hence, we are not far from a time where carbon costs become mainstream and internationally standardised.
Figure 1: Varying carbon tax prices across international jurisdictions (as of latest 2020) Source: World Bank’s Carbon Pricing Dashboard:https://carbonpricingdashboard.worldbank.org/map_data
What are Companies Doing?
With increasing pressure from investors, customers and governments, companies globally are adopting a mix of methods to reduce their carbon emissions. We share with you a few industry practices used by companies to reduce their carbon emissions and potential costs:
Investing in renewable energy: initiatives such as RE100 are pushing companies to ramp up their investments and commit to 100% renewable electricity
Internal carbon pricing: Also known as shadow pricing. Companies adopting this method hold business units accountable for their carbon emissions by allocating a certain carbon cost to them. Companies recognize that putting an internal carbon cost not only incentivises emission reductions, but also prepares their cost structures and business model for a decarbonising world.
Carbon credits off-setting: companies are purchasing carbon credits from accredited sources, such as Neste mentioned below
Incentivisation: corporations are also using incentives to reduce company travel (especially by flights) where both clients and employee can enjoy varying benefits for arranging virtual meetings, if applicable
Financial Opportunities of a Decarbonising World
One of the greatest risks, but also opportunities for companies that are prepared, is a decarbonising economy. While most companies are just only realising their carbon footprints, there are companies that are not only helping reduce carbon emissions but are doing so with extra profitability. As an example:
Neste is the world's largest renewable diesel producer. Neste’s MY Renewable Diesel is a game changer in both land and air transportation as it is a high-performing low-carbon biofuel, that is suitable for all diesel engines and helps users reduce their carbon footprint by 70%-90% compared to fossil fuel diesels. By end 2019, Neste’s renewable diesel helped remove the equivalent of 3.5 million passenger cars carbon emissions. In the process they have materially financially benefited from the carbon credits they sell in the California Low Carbon Fuel Standards (LCFS) scheme
SAP, the German software company has been able to use its carbon reduction targets to also reduce its energy costs through improved energy efficiency. The company has set its eyes on becoming carbon neutral by 2025, by implementing a 3-part strategy: avoid, reduce and compensate. This strategy has already not only resulted in costs savings of about EU 273mn in past three years, but also enabled them to achieve their 2020 emissions reduction targets well ahead of schedule in 2017
Are Your Portfolio Companies Ready?
As Panvestors we seek companies who are committed to reduce their carbon footprint in a measured, practical, impactful, realistic and financially sustainable manner. To ensure we can measure and monitor our portfolio companies progress, we look to the potential financial impact of their carbon reduction efforts, through measuring their Carbon Adjusted EPS, Carbon Adjusted EPS Growth and also Carbon Adjusted PE. As an example: Danone’s Carbon-adjusted EPS is set to grow faster in the coming years than recurring EPS as the company's carbon emissions are falling faster than the underlying volume/earnings growth. In 2019, Danone’s carbon-adjusted EPS grew 12%, ahead of the company's 8.3% recurring EPS growth. This shows that as and when Carbon taxes and/or carbon reducing regulations are enforced, Danone’s business and financial model will be more resilient than those without carbon reduction strategies.
What you should look for in your Portfolio Companies?
Firstly, companies and portfolios should have minimum difference between their traditional reported EPS Growth and their Carbon Adjusted EPS Growth. A company or portfolio with a 10% reported EPS growth but a 4% Carbon Adjusted EPS growth, is carrying serious future earnings risks. Our Global Panvest Fund’s portfolio of companies had a weighted average 2019 EPS growth of 11% vs their Carbon Adjusted EPS growth of 13.2%. This highlights that our portfolio companies are reducing their carbon emission and costs at a financially significant rate. Do you know what your portfolios Carbon Adjusted EPS Growth is? Secondly, Portfolios and Companies valuations should be compared with Carbon Adjusted valuation metrics. A reported 10x Price to Earnings (PE) portfolio or company may seem cheap and fair value, until you carbon adjust its earnings. A Carbon Adjusted PE for the same portfolio or company may highlight a very different picture altogether. You may be sitting on significant future value destruction as and when carbon costs are internalised in decarbonised world. In advance, Happy World Environment Day! Munib Madni, Founding Panvestor