How are energy companies preparing for a future with carbon pricing?

Carbon dioxide concentration in the Earth’s atmosphere reconstructed via ice cores. Source:NASA

Basis for Carbon Pricing

A discussion on carbon pricing almost always goes back to the economic concept of externalities — the positive and negative impacts (or costs) of the firm’s activities that are incurred by a third party such as the government, public health and of course, the natural environment.

While some externalities are evident, easily quantifiable and even publicly available (for example, the number of local jobs created by a firm’s operations), other externalities are notoriously difficult, time consuming and expensive to accurately quantify. For example, consider the negative externality from the waste water produced in an industrial park. While effluents can be processed to meet required disposal standards, it is often difficult to completely eliminate negative impacts on the existing water resource.

This gradual degradation of natural resources has a cost that is borne by society but not always priced into the products and services provided by businesses — essentially the reason for the introduction of Pigovian taxes, or taxes on people or firms that are involved in activities with negative effects to society.

Carbon pricing is a form of Pigovian tax on greenhouse gases (GHG) by imposing a clear, tangible cost to the negative externalities from a firm’s carbon footprint (I summarize carbon footprint in point 5 of this article). Interestingly, carbon pricing systems already apply on about 22% of global GHG emissions (at the time of writing) as shown on the World Bank’s Carbon Pricing Dashboard.

Summary of global carbon pricing initiatives as of April 2021. Source: World Bank Carbon Pricing Dashboard

Summary of Pricing Methods

Although carbon pricing systems are often tailored to a country’s or region’s specific needs, they can generally be classified into 2 main categories:

• Carbon tax, where a tax is levied on greenhouse gas emissions or the carbon contained in hydrocarbon fuels such as coal, oil and natural gas. The price of emissions (e.g. $/tonne of CO2 equivalent) is fixed by the regulating authority.
• Emissions trading system (ETS) or cap-and-trade, where the regulator first sets the maximum level (or cap) on greenhouse gas emissions for the country or region. Next, the regulator divides this cap into permits, each representing a predetermined quantity of emissions. These permits are then issued to firms which will then have a choice from 3 scenarios — 1. Emit less GHG than the permit’s allowance and sell the remaining quota on the ETS; 2. Emit the amount of GHG allowed in the permit for the period; 3. Emit more than the allowed GHG in the certificate and purchase the required surplus on the ETS (or risk paying penalties). The price of these permits are variable based on the supply and demand in the market, determined usually via auctions.

Summary of Energy Companies’ Assumptions

The increasing adoption of carbon pricing mechanisms will require businesses to anticipate, prepare for and mitigate risks associated to this change in policy. The strategies taken by businesses to navigate this potentially challenging trend may very well be the subject of discussion in business schools in the future.

A particularly interesting sector to study would be the global energy companies involved in the extraction, distribution and consumption of hydrocarbon fuels (coal, oil and natural gas).

Here is a summary of the positions of XX large international energy companies, based on publicly available sources:

bp

bp supports “well designed” carbon pricing systems built using the tax or cap-and-trade methods. The company states that carbon pricing is a necessary, fair, efficient and effective method to reign in emissions and assumes $40/tonne of CO2 equivalent for cases above defined thresholds of anticipated GHG emissions with sensitivities of $0 and $80.

Additionally, bp includes a price of $100/tonne of CO2 equivalent for the period from 2030 to 2050.

Equinor

Equinor states that carbon pricing is “the most proven and cost effective way to tackle climate change” and cites the fact that Norway has implemented a carbon tax for over 20 years.

The company has an internal requirement for carbon pricing to be included in investment cases globally, across all producing assets and even non-sanctioned projects globally. An assumption of $55/tonne of CO2 is used in countries without carbon pricing systems and the company expects to review this value periodically. A robustness test for Equinor’s assets is also performed with a sensitivity case of $100/tonne of CO2.

ExxonMobil

ExxonMobil’s CEO Darren Woods stated that the company supports carbon pricing since the policy would create a transparent price for consumers and incentivize the reduction of emissions.

Shell

Shell has regularly published the Shell Scenarios, a testament to its long-term strategic outlook to prepare for various energy transition scenarios. Based on its 2020 Annual Report, the company has developed carbon pricing estimates that are country-specific and also time-dependent (short to long-term outlooks). These estimates range between $5 to $110 per tonne of GHG and the company expects a minimum price of $100 per tonne of GHG emissions by 2050.

Total

Total’s Upstream unit already assumes a carbon price of $40/tonne of CO2 in all of its global locations when making investment decisions, even if carbon pricing does not apply in those countries. The company will also assume $100/tonne of CO2 for sensitivity cases from 2030 onwards.

Conclusions

Several noticeable trends are apparent from this sampling of multinational energy companies — firstly, these companies already use internal carbon pricing values that vary between $40 to $110 per tonne of GHG when evaluating investment options.

Despite the apparent consensus to support carbon pricing, an external observer could not help but ask the question — “Why are energy companies accepting and even supporting the policy to tax their own products?”, to which the following explanations are offered:

1. Firstly, one could argue that these companies intend to be responsible corporations since climate change is a global phenomenon with long term implications for everyone.
2. Secondly, carbon pricing provides clarity on investment decisions while also incentivizing investments to reduce emissions.
3. Thirdly, this could be due to pressure from investors— examples include this article from the Financial Times which explains how BP and Shell finally accepted to writedown asset values after pressure from asset managers to acknowledge the financial impact of climate change on their operations.

While it is rather uplifting to see that global energy companies are already preparing for and adapting to carbon pricing, there are 2 other important points to consider:

1. A report by Wood Mackenzie which stated that a change in carbon pricing will be required to achieve the Paris climate target of 1.5 deg C increase compared to pre-Industrial levels — recommending a price support of up to US$160/tCO2.
2. This entire summary is a sampling of information from the large multinational energy corporations which are public listed (and therefore required to provide information to investors). However, it should be noted that these large multinational companies or “majors” are overshadowed by national oil companies (NOCs) — based on data from IEA, NOCs represent 56% of global hydrocarbon reserves and 45.6% of production, essentially the single largest groups for both categories. The success of carbon pricing efforts globally may well depend on the NOCs and their receptiveness to its implementation.

The following research areas are recommended for a further understanding of carbon pricing beyond the information discussed here — what standards are in place for carbon accounting and which standard is most widely adopted? How are NOCs preparing for carbon pricing policies? What effects will carbon pricing have on energy prices and economic activities? What regulations and safeguards are in place to prevent the manipulation of carbon pricing systems?

Author’s note — carbon pricing is a fascinating topic with potential for value and job creation via carbon accounting, tracking and trading systems. Constructive feedback and comments are welcome.