La Française: Capturing value in a carbon-constrained world

June 4, 2024

By Oceane Balbinot-Viale, ESG Finance Analyst, Crédit Mutuel AM

As investors, World Environment Day serves as a reminder of the critical intersection between environmental sustainability and economic viability.

As global attention focuses on the ever more urgent need to address climate change, carbon pricing mechanisms (CPMs) emerge as a pivotal lever in the transition to a low-carbon economy: this is shown by European Union’s decision earlier this year to expand its Emissions Trading System (ETS) to include maritime shipping, and last year’s decision to create an additional ETS (“ETS2”) to address CO₂ emissions from fuel combustions in buildings, road transport and additional sectors.

These significant moves highlight the growing regulatory emphasis on carbon emissions across various sectors. This development, alongside the ongoing bullish trends in North American carbon markets driven by stricter regulatory reviews and supply adjustments, signals a pivotal shift towards more stringent carbon pricing mechanisms globally​ – and the need for investors to understand financial implications.

First things first, however: what is carbon pricing, what is its purpose and how does it work? Regulatory carbon pricing encompasses policy frameworks such as carbon taxes and cap-and-trade systems, designed to assign a monetary value to greenhouse gas emissions. According to the World Bank, there are currently 75 carbon taxes and emissions trading schemes worldwide covering around 24% of global emissions.

These mechanisms operate by either setting a direct price on carbon emissions or establishing a market-based cap on emissions, with tradable allowances. By internalising the externalities associated with carbon emissions, carbon pricing essentially creates economic incentives for emissions reduction and technological innovation.

The aforementioned example of the European Union’s ETS expansion shows the concrete financial implications for shipping companies continuing business as usual: companies of the sector must purchase or surrender European Union Allowances (EUAs) for each ton of reported CO₂ (or CO₂ equivalent), which may incur higher operational costs. The cost of compliance is generally expected to be passed onto end customers through higher freight rates – this may, in turn, potentially affect the cost competitiveness of said companies.

Corporate exposure to carbon pricing varies widely across sectors and geographies: indeed, the recent downturn in EU carbon prices due to oversupply and lower emissions from the power sector contrasts with the upward momentum in the California-Quebec joint cap-and-trade program, reflecting the complex interplay of market forces in different regions.

The volatility of carbon prices, influenced by factors such as regulatory changes and market dynamics can have varying impacts: companies operating in carbon-intensive industries, such as energy, manufacturing, and transportation, face significant cost implications and potential asset stranding. These firms must navigate increased operating expenses and potential regulatory compliance costs, which can impact EBITDA margins and alter competitive dynamics.

However, early adopters of lower emitting technologies – e.g., the adoption of cleaner fuels such as liquefied natural gas (LNG) or the installation of energy-saving technologies like air lubrication systems and rotor sails in the case of the shipping sector – are likely to benefit from regulatory incentives and cost savings. These firms may achieve competitive advantages even beyond lower compliance costs, such as improved market positioning and enhanced brand reputation.

As far as investors are concerned, assessing a company's exposure to carbon pricing is therefore integral to comprehensive risk management and portfolio optimisation. The ability of an investee firm to manage carbon pricing effectively – through strategic asset allocation, operational efficiency improvements, and robust environmental, social, and governance (ESG) practices – becomes a key determinant of its long-term financial performance and market valuation.

A significant number of large market capitalisation companies already consider an internal carbon price, often to make more informed investment decisions (though when internal carbon prices are particularly low, they can often be perceived as a marketing tool). However, too few companies propose a business plan comprehensively integrating the impacts of carbon price evolution. This is when integrating carbon pricing into investment analysis necessitates a sophisticated understanding of regulatory environments, sectoral impacts, and corporate strategies on the investor’s end, which may be reflected in the following approaches:

Besides staying abreast of regulatory developments, integrating carbon pricing scenarios into to stress-test corporate earnings, cash flows, and valuation metrics – as is more and more the case – is becoming increasingly important. Moreover, it is crucial to keep in mind that the aforementioned volatility of carbon prices presents both a risk and an opportunity: investors may consider diversifying exposure across regions and sectors to mitigate the impact of price fluctuations. However, carbon pricing can also introduce market inefficiencies that astute investors can benefit from: investors who leverage carbon futures and options can capitalise on these price fluctuations to generate alpha.

In addition, inefficiencies in how companies are valued based on their carbon exposure can present opportunities for value investing. Firms which are undervalued due to market underestimating of their carbon management capabilities may offer attractive entry points for investors.

Last but not least, the subject of carbon pricing is one where ESG integration and active ownership become critical: indeed, understanding investee companies’ compliance strategies, encouraging transparency in carbon emissions reporting and the adoption of best practices for the reduction of these, help create a more comprehensive framework for identifying value drivers. 

From an investor’s perspective, World Environment Day and the matter of carbon pricing have in common that they remind us how deeply the structural shift towards a low-carbon economy underscores the need for a long-term strategic allocation to sectors and companies aligned with this transition.

This is also emphasised by other recent regulatory developments such as the commencement of reporting obligations for the EU’s Carbon Border Adjustment Mechanism (CBAM) in 2023, which seeks to level the playing field on carbon pricing for emissions-intensive trade-exposed goods.

By integrating carbon pricing considerations into investment frameworks, investors can not only mitigate risks but also capitalize on the opportunities presented by the transition. The alignment with global climate goals should therefore not merely be perceived as a response to regulatory pressures, but rather as a strategic imperative which enhances long-term value creation.