Carbon leakage: what is it, and why is it important for investors?

Committing to limiting the global temperature increase to 1.5°C by the end of the century means an implicit commitment to a ‘carbon budget’. The International Panel on Climate Change (IPCC) estimates the carbon budget for hitting 1.5°C with a 50% probability to be c.500 billion tons of CO2. The world is currently emitting c.40 billion tons per year, so in a little over 10 years we will have exhausted our emissions budget. With a limited carbon budget, accounting for carbon in supply chains will become increasingly important. 

Carbon leakage occurs when carbon regulation causes emissions to be displaced to another region with less stringent standards. If one county or region is pursuing policies on domestic emitters to cut carbon and increasing input costs, some manufacturers will look to circumvent this by exporting production to a region with lower emissions standards. Globalisation has many benefits, but this environmental arbitrage is an obstacle on the race to net zero.

Closing the loophole

In a previous blog I explained how the EU’s Emission Trading System (ETS) is leading the world in addressing climate change through a market-based apparatus. One of the reforms to the system is a Carbon Border Adjustment Mechanism (CBAM), which aims to adjust the price of certain imports to account for CO2 emissions embedded in their production. By ensuring importers pay the same carbon price as domestic producers, the CBAM aims for equal treatment for products made in the EU and imports with lower emissions standards.

The CBAM will initially apply to importers of cement, steel, aluminium, fertilisers and electricity given their high emissions and potential for carbon leakage. In time, it’s likely the CBAM will be applied to all parts of the value chain to capture indirect emissions. This concept of ‘carbon supply chain tracking’ and ‘carbon adjustment taxation’ have important implications for investors.

The first is measurement. Today, the most widely used carbon emissions score is Scope I and II: consumption-based measures. For example, an apparel retailer would only include their own emissions, and emissions associated with power consumption to run their operation. In contrast, Scope III emissions would also include upstream emissions, meaning those embedded in the manufacturing and transportation of T-shirts. Scope III is a consumption and production measure.

The additional clarity from Scope III emissions will be great as it will highlight which companies have the highest emissions across their value chains. 

Secondly, a CBAM is potentially inflationary given the higher input price in the form of a carbon tax. Longer term, as economies transition to cheaper clean energy like solar and wind, carbon adjustment mechanisms should in theory be deflationary as cheaper forms of electricity become available. However, the longer countries delay, the more likely aggressive policy intervention will be required, which will be reflected in higher carbon pricing. This is a point I covered in a previous blog.

Finally, measuring and taxing supply chain carbon emissions will also indirectly force companies outside the CBAM to adopt the more stringent emission standards to avoid higher import taxes. Although this should be a force for good, any tax has the potential to create unintended consequences. One obvious consideration is how the adjustment tax may influence international trade flows. China is Europe’s largest importer, so inflation is a potential issue given the high proportion of coal in China’s energy mix. Another important consideration is how the CBAM is rolled out. For example, if it’s applied to raw materials and not to finished products, then importers may be encouraged to import finished products rather than raw materials.

Looking ahead

Carbon supply chain tracking is going to be of increasing importance, driven by both voluntary actions – corporate ethics being reflected through the supply chain – and legislation.

Companies will not only need to decarbonise their own business operations but will increasingly face calls to account for and track emissions in their supply chains. This presents both opportunities and threats for investors. Companies with lower emissions in their value chain relative to peers will have an advantage. Those that are slow to decarbonise their supply chains risk higher taxes and input prices, customer disenfranchisement and a higher cost of capital, which we believe will be reflected in the firm’s competitive position and share price.