The time value of decarbonisation

LGIM proposes a carbon discount rate that can be used to ‘discount’ the value of future carbon emissions reductions, relative to near-term ones. We justify the use of this rate by considering how a reduction of one tonne of CO2 per year (1tCO₂/year) – relative to business as usual – will compound over time. Accordingly, we believe near-term carbon reductions are more valuable than equivalent reductions in the future.

The problem of comparing emissions pathways

Since the adoption of the Paris Agreement in 2015, private sector companies have faced mounting pressure to reduce their emissions and help limit global warming. As a result, we have since seen a proliferation of corporate net-zero commitments. However, not all commitments are created equal. Some entail gradual decarbonisation beginning immediately, while others delay action and thus require deeper and more rapid decarbonisation in the future.

As investors, we may want to evaluate companies' proposed decarbonisation pathways in terms of their equivalence for the overall carbon budget. However, it can be difficult to compare companies’ pathways in a standardised, like-for-like way.

Our proposed solution: Applying a carbon discount rate

To address this issue, LGIM’s Climate Solutions team has developed a new tool: the carbon discount rate. This rate determines how much we should discount the value of future carbon emissions reductions relative to near-term ones. This rate allows us to compare the merits of different companies’ decarbonisation pathways at different points in time.

We estimate that decarbonisation should be discounted in line with the chart below. This translates to an average rate of around 14%, though the chart offers a more precise estimate of the value of decarbonisation at different points in time. This means that decarbonisation of 1tCO₂/year is worth 100% today, around 92% if delayed by a year, and just 19% if delayed 10 years.

Our method: Quantifying the time value of decarbonisation

To arrive at these figures, LGIM has developed a novel method, using our proprietary net-zero scenario modelling. We centre our analysis at a global economy level, but we believe our results can directly translate to company-level calculations.

To begin with, we use our ‘LGIM Net Zero Scenario’ to quantify how much decarbonisation should occur each year on average in order to limit global warming to 1.5 degrees in a gradual, balanced way. After selecting a scenario, we then consider how this decarbonisation scenario compares with a scenario where emissions reductions are delayed into the future if we are aiming to achieve a carbon budget equivalent outcome by 2050. We chose 2050 to reflect the planning horizon most companies are using in their net-zero pledges.

To this end, we can consider how each year of delay adds to the annual average decarbonisation burden. For example, if we collectively began decarbonisation now, we would only have to achieve an average annual decarbonisation of two gigatonnes (Gt) of greenhouse gases per year through 2050.

However, if we waited to decarbonise until 2030, and continue gradually increasing our emissions in the meantime, we would then need to decarbonise an average of 7GtCO₂e per year to stay on track for the same carbon budget to 2050. In more extreme examples, if we waited until 2049, we would need to decarbonise 441 GtCO₂e per year for two years, and if we waited all the way until 2050, we would need to decarbonise a huge 934 GtCO₂e in one year.[1]

Based on these premises, we can then calculate the carbon discount rate for different decarbonisation start dates by dividing the annual average decarbonisation burden of the Net Zero scenario (around 2GtCO₂e /year) with the average decarbonisation burden of delayed scenarios (which increases the longer the start date is delayed).

What gets measured, gets managed: An important step towards decarbonisation

This analysis represents one of the first attempts to quantify the time value of decarbonisation and equips investors with an important tool for analysing the decarbonisation commitments of different companies.

Central to this analysis is the assumption that companies will be expected to do their ‘fair share’ of decarbonisation – either from public pressure or regulation. Given this assumption, the carbon discount rate enables us to see the benefits of early decarbonisation, and the higher annual burden associated with delayed decarbonisation. The carbon discount rate can also help investors contextualise companies’ capital expenditure on decarbonisation.

In a more general sense, the carbon discount rate helps illustrate how the longer we delay climate action, the more difficult and complicated it will become to achieve our climate goals. As such, we believe delaying action seriously threatens the likelihood that we achieve these goals and will likely create new risks and uncertainties surrounding achieving deep decarbonisation in a limited amount of time.

As mentioned, our final estimated carbon discount rate of ~14% is highly shaped by our selected climate scenario. If we alter the climate scenario, which will affect the total carbon budget and annual emissions reductions required, the discount rate will inevitably change.

Nonetheless, we still believe that our methodology is an important step forwards to be able to begin thinking about how carbon reductions should be valued at different points of time. It also allows different scenarios to be tested, and can therefore be adapted for different analytical use-cases.

[1] For the purposes of this analysis, we have not considered the potentially large physical climate risks of delayed decarbonisation, such as tipping points and irreversable damages. However, it should be noted that these risks are potentially material and could further decrease the value of delayed decarbonisation