Many people are still laboring under the misconception that carbon risk and carbon value are future propositions which, although it might be nice to know something about now, can be put off thinking about until a future date. Not true. Carbon risk and value exist today and those who continue to think of them as something they need not worry about now may be overlooking hidden value within their own businesses or those of others, or, may be buying or financing a risk they have not factored into their business model. In our experience, it is the lack of existing federal or provincial green house gas ("GHG") emission regulations that is driving this perception. This perception is incorrect since carbon value does not require federal or provincial regulation to exist, nor does the non-existence of such regulation mean that carbon risk does not exist.
What is carbon value?
Carbon value is the economic value that can be extracted from a reduction in GHG emissions.
What is carbon risk?
Carbon risk is the risk associated with a current or future regulatory obligation that a business may have to reduce its GHG emissions. It can also result from the failure to account for carbon value.
Where does carbon value reside?
Carbon value resides in the changes (whether to equipment, materials or processes) that are made by a company and which have the effect of reducing its GHG emissions. Not all of such changes can be monetized as there are elements at play other than mere reduction but the initial reflex of businesses that reduce their emissions, even as a by-product of some other activity should be to check for carbon value.
How is carbon value created now?
Carbon value can be created now by the conversion of a GHG emission reduction into a tradable commodity, which can have various names but which we will generically refer to as a carbon credit.
In Alberta, a regulated market for trading GHG emission reductions exists today and carbon value can therefore be created by regulated entities, by exceeding their emission reduction targets or by non-regulated entities, by the voluntary reduction of their emissions on a project basis.
In the rest of Canada, reductions are voluntary and because there are no regulated markets, project based. A project is simply: 1) the definition of a scope of GHG emissions that emanate from a defined source; 2) the application to the defined source of a change in technology or process that has been described in a scientific protocol; 3) the measurement of the defined scope of emissions after the application of the scientific protocol to the defined source; and 4) the verification of the application of the scientific protocol and the measurements by an independent third party.
If a project proponent wants to have the credits from a project registered on a project registry, then the project will need to be validated according to the rules of the registry and the verification will have to be done by an entity accredited for such purpose by the registry. If the project meets the registry's standards, the reductions that are created by the project will then be serialized (assigned a number) and will appear on the registry. Often, projects are validated and run for several years and the emission reductions are verified on an annual basis. Once the emission reductions have been verified for a specific year, they can then be registered on the registry. Once the credits are registered, they can be transferred between account holders on that registry and or retired (i.e. taken out of circulation).
Two things are important to note in relation to the process described above. First, it is not necessary for emission reductions to be registered or even verified for them to have a market value. Second, the verification standard that is used for the project is a key element to determining what the value of the credits generated will be. Different standards have different market values and it is important for a company that feels that it has potential carbon value to determine what standard it will use to monetize that value.
Who can help me find carbon value?
The members of the Climate Change Group at Gowlings are familiar with many of the situations in which carbon value can arise and will be happy to discuss with you where you should be looking for this value. However, the process of creating carbon value is in part a scientific one and Gowlings has developed a network of professional contacts in this area and can guide its clients to reliable resources for the performance of the analysis of the emissions baseline, the development or choice of reduction protocol and the verification of any reductions. This ability is important as the level of service and expertise in this industry is not uniform.
Who are the buyers of carbon value?
Carbon credits are generally being purchased by three groups of entities: companies that believe they will have a compliance obligation in a future regulatory framework, investors and companies that are currently offering "greening" and carbon neutrality services or are looking to go carbon friendly or neutral on their own.
This market is currently conducted mostly over the counter in Canada and as a result, precise numbers with respect to trading volumes and prices are difficult to come by but as public awareness of impending regulatory obligations and a desire to reduce emissions increase, we expect that this market will become more transparent. In terms of its value, it is expected that, if the United States adopts emissions trading the total value of this market worldwide will rise to over 600 billion U.S. dollars by 201331.
Who has carbon risk? Where is it coming from?
Many people view carbon risk as something that will exist only in the future. Not true. Carbon taxes exist in various jurisdictions and emissions are already restricted in Alberta. In addition, to the extent that it is likely that a company will eventually have a reduction obligation under Canada's federal GHG regulations or a provincial equivalent, carbon risk exists now. Indeed, under the proposed federal framework, the industries that will be subject to emissions limits have already been identified, as have the thresholds for compliance. The same is true of the Western Climate Initiative, the standards of which will be implemented in Québec, Ontario, Manitoba and British Columbia through provincial legislation. With respect to the expected commencement dates of these obligations, Québec and Ontario have already indicated their desire to bring legislation in as early as January 1, 2010 (Quebec filed draft legislation on May 12, 2009) which, at the time of the writing of this article, also remains the target date for the federal GHG emissions legislation. Observers agree however that this target cannot be met by the federal government and will be pushed back.
As a result of the foregoing, Canadian businesses could see legislated emission reductions in force outside of Alberta as early as 2010 and very likely on or before January 1, 2012. Our message to our clients is that these deadlines are important and imminent but the risk they create is already here.
The obvious risk is the risk to companies that will be subject to an emissions cap themselves. Determining emissions and getting a handle on ways in which they can be reduced is not a process that can be accomplished overnight and companies that continue to put off the exercise of measuring their GHG emissions are potentially decreasing their ability to mitigate the risk that they may have under a future regulatory regime. In acting this way, companies are failing to engage what will be a permanent shift in the North American economy and may be creating a risk of litigation for having failed to manage this evolution appropriately.
The less obvious risk is that being incurred by buyers, sellers and investors. Indeed, any buyer acquiring a company that will be a regulated entity under an eventual GHG emissions regulation, is incurring a risk if it is not conducting proper carbon diligence and factoring the cost of compliance with such future obligations into the purchase price.
Similarly, a seller that has hidden carbon value in its business, creates carbon risk, where it sells the business without forcing the buyer to price in the carbon value or exclude it from the transaction.
Banks and other lenders or investors, if they are lending money or investing without conducting proper carbon diligence are not taking into account carbon risk and are not therefore using all of the tools at their disposal to correctly analyze the business to which they are lending or in which they are investing.
Similarly, where they fail to take into account carbon value, they are not properly determining the value of the business and may therefore create carbon risk by refusing needed capital to their client based on an underestimation of the company's value.
Finally, carbon risk is also incurred where sellers of technology with the potential to create carbon value fail to protect their rights in that value. Failure to take into account the potential carbon value, is in and of itself a carbon risk.
As a result, although the regulation of GHGs may not take place for another 12 to 36 months, outside of Alberta, companies that are acting now to purchase or sell assets or shares, lend money, invest or sell products are perhaps buying or creating carbon risk without realizing it.
What does businesses need to do?
Businesses need to begin to develop internal processes and tools for recognizing carbon value and risk both internally and externally.