Clearing the Air on Carbon Disclosures

The sweeping 1,400-page energy bill passed by the House of Representatives in late June, and now on its way to the Senate, contains the makings of a new asset class for affected companies: carbon emissions allowances. Further, the proposed legislation, dubbed the American Clean Energy and Security Act of 2009, would also create new liabilities for companies that are unable to comply with the new proposed carbon emissions rules.

If the bill becomes law, whether a company winds up on the winning end of the new emissions rules will be a function of how its management tackles the issue of carbon risk. However, one thing is clear: Chief financial officers will be more engaged in energy management than ever before, with the legislation having a direct, and possibly material, affect on corporate financial results.

Emissions allowances are the centerpiece of the bill's so-called cap-and-trade system for carbon dioxide, the greenhouse gas thought to be most responsible for global climate change. In general, the proposed cap-and-trade system is designed to reduce economy-wide CO₂ emissions in the United States by 17% by 2020, and by 83% by 2050, compared to 2005 levels.

To do that, the government will either give away or auction off carbon allowances, which are permits that gives U.S. companies covered by the program the right to emit CO₂ into the air. One allowance is the equivalent of one-ton of CO₂, and the bill will cap or limit the total amount of allowances released in a year to acheive the overall emissions reduction. As a result, affected companies — big carbon emitters such as utility, chemical, oil and gas, and other large industrial companies — may use the allowances to offset what they spew into the air while running their plants and factories. It is still unclear under what circumstances free allowances will be doled out by the government.

"The Europeans very famously gave away allowances [in the European Union's cap and trade program] and produced a huge windfall to polluters," says Philip Adams, president of World Energy Solutions, which operates online exchanges for energy commodities. He says Congress will likely scrutinize any free allowance allocations in light of the European giveaway.

Companies that wind up with more carbon allowances than they need because they shuttered older plants, switched to low-carbon electric generation, or ramped up efficiency efforts will have the option to sell excess allowances to companies that have a shortfall. Independent exchanges will be set up to facilitate trading of federal allowances. Currently, several regional exchanges already exist in the United States, based on state mandates and voluntary emissions reduction programs.

One working model for a federal cap-and-trade system is the Regional Greenhouse Gas Initiative, the first mandatory effort in the country to reduce CO₂ emissions. The 10 Northeastern and Mid-Atlantic states that belong to RGGI have pledged to reduce CO₂ emission from the power sector by 10% by 2018. Currently, RGGI allowances are trading in the $4 to $5 range (see the chart at the end of the article).

For factories and plants that pump out more CO₂ annually than they are permitted, owners will be forced pay penalties equal to twice the most recent clearing price for a ton of CO₂ emissions, says the bill.

Slated to begin in 2012, the federal cap-and-trade program will likely yield an average market price of $28.24for a ton of CO₂, says environmental research and benchmarking firm Trucost. That price could drop depending on supply-and-demand scenarios and the final program rules. Still, by using the Trucost estimate, the average overall carbon cost for S&P 500 companies would total $93 billion, which is more than 1% of the revenue generated by those companies in 2007. That same price point would also depress earnings before interest, taxes, depreciation, and amortization by 5.5% for the S&P 500.

The affect on financial results will likely cause investors to demand more information about carbon-related risk — and regulators may push for the same thing. In March, the U.S. Environmental Protection Agency issued for public comment proposed rules that would require the largest 13,000 facilities that emit greenhouse gasses to measure and report emissions levels starting in 2010. The draft rule would also force suppliers of fossil fuels and industrial greenhouse gasses to do the same, and would requuire car and engine makers to report to EPA the emission rates associated with their products.

Further, according to a recent report by PricewaterhouseCoopers, a securities rule known as Regulation S-K already addresses the disclosure of environmental liabilities, and U.S. generally accepted accounting principles require disclosure of significant risks and uncertainties that could have a material effect on the financial condition of a company.

"As issues surrounding climate change become increasingly material to investors, and therefore, to a company's value, [the issues] can be expected to have a considerable impact on financial reporting," notes the PwC report. In addition, as investors' interests are piqued, it will start a cycle of disclosure, say the authors, Scott Gehsmann and Rob McCeney, partners in PwC's transactions services group. "As the impact of climate change on financial reporting rise in significance, investors, stakeholders, and regulators will demand greater transparency and comparability of companies' financial information."

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