Risk Management

The Carbon Effect on Earnings, M&A

Proposed energy legislation will have direct and indirect consequences on the revenues, profits, and M&A transactions of heavy CO2 emitters.
Marie LeoneJuly 6, 2009

The U.S. House of Representatives narrowly passed a new carbon cap and trade bill last week, bringing American businesses one step closer to a mandatory lid on carbon dioxide emissions — the air pollutant cited as being most responsible for global climate change.

The legislation, sponsored by Reps. Henry Waxman (D-Cal.) and Edward Markey (D-Mass.), requires steady reductions in CO2 emissions starting in 2012, with a first goal of capping so-called greenhouse gas emissions at 2005 levels. The bill — known as the American Clean Energy and Security Act of 2009 — also stipulates that by 2050, greenhouse gas emissions from power plants and factories not exceed 17% of the 2005 levels.

Now making its way to the Senate, the legislation also sets a national standard for renewable electricity.

Observers expect the Waxman-Markey bill, if it becomes law, to affect companies in several direct and indirect ways. Compliance costs, for example, would hit corporate cash flows and earnings, while CO2 allowance trading would launch a new asset class that could be traded on exchanges.

Financial statement disclosures, and attendant reporting, would also change, eventually; so far, though, neither American nor international accounting-standards setters have pushed through any new rules.

Despite the uncertainty surrounding the pending legislation and accounting rules, some observers have been sharpening their pencils and calculating both the quantitative and qualitative impacts of carbon costs on companies. For instance, environmental benchmarking firm TruCost shows that the drop in earnings — before interest, tax, depreciation, and amortization — would vary widely for carbon-intensive companies in the S&P 500, from a nominal 1% to a whopping 117%.

Direct emitters, including utility, oil and gas, industrial goods, and basic resources companies, would feel the tightest squeeze, with the potential 117% hit to EBITDA. Other industries, such as retailers and automakers, would feel a supply-chain pinch from increased electricity prices, says the TruCost report, which was commissioned by the Investor Responsibility Research Center Institute for Corporate Responsibility.

Overall, carbon costs would decrease EBITDA by less than 1% for 203 companies in the S&P 500, while 71 companies could see earnings fall by 10% or more, the report emphasizes.

No matter how the numbers are sliced, the hardest-hit sector would be the electric utility industry, which TruCost says emits 59% of the greenhouse gases released from plants owned or controlled by S&P 500 businesses. What’s more, if the 34 large-utility companies analyzed by TruCost had to pay the estimated average amount of $28.24 for each metric ton of emissions in 2012, carbon costs could almost halve their combined earnings, notes the report.

In terms of revenue, carbon costs would equal between 1% and 12% of revenue for five sectors — utilities, basic resources, chemicals, oil and gas, and food and beverage. Here too utilities face the greatest exposure, with carbon costs amounting to an average 12% of revenue. The research firm expects some of that cost to be passed through to utility customers, but relative to sector peers, utilities “will be most exposed to [carbon-related] liabilities.”

Basic resources, which includes steel and aluminum processing, as well as coal mining, would be the next-most-affected sector, with carbon costs potentially rising to 4.4% of industry revenues, followed by the chemical sector, with carbon costs accounting for just above 2% of sector revenues.

On a company level, the five corporations with the largest total CO2 emissions in the S&P 500 are ExxonMobil, Chevron, American Electric Power Co., The Southern Company, and ConocoPhillips. This quintet accounts for 22% of the total emissions from companies in the index.

While companies ponder the impact a cap-and-trade law may have on financial results, merger and acquisition experts say the legislation, if passed in its current form, would also affect deal-making. In fact, it already has.

“The truth is that carbon emissions are already playing a part in certain industries and affecting deals in those sectors,” says Scott Gehsmann, a transaction services partner with PricewaterhouseCoopers, who co-authored the client advisory, “Capitalizing on a climate of change,” with his colleague Rob McCeney. Carbon emissions and related costs have a “current relevance, and a future growing relevance” for M&A deals, adds Gehsmann.

Luxury sports car maker Porsche provided PwC with a strong example of how legislation tied to carbon emissions is affecting strategic acquisitions. In 2005, Porsche bought a piece of Volkswagen AG, and then upped its stake last year to 35%. That move may not have been entirely based on grabbing market share from Europe’s No. 1 carmaker, according to a statement by Klaus Berning, a Porsche board member.

At the 2008 Los Angeles Auto Show, Berning announced that, “Our VW strategy is part of protecting Porsche…. It is our guarantee that Porsche will remain Porsche.” The PwC partners say that “Berning was alluding to the fact that the acquisition would allow Porsche to rely on Volkswagen’s technology and considerable engineering capabilities to develop more efficient models for its vehicle lines.”

Indeed, the European Union is planning to limit CO2 emissions from cars in 2012, and levy fines on companies that exceed prescribed thresholds, including those that manufacture heavy carbon burners. “Based on Porsche’s current fleet, it would have to pay a penalty of about $517 million annually” for non-compliance, notes PwC.

However, by owning a piece — if not all — of Volkswagen’s low-emissions fleet, Porsche would be able to offset penalties, while cutting down the cost of developing fuel-efficient cars by acquiring the technology from VW. (Porsche’s bid to takeover Volkswagen this year has failed, so far.)

Carbon-related costs are also sure to affect an acquirer’s risk management strategy and due diligence processes, Gehsmann tells CFO.com. For example, high carbon-emitting companies will look to buy businesses that are energy-efficient; that hold a significant amount of allowance credits (to offset their own emissions); or that are part of the alternative energy market and thus are positioned to profit from tax incentives or booming demand generated by environmental legislation.

Deal-making to cut risk has already begun. Consider the 2007 acquisition by German power and gas company E.ON, which bought the U.S. assets of Airtricity, a wind-farm developer, for $1.4 billion. Then there’s the 2008 reacquisition of CNX Gas Corp. by former parent Consol Energy. At the time, Consol CEO J. Brett Harvey explained the about-face by saying that carbon constraints pose challenges for all fossil fuels but would affect gas to a lesser extent than coal or petroleum, according to the PwC paper.

Further, the report claims that lenders are “already assessing the effects climate change may have on a business for which they are contemplating financing.” In addition, valuation will become a significant issue with respect to deals involving renewable energy assets, with buyers less willing to pay for early-stage projects.

Also, capital-raising transactions related to the “clean” and renewable technology sector will likely increase during the next year. In 2008, several initial public offerings were launched in that area, primarily tied to the solar energy sector, including GT Solar International and Real Goods Solar Inc. Venture capital investments in clean technology also rocketed last year, reaching $4.1 billion in 2008, a 54% boost from the 2007 mark, says PwC.

The ramp-up in investment and M&A activity also means that disclosures related to climate risk will grow in importance for financial-statement users, says the report. The authors suggest that the Securities and Exchange Commission may mandate disclosures of climate-related risks in energy-intensive industries. They also contend that “to maximize their ability to raise capital, companies must have a good understanding of climate change-related risks and form a view with respect to how they should be managed.”