Beyond the Carbon Footprint

The carbon economy is creating an opportunity for companies to create competitive advantage. It's also creating a challenge for analysts to figure out which companies are doing well and which have merely added a cost factor to their operations. A carbon-constrained world is on its way, regardless of who will move into the White House in November. As is the case with all developments that imply major change, coming to terms with the new economy will take time and effort.

In the past, companies and politicians have ignored carbon as an environmental and economic issue. Today, while most businesses take serious note, some have set their efforts on lobbying policy makers to grant exemptions from the need to price carbon emissions.

On the upward slope of the Carbon Adoption Curve sits the recognition that all businesses are affected in one way or another-and that we are probably not all doomed. At that stage, a lot of companies ask what they need to do, essentially trying to understand what the minimum requirements are to be compliant. Those answers are not trivial. In fact, such baseline and accounting questions will keep many executives awake and consultants in business.

But, perhaps more importantly, companies should ask a different question: how can they turn this challenge into an opportunity? They wouldn't be alone. Leaders in the carbon economy have found a way to do well by carving out a competitive advantage.

Smart companies quickly get the "bean counting" aspect done and out of the way. To them, carbon is not another compliance report but an additional dimension in which to make the right investment decisions, drive innovative thinking, and connect with the customer. Of course, efficient and auditable accounting is important as a first step.

Jesco d'Alquen is CEO of tradeslot, a technology company in Melbourne, Australia that creates optimization and allocation platforms for carbon and other commodities in cooperation with a network of international thought leaders in strategy, market design, and auction theory. The company has won a series of U.S. and Australian patents.

Smart companies know what their carbon footprint is, but they really care about how they are doing relative to their competitors 2. As we move into market-based carbon regimes, the footprint discussion expands from being primarily a matter of social responsibility and reputation to one of cost management and strategic planning. To beat the guy next door, the first and obvious lever is to invest in smart abatement projects that reduce emissions. Ultimately, the carbon economy aims to achieve a net reduction of CO2 in the atmosphere through market pressure.

But thanks to the nature of CO2, it is actually irrelevant where emissions are reduced. That brings businesses back into well-known territory: make-or-buy decisions. The Kyoto Protocol created a thriving market between the developing world and industrialized nations, allowing certified reduction credits to be traded freely3. This led to a natural benchmark for any activity a company might consider internally to reduce its carbon footprint.

Cost differentials in markets for credits and permits are no small matter and as important as the make-or-buy decisions above. Buying an offset for a ton of carbon can set a company back $10 to $404. If a company is a large emitter of CO2 or a large user of energy, that spread will be noticeable on the balance sheet once a mandatory carbon regime kicks in. The big variable here is the price of carbon, not just the amount emitted, which is why counting tons of carbon is just the beginning.

With a range of potential investment and offset options, the internal cost of carbon (or Weighted Average Cost of Carbon, WAC CO2) varies from company to company and creates a competitive indicator. How much per ton of CO2 does it cost the company to reduce its emissions? How much per ton is the company spending on offsets? These indicators illustrate whether a company is making smart abatement decisions against a backdrop of alternatives. They show whether the management team is market-savvy and understands how to balance risk and financial outcome in the evolving offset market.

Once a company understands its current and future position, it is able to make better investment decisions. For example, take an abatement project that doesn't meet the hurdle rates and is therefore not viable today. But forecasting the company-specific cost of carbon could show a project becomes doable when kicked off after 2010. Conversely, an investment proposal may show a positive return today, but will the planned facility still hit the required return on investment after the forecast weighted average cost of carbon is built in?

Analysts are getting more and more interested in understanding the efficiency of companies dealing with their carbon liabilities6. Investors are guaranteed to penalize companies that show a high weighted average cost of carbon, as poor carbon decisions today will take a big bite out of profits and share prices tomorrow7. Conversely, mergers and acquisitions could create additional value by allocating assets to companies with a preferential internal cost of carbon.

With this in mind, it becomes apparent why a shadow price for carbon is not a substitute for understanding the company's WAC CO2: the former is largely based on an educated guess about the market, while the latter is a true reflection of the company's capabilities to seek alternatives and beat the market.

The carbon economy is not asking businesses to forget what they know about rational decision-making. It is not introducing a parallel universe to the world of rewards, incentives, and opportunities. Rather, like globalization and the Internet, it adds a set of tools to be used in a new battle for adaptability, where only the fittest will survive.

*Footnotes