A Carbon Tax is coming, why?

A carbon tax is coming and there can be little doubt that it is coming soon. Carbon will start to cost, and that will have a major financial impact on business.  Most organisations will be affected over the course of the next five years and must prepare to manage carbon pricing risks now.

The UK has pledged to reduce their greenhouse gas emissions by 78% and the EU 55% by 2030 respectively, compared to 1990 levels.  The US has published less stringent targets for reducing its greenhouse gas emissions by 50% – 52% compared to 2005 levels.  Meeting these targets, milestones on the way to Net Zero, will mean considerable changes to government policy and how markets operate.  A carbon tax will be one of the tools the government will use.

How much would the Carbon Tax cost?

To get an idea of what carbon prices could be, one needs to look at emissions trading systems (ETS) also called cap and trade. The EU Emissions Trading System applies to power stations, steelworks other large emitters and airlines (As you can imagine Michael O’Leary of Ryan Air has plenty to say about that).  The carbon price in the EU ETS in June 2021 averaged €47.25/tonne, but by the end of October 2021 it was €60/tonne.  The price in newly formed UK ETS rose to around £55 per tonne in late September 2021, from a low of £42.40 in July.  By the end of October 2021, it was around £56/tonne.

We don’t believe that a UK carbon tax will be set at the UK ETS level, because an ETS includes a percentage of free allowances.  We believe that it will be set at a lower price to account for this.  If initially the aim is to establish the principle of a carbon tax it could be quite low.  However, we believe a cost of around £20 per tonne of CO₂e is probable.  This estimate is based on the UK’s previous “carbon tax”, the CRC EES.  Read our blog, The CRC – the UK’s first carbon tax.   Be assured of one thing, the price will not be set at a cost that would significantly disadvantage UK business.

What is the difference between a Carbon Tax and an Emissions Trading System (Cap-and-Trade)?

A carbon tax is where the government sets a price per tonne of greenhouse gas (CO₂e) that is emitted.  The scope of the tax can vary, some only apply to large emitters like power stations and cement works, others to all businesses and some include consumers. That depends on the actions taken by the companies and individuals involved.

A cap-and-trade system (emissions trading system) involves the government setting a limit (cap) on emissions, then issuing emission allowances corresponding with that limit.  The emitters must hold allowances for every tonne of greenhouse gas (CO₂e) they emit.  Allowances can be bought and sold by companies, which establishes a market price.  Companies that can reduce their emissions at a lower cost than the allowances they hold, can sell the unused ones to organisations where the cost of emissions reduction exceed the cost of the allowance.

A carbon tax provides certainty about the cost, but not about the level of emission reduction that will be achieved. Whereas, a cap-and-trade system provides certainty about the level of emissions reduction, but not about the cost to the organisation.

Who will be liable to pay the Tax and what will it cover?

We believe that initially it will only be levied on large companies and will apply to gas, electricity and probably transport fuels.  We also believe that the tax will apply to business mileage undertaken in private cars.  Our thinking is partly based on the scope of the UK governments SECR legislation, which requires these emissions sources to be reported.

How to prepare for a Carbon Tax

Companies need to start planning to minimises their exposure to a carbon tax today by following these five-stage process.

1. Establish your current carbon status. First you will need to calculate your total carbon emissions (Scope 1 and Scope 2).  Next you calculate your carbon intensity.  The most common metrics are tonnes per £ of revenue or tonnes per sq. metre of floor area.  Currently, we do not believe that the emissions from your supple chain (Scope 3) will be required.  However, this may not be the case indefinitely, so you should put plans in place to record these in the near future.
2. Determine variations in Carbon intensity. Ignoring any capital projects ascertain if your carbon intensity will increase or decrease as revenues increase, then model the emissions for different scenarios.
3. Decide on a set of carbon prices and timescale for their introduction. As a starting point we would suggest; £20 in 2022, £25 in 2024 £30 in 2026 and £35 in 2028.  We would suggest using a range of different future prices.
4. Price your future emissions. You calculate this by multiplying the future prices by the emissions in tonnes to determine your total annual tax liability.
5. Produce a discounted cash flow. Using your company’s cost of capital, discount the future carbon price, which will allow you to calculate the economic impact at current costs.

This information can be used to help you chose capital projects.  It will help you to decide the timing of implementation depending on the price of carbon.  These projects fall into three broad categories.

First, efficiency projects that should be implemented even if the price of carbon is low.

Secondly, some projects that are not capital-intensive and have long lead times and can be started now so that your future emissions are lower, just as the carbon price increases.

Thirdly, certain capital-intensive projects can be developed now, but not launched until the timescale and cost of carbon is more certain.

Conclusion

Carbon taxes are coming, so recognising how they will impact your business and then planning for them is essential.  We believe that initially the tax will affect only large companies.  However, once the impact of the pandemic has diminished, expect the tax to be applied to medium sized companies in short order.

Follow the steps outlined above and you will be able to take informed decisions on future capital projects.  This will minimise the impact of the tax on your operations.  Whatever the size of your company, protecting shareholder value as markets adapt to decarbonisation, is an essential.  Be bold in explaining your foresight in tackling the impact of a carbon tax.  Your customer and other stakeholders should be impressed that you are doing the right thing, both for them and for society.

A final thought, don’t expect existing “carbon” taxes, (e.g., fuel duty) to go away.  They will still be collected, but we believe any new carbon tax is likely to be revenue neutral.

Glen Winkfield
glenw@ghginsight.com

8^th November 2021