How climate leaders will trump complacent companies

Climate leaders - those that decarbonise their businesses faster than others - will have a rising cost advantage over competitors in the decade ahead.

Unsustainably low carbon prices and offset prices have led to corporate complacency over the cost of carbon emissions.

This is set to reverse and will represent an unwelcome cost surprise for unprepared companies.

Carbon pricing is becoming more widespread

Carbon prices, or similar programmes, are becoming more widespread. The EU Emissions Trading Scheme (ETS) is a sign of things to come, with China, Canada, and parts of the US all developing carbon pricing markets modelled on the EU system. Other countries are introducing carbon taxes or levies designed to have a similar effect.

Even within the EU, carbon pricing is poised to expand. The EU carbon pricing scheme has been successful so far in its aims, cutting emissions by about 43% in the industries covered (power and heat generation and energy-intensive industrial installations).

However, more needs to be done to reach the EU’s target to be climate neutral by 2050. The EU has already released plans to expand its ETS across a variety of different industries, including shipping, road transport and buildings.

Carbon offsets to follow path of carbon prices

Meanwhile, some companies are making headlines with their net zero climate plans but many of these are based on widespread use of offsets. Carbon offsets come in many forms; a popular option is investment in reforestation projects.

These offsets are currently cheaper than investing in low emission technology for many industries, leading corporate management teams to conclude that they can rely on offsets instead of investing in low carbon production or technology.

This is an illusion. The price of these offsets, at $5-10/t, is unsustainably low. These companies will be forced to pay much higher prices in future to meet their climate commitments, or walk away from their targets.

Why will offset prices rise?

To understand why the prices of carbon removal offsets will rise, we need to consider the big picture. All countries and participants who signed up to the 2015 Paris climate change agreement have committed to work together to meet the goal of limiting global warming to 2C or below, compared to pre-industrial levels.

It is well established that there simply isn’t enough available land to meet a significant part of global emissions reductions through reforestation. That’s especially the case at a time when the global population is growing and there is rising pressure on agricultural productivity from climate change itself.

How far could offset prices rise?

As the demand for reforestation (and other) offsets increases, and the early supply of available land is used up, we can expect prices to rise substantially as competition for land with other uses steps up.

Bloomberg New Energy Finance recently looked at this topic in an excellent research paper (Long-Term Carbon Offsets Outlook 2022: Boom or Bust? 10 January 2022). This examined scenarios for the offset market that factor in forthcoming regulations to standardise the market.

The paper concluded that the price of offsets could increase to $47/t in 2027, and to over $200/t in 2029.

This is in a Science Based Targets scenario (SBTI) in which regulations are tightened so that only actual carbon removal offsets are allowed (i.e. no avoided emissions offsets and no avoided deforestation pledges). This means demand will quickly outstrip supply from corporate net zero plans.

carbon offset prices

The voluntary market scenario assumes the offset market remains similar to today, and allows offsets that avoid future emissions rather than actually removing them. This leads to excess supply, keeping offset prices low. While it is the situation today, avoided emission offsets are coming under greater criticism and scrutiny. We do not expect their continued use in the corporate sector to be seen as good practice for long.

The hybrid scenario looks at a gradual evolution of the offset market, from the voluntary market today to the SBTi scenario. 

Low carbon leaders will have a cost advantage

It is just common sense that as the world increasingly puts a price on carbon emissions, the value of a tree that takes 50 years to mature and stores one tonne of carbon, on average, will be worth much more than $5. Some companies are therefore making a big mistake by committing too much of their climate efforts to offsets.

Whether companies face costs through an official scheme like the EU ETS, a government tax on carbon, or the rising price of offsets they have committed to buy in their net zero sustainability pledges, one thing is clear.

Those companies that really reduce absolute emissions now will be much better placed as the true cost of emissions come through.

Important Information
The contents of this document may not be reproduced or distributed in any manner without prior permission.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect nor is it to be construed as any solicitation and offering to buy or sell any investment products. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Any security(ies) mentioned above is for illustrative purpose only, not a recommendation to invest or divest. Opinions stated are valid as of the date of this document and are subject to change without notice. Information herein and information from third party are believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. You may not get back the full amount invested. Derivatives carry a high degree of risk. Exchange rate changes may cause the value of the overseas investments to rise or fall. If investment returns are not denominated in HKD/USD, US/HK dollar-based investors are exposed to exchange rate fluctuations. Please refer to the relevant offering document including the risk factors for further details.
This material has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.