United StatesThe private sector holds the key to decarbonizing the economy over the next quarter century. As countries set “net zero” or equivalent targets backed by carefully designed roadmaps for sectors such as energy, transportation and food, there’s a widespread assumption that “national net zero” should mean “net zero for all,” including “corporate net zero” (CNZ) for today’s businesses. Although there are some benefits to unpacking national net zero targets in this way, there are also several important drawbacks. A more sophisticated approach is urgently required.
Ahead of the COP26 conference in Glasgow later this year, governments are likely to set or raise national targets for decarbonizing their economies. In much of the world, the private sector will mobilize to serve rapidly expanding markets, for example, for electric vehicles or plant-based food. Experience suggests that we’re about to witness a huge amount of creative destruction as entirely new industries are born, nascent sectors flourish and demand fades for products and services we once considered permanent, threatening or even destroying what have been large companies — a fate similar to landline-based telephony or, potentially, to cash-based transactions.
As the opportunities and risks linked to climate change become mainstream for many companies and their stakeholders, corporate net-zero targets have several attractions. Faced with a simple message that they should develop, analyze and act on specific climate change opportunities and risks, management teams will not only identify ways to improve the company’s risk-adjusted returns but may also produce or facilitate breakthroughs for their customers or suppliers, for example, by placing bulk orders for low-carbon products.
Similarly, multiple CNZ commitments across a sector may enable discussions around possible collective action, for example, the establishment of clusters to generate and consume “green” hydrogen. Early action by companies can encourage governments to further develop their policies to mitigate climate change, while corporate pledges may unlock capital to catalyze new climate-friendly activities, such as nature-based solutions.
The drawbacks of a blanket adoption of corporate net zero
There are several crucial drawbacks to the blanket adoption of corporate net-zero targets.
First and most obvious is the definition and interpretation of net zero. Apart from the ambiguity around each entity’s pathway to net zero (i.e. “how much, by when?”), the role for offsets is contentious — for example, should a cement manufacturer be able to account for the carbon benefits of its investments in peatland restoration, or, if we allow this, does that create a moral hazard (to pollute)? And how should low-carbon technologies be treated? For example, when a new wind farm is built, does it really make sense that the entity purchasing the electricity gets the carbon benefit while the investor (or wind farm owner) receives no such boost to their own carbon accounting?
Second is capital inefficiency. To ensure there’s sufficient “creative destruction” as we reset our economy, we need to avoid hampering the essential sunsetting of certain activities in favor of new ones. The law of diminishing returns predicts that, as companies implement efficiency measures and cost-competitive technologies to reduce their emissions, they will need to consume more and more capital to save the next tonne of carbon, for example, steel manufacturers seeking to switch to direct hydrogen reduction. At the same time, companies producing alternative products, such as construction materials based on wood, may offer much higher financial returns on an equivalent amount of capital with much lower risk. Faced with a choice, investors are likely to prefer the latter.
Third, skills. To pivot successfully to entirely new activities, today’s companies need to harness alternative expertise. For example, can today’s oil majors with their competence in seismology and the handling of liquids, realistically develop a competitive advantage in the development of power projects and in electricity trading to outcompete today’s power generators?
Fourth, value chain effects. Notwithstanding the challenges of measuring so-called “Scope 3” emissions, a company that pursues a net-zero position without concern for its customers or even its suppliers may unwittingly hold back climate change mitigation across the “system” (i.e., the wider economy). For example, if the renewable energy supply required to enable a manufacturer of insulation material to become net zero costs significantly more than the fossil fuel supply it used previously, the price of its product will rise, thereby reducing its potential to assist customers with their energy savings.
Fifth, the “someone else’s problem” effect. It’s too easy for today’s management teams to commit a company to long-term targets that they personally won’t be around to deliver on.
Lastly, confusing signals. As decarbonization progresses, management teams may be faced with a conflict between achieving financial objectives and delivering on the company’s net-zero pledge. This may not matter at the outset, but once the “early wins” in emissions reduction have been secured, difficult conversations about the trade-off between financial and environmental outcomes are, in my view, inevitable.
Climate change resilience first
So, what’s to be done? A sound starting point is to use “corporate net zero” as an agenda item for a deeper discussion about climate change between companies and their investors. But rather than starting that conversation by simply insisting on the adoption of net-zero targets, investors should seek to assess whether the company is already or is aiming to become “climate change resilient” using the framework recommended by the Taskforce on Climate-Related Financial Disclosure (TCFD), which covers both emissions reductions and physical climate risks.
This should cover the four areas outlined by TCFD:
- Governance: What changes has the company considered and made to ensure that climate change issues are managed comprehensively over a long timeframe?
- Strategy: How has the company’s business strategy evolved in response, what alternatives has management considered, and what will be the impact on the company’s expected return on invested capital?
- Risk and opportunity: Has the company mapped out the key changes in these areas arising from climate change and implemented programs to monitor them over a long timeframe?
- Metrics, targets and reporting: Is the company’s planned reporting in this area likely to provide decision-useful information to shareholders and other stakeholders?
These conversations should lead to a comprehensive, rational plan for each company to manage climate change issues over time, tailored to its individual circumstances. For some, the optimal result will be to adopt a simple-to-communicate corporate net-zero target described in a way that avoids the drawbacks discussed earlier. For others, particularly those in hard-to-abate sectors, a more appropriate response would be (a) a business plan focused on the efficient use of capital in the context of a wider set of risks, (b) imaginative and proactive collaboration with peers and government to shape new markets, and (c) clear communication with all stakeholders.
We need to be careful that “corporate net zero” does not turn into “one-size-fits-all.” The failure to take a thoughtful and sophisticated approach to these issues will likely result in management confusion, muddled or misleading external communication and perhaps most significantly, the misallocation of capital. Now is the time to get our proverbial ducks in a row!
IMPX-20210429-0396