In search of a market-driven price on carbon

Every year, CERAWeek takes the pulse of the global energy industry. This year, energy transition firmly dominated the agenda and the dialogue. It was clear energy transition is not a future thing -- it was the norm, and it was business.

The conversations that occurred focused on an overarching theme of pragmatism about where, what and how to make money in future fuels and commodities, and how to maximize and decarbonize many existing operations. There were also concerns around policy stability, market formation, affordability and global security.

One theme that was a bit of surprise were inquiries from the industry about how to advance the incorporation of carbon into business decisions, into the value of commodities, assets and companies. To be clear this was not about governments imposing a price on carbon, but about market formation.

The idea that the market, on its own, could price carbon isn't new. The heart of the Task Force on Climate-related Financial Disclosure, or TCFD, argued that climate risk posed financial risk that should be incorporated into financial decisions.

TCFD broke it down into physical risk, transition risk and liability. Transition risk is the one that deals the most with the implications of carbon. Transition risk proposed that, all else being equal, more carbon intensive companies, assets or products could face a greater financial risk from future climate policy and consumer choices, which could increase cost or reduce demand. Choice is the key word. If provided a choice, would someone choose a lower carbon commodity or good? In making that choice, demand would be impacted, and thus value.

Making a choice, however, requires information. Without information, consumers cannot distinguish. They cannot choose. They cannot assign any value.

The need for better information was identified by the TCFD. Companies have responded with an increased level of emissions disclosure. Scope 1 and 2 emissions disclosure appears to be on course toward table stakes. The occurrence of scope 3 disclosure has increased but is far from comprehensive.

The greatest challenge on emissions data today, however, may not be the degree of disclosure or type, but its consistency. Some common differences we see in reporting emissions is whether it is on an absolute or intensity basis, equity or operational, and/or use of different reporting units. These differences limit the comparability, utility and the ability of consumers to choose.

For the oil and gas sector, which is in the spotlight on this issue, an increasing number of companies have begun to invest more materially to deliver greater levels of assurance around their emissions as well as in driving improvements. S&P Global Commodity Insights is seeing evidence of improvements in disclosures and in carbon intensity reductions. But on a well-by-well and company-by-company basis, performance is not homogenous.

There remains limited evidence how or if emissions disclosure has influenced company evaluations, cost of capital and other financial metrics. This is a problem as better actors need to be rewarded. Moreover, as companies move through the lower-end and lower-cost portion of their marginal abatement curve, returns on further investments diminish and abatement options become more costly. Without proper financial incentives the signal to companies will be weaker, private capital will not be as efficient and demand on the public purse greater.

Incorporation of emissions metrics into financial performance would help better align incentives to stimulate greater investments earlier. At CERAWeek 2024, it was interesting because we heard that at least some parts of global energy sector agree.

In some nations, governments have identified the need to align incentives by imposing a price on carbon. These measures, however, are fragmented to select regions. They are also limited in how far they can push -- if they become too stringent, they can harm the competitiveness of domestic industry and in doing so drive capital and emissions to less stringent regimes. This is known as carbon leakage.

Some nations have advanced the idea of implementing a carbon intensity-based trade mechanisms to protect their industry from regimes that they view as having less stringent climate policies.

The European Union's Carbon Border Adjustment Mechanism, for example, has the potential to drive a carbon price into commodities and thereby companies beyond their borders. This policy is being watched closely and has the potential to proliferate. If it does, it could result in multitude of different approaches that could bring its own challenges. It is also quite possible these policies could face real trade challenges.

A growth in level of mandatory corporate scope 3 disclosure is also interesting to note as it will require companies to scour their supply chains, and in doing so they may obtain new insights into what their various providers look like from a carbon intensity perspective and begin to make different choices.

Although these new regulations and requirements could help improve the level of information, it is also not clear if they will contribute to greater consistency in emissions reporting. These policies are also not without risk. If we want the market to incorporate carbon into business decisions, then a consistent transparent emissions framework is a likely prerequisite.

Given proper information, consumers may choose not to make different choices. But without that information, we should not expect any change in behavior. At S&P Global Commodity Insights, we are seeing evidence, at CERAWeek and elsewhere, that the market does want to transact on carbon. What it has been lacking is the information required to do so. Getting this right is important to put in place the right signals to align incentives and mobilize capital as the public purse cannot do this alone.