December 22, 2006
Costs of Carbon and Coal: Examining Emissions Trading Scheme Impact on Shareowner Value
by Bill Baue
WWF and SAM Group collaborate on a study modeling impacts of rising costs of carbon dioxide
emissions on the valuation of German utility RWE, the biggest private carbon emitter in Europe.
As the largest German electric utility, RWE (ticker: RWEG) is a poster child for
illustrating how climate change impacts companies when the emission of carbon dioxide (CO2--the
primary greenhouse gas (GHG) causing global warming) becomes increasingly regulated. The 2005
European Union Emissions Trading Scheme (ETS) created a market-based carbon
cap-and-trade system that constrains big carbon emitters such as RWE, forcing them to factor carbon
into their business decisions. On the other side of the coin, the company announced
this week it is under investigation by the German Federal Cartel Office on charges of illegally
factoring the costs of CO2 into electricity prices, exemplifying the risks of walking a tightrope
between carbon and regulatory constraints.
RWE thus represents an excellent case
study for assessing the risk to shareowner value from rising constraints on corporate carbon
emissions, which regulators are doing in order to internalize the cost of carbon pollution that
companies have until now externalized onto society. WWF, which criticizes the embedding of full carbon costs in
electricity prices since ETS provides free carbon allowances, and Sustainable Asset Management (SAM) Group, which manages the Dow Jones
Sustainability Indexes (DJSI), joined forces to produce just such a study. The study, entitled
Carbonizing Valuation: Assessing Corporate Value at Risk from Carbon, finds that RWE could
lose up to 17 percent of its shareowner value if it continues on a "business-as-usual" strategy
that fails to take increasingly stringent carbon limits into account.
"In a world where
carbon emissions will become expensive, utilities need to keep an eye on the long-term value of
their company," said study co-author Bjørn Tore Urdal of SAM Group. "[T]he European Commission
[recently] rejected nine out of ten National Allocation Plans (NAP) for the next phase of the EU
Emission Trading System; this illustrates that in the long term the carbon price is going to climb
high and those companies and investors need to take note."
The European Commission (EC) has slashed seven percent from
proposed NAPs that European countries submitted, with Germany bearing the biggest brunt of cuts--by
32 million tons. The EC justified the cuts as requisite to meet the projected 80 percent reduction
in carbon emissions by 2050 necessary to stabilize the level of carbon in the atmosphere at 450
parts per million (ppm) and avoid catastrophic climate change, according to scientific consensus.
"The CEO of RWE has written to the German Chancellor to complain about the European
Commission's decision to lower CO2 allowances to 453 million tons in the second phase of the EU-ETS
system (NAP 2 period)," Mr. Urdal told SocialFunds.com. "This is lower than what we have modeled
for in this study, and reflects a game change that is difficult to accept for utilities."
The study models three scenarios for replacing the aging infrastructure of RWE's power plant
portfolio: fuel-by-fuel (with replacement plants run by the same fuel as retiring plants), coal
only, and natural gas only. Coal-fired plants represent more than half (56 percent) of RWE's
current generating capacity, with six hard-coal and eight lignite (a softer form of coal) plants.
The company has seven natural gas plants (accounting for 17 percent of generating capacity) and
five nuclear plants (27 percent.) The report points out that 70 percent of the new electricity
generating capacity being built or planned in Germany from 2006 to 2020 is coal based.
likely scenario for RWE will be to carry on its capacity on a status quo level, replacing retiring
capacity by the same technology," the report states, noting the practicality of continuing with
existing infrastructure for coal and lignite in particular.
However, natural gas emissions
are typically one third of those for combusting lignite coal, according to the report, calling into
question the wisdom of fuel-by-fuel or coal-only replacement strategies once the rising cost of
carbon is taken into consideration.
"In the context of these imminent replacement
strategies, the main aim of introducing the CO2 trading scheme is to reduce, if not completely
eliminate, coal-based electricity generation and to substitute lignite generation [with less carbon
intensive alternatives]," the report states.
To understand the study methodology
comprehensively, readers must have an in-depth understanding of both financial calculations of
shareowner value and scientific calculations of carbon emissions. The study also factors in
political calculations that anticipate increasing costs for carbon as emissions limits become
stricter and stricter--an assumption proven correct by the recent EC decision to lower NAPs.
After crunching all the numbers by various scenarios, the researchers find it most financially
rewarding to replace retiring plants with coal plants--so long as the price of carbon remains under
€33 per ton.
"A replacement strategy based purely on coal carries nearly twice the
value of a pure gas replacement," according to the study. "Needless to say, the resulting carbon
emissions based on the most valuable replacement strategies cases raise serious concerns . . ."
"The comparison of carbon emission trajectories with the concept of a sustainable emission
path for the modeled portfolio shows that emissions will be massively over the norm," it continues.
"For coal-only and plant-by-plant, we calculate aggregated carbon emissions for the period 2006 to
2050 to be a staggering 50 percent beyond the sustainable level required."
becomes more expensive than €33 per ton, as it inevitably will, gas becomes the hands-down
choice, both from an environmental and a financial perspective. At €45 per ton of CO2
(compared to the base rate of €20 per ton), the study calculate 17 percent decrease in value
for fuel-by-fuel replacement, versus only one percent loss of value for natural gas only.
"In the case of RWE, we have demonstrated that, all else being equal, value at risk from carbon
is significantly reduced by increasing gas exposure as an active replacement strategy," the report