Pricing carbon into company valuations

At Arisaig, we believe that Purposeful Growth companies – those that think about overall value creation across multiple stakeholders, including customers, employees, local communities, and the environment – tend to deliver superior long-term shareholder returns. At first glance, this seems to be at odds with the views of Milton Friedman, who is often characterized as being anti-stakeholder in his stance on shareholder primacy. However, this only holds if the value creation process of a company is entirely disconnected from its impact on stakeholders. The evidence suggests that since his famous ‘doctrine’ in 1970, stakeholders have exerted increasing influence over companies, whether it be via more conscientious consumers[1], more purpose-driven employees, more aggressive and targeted fiscal systems (corporate tax as a % GDP is up by c. one third since 1970[2]) and/or more informed communities (i.e., voter bases). This has, we believe, increasingly welded together the interests of stakeholders and investors to the point where Boards and management teams that are not proactively addressing the needs of wider stakeholders are likely failing in their fiduciary duties.

As our readers may be aware, we value our companies over a 20-year horizon, a timescale that challenges the imagination, but forces us to consider this transmission of stakeholder value onto a company’s finances. One such example of this is the way in which environmental costs – and in particular those contributing to climate change – are being internalised within companies’ financials, both directly (e.g. via carbon taxes[3]) and indirectly (e.g. via stakeholder action such as changing consumer tastes).

We have been tracking the carbon footprints[4] of all our portfolios for almost a decade. While the carbon footprint of our portfolios remains well below that of comparable [5], the growing urgency of climate change means that no company is immune from the consequences. This has helped inform both investment decisions (e.g., the divestment of dairy companies) and engagement practices in recent years.

To better understand the potential implications of carbon costs being internalized, we have run some detailed analysis looking at how a carbon tax might impact the profitability and indicative returns of our portfolios.

Step (a) Establish carbon footprint of our holdings: Given the sparsity and disparity of carbon disclosure practices, we use externally acquired data[6] to get a consistent picture of the carbon footprint (measured as tonnes of scope 1 + 2 per US $ million of revenue[7]) of our holdings. Where available, we cross-check this external data with what we know from the companies’ own disclosures.

Step (b) Apply a carbon price: We settled on a figure of USD 75 per tonne, which is a level suggested by the IMF as being required by 2030 to keep global temperatures below 2°C[8]. We multiply the carbon footprint by the carbon price to estimate the absolute cost of carbon tax.

Step (c) Add costs to operating expenses and deduct from margins: We then incorporate carbon costs into each companies’ operating expenses to determine the margin hit[9]. Finally, we incorporated the margin hit into our long-term valuation model (the ‘Arisaig Crystal Ball’, or ACB) to identify the impact on indicative returns. In simple terms, we flex the end-state EBITDA margins in our models by the compression assumed in the previous step. We can then compare the returns of this scenario with our ‘Base’ scenario model to understand the potential impairment.

We compared the findings of our holdings with the S&P EM BMI index. We found that our holdings have worse disclosure than the broader market, which is likely due to our skewing to smaller companies and less developed countries. Whilst a challenge in terms of information sourcing, it is a huge opportunity for engaged public equity investors like us to influence positive change.  More encouragingly, we find that our holdings have a lower carbon footprint than their peers within the wider index, which translates into a lower margin compression in the event of a carbon tax. Although this data is far from perfect, it does provide some indication of the relative insulation of these holdings to future carbon taxes.

From a returns perspective, we were also reassured by the modest predicted impact. According to our ACB, the imposition of a USD 75/tCO2e carbon tax on scope 1 and 2 emissions would only hit indicative returns by roughly 3%. While this is not insignificant, we note it assumes a full transmission of the carbon tax on earnings i.e., zero elasticity in pricing or other costs to offset this.

This analysis provided some reassurance but is not the only way of approaching climate transition risk. As described at the outset, there are various ways in which stakeholder interests can transmit into companies’ finances. Some areas of ongoing work we have identified include:

• Improving disclosure standards – without clear and accurate data on carbon emissions, stakeholders are unable to appraise the risks and opportunities. We must therefore continue to engage with our companies to improve their measurement and disclosure. We have a target of all our holdings reaching Transition Pathway Level 2 by 2023, which would involve them, among other things, disclosing Scope 1 and 2 emissions.
• Pushing for ‘Net Zero’ for all of our investments – once carbon emissions have been accurately measured, an action plan can be drawn up. We seek to support all of our holdings to reach ‘net zero’ (i.e. removing all the emissions generated within their operations) by 2050. By successfully pursuing this objective, companies can minimize the risk of carbon pricing.
• Re-run the analysis as data on emissions and carbon pricing improves – based on progress in recent years, we expect relatively rapid improvements on the data front. Repeating the analysis will keep it relevant.
• Understanding alternative carbon transmission mechanisms – within many of the sectors and markets we invest in, direct carbon taxes of this magnitude are likely a long way off. However, shifting demand patterns may materialize much sooner. This is hard to capture across all companies in a top-down manner, but with the help of the analysis above, we can zoom into the companies and industries where hit to fundamentals might be the most severe.

[1] e.g. see NYU Stern’s Center for Sustainable Business research – https://www.stern.nyu.edu/experience-stern/faculty-research/latest-research-nyu-stern-center-sustainable-business-and-iri-shows-sustainability-surviving-covid

[2] OECD data to 2020

[3] The pros and cons of using this approach is a blog piece in itself, and perhaps only for the ardent followers

[4] Or more accurately, the greenhouse gas (GHG) emissions, measured as a carbon equivalent

[5] The greenhouse gas intensity (based on estimated direct + first-tier indirect emissions) of our portfolios are between 66% and 86% lower than comparable indices as of 31 December 2021, according to externally acquired data.

[6] Via Trucost, a subsidiary of S&P

[7] We exclude scope 3 from this specific analysis as we are yet to see enough consistency in disclosure

[8] See – https://www.imf.org/en/Publications/staff-climate-notes/Issues/2021/06/15/Proposal-for-an-International-Carbon-Price-Floor-Among-Large-Emitters-460468; there are a wide range of carbon price estimates out there, with some suggesting a level of $140+ being required to keep emissions in check.

[9] NB. This assumes a full transmission of the carbon tax on earnings – i.e. zero elasticity in pricing or other costs to offset this

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