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It’s no secret that the transition to net-zero emissions will come at a significant cost to businesses. Yet, as recent rising temperatures across Europe have shown, it is becoming increasingly difficult to ignore the economic threat posed by climate change.
Climate-related disasters are already causing damage to property, equipment and ultimately profits of businesses in all sectors, while basic resources such as food, water and energy are also at risk.
This summer’s heatwaves across Europe have only added to the seriousness of the situation. A recent survey by Deloitte showed that nearly three in ten companies are already feeling the operational impact of such disasters, such as: B. Damage to capital stock and workforce disruption.
Unless drastic measures are taken, it is likely that this problem will become more prevalent and business leaders in all sectors will become vulnerable to the changing economic and environmental environment.
Consequently, government and regulatory agencies around the world are beginning to implement policies to mitigate the effects of climate change. Such initiatives will be crucial in our fight against global warming.
However, recent research also shows that tackling these increasingly stringent regulations – particularly measures that promote a more sustainable relationship with energy use – will pose a different challenge altogether.
Significant compliance costs, exacerbated by rising commodity prices nationwide, pose significant political risks for the corporate sector as they seek to adapt to the changing regulatory landscape. Against this background, it is important for both policy makers and companies to understand and manage such regulatory risks.
compliance costs
The burden of complying with environmental regulations has increased significantly over the past few decades, making it more costly for companies to comply.
This, coupled with the moral and financial incentive to demonstrate action on climate change, has put many companies in a difficult position. The utilities sector in particular has felt the strain as the industry, as a key driver of global warming, makes it a natural candidate for regulation.
Mitigating emissions can take a number of forms, with the most commonly used policy tool being carbon pricing. By putting a price on carbon, governments can capture the external costs of carbon emissions and tie them to their sources.
Carbon pricing schemes such as emissions trading schemes (ETS) and carbon taxation have been adopted by some 40 countries around the world, with the EU’s own ETS representing the world’s first – and largest – carbon market.
Limiting CO2 production and internalizing the costs involved – be it damaged crops or air pollution – is a powerful way to mitigate the effects of climate change. However, due to the significant compliance costs involved, such regulations pose significant political risks to the corporate sector.
problems in practice
I recently participated in a research project with my colleague Ning Gao, Senior Lecturer at Alliance Manchester Business School, and our PhD student Tiancheng Yu to examine the unintended impact of climate policy risks on corporate financing decisions.
This included a detailed analysis of the impact of the Nitrogen Oxide Budget Trading (NBP) program implemented in 11 US states with the goal of reducing nitrogen oxide (NOx) emissions and air pollution.
Our study showed that the regulation created significant compliance costs for utilities, which were ultimately passed on to their customers.
As a result of the policy, electricity prices in compliant states rose more than 9 percent, causing manufacturing companies to feel the strain. As energy-intensive companies were hit the hardest, the NBP delivered a significant price shock to their cost structures, leaving them with higher debt costs, greater operational inflexibility and greater risk of financial distress.
In response, these companies have become more conservative in a variety of financial and investment strategies. Many took steps to reduce their financial leverage and exposure to government debt, while the amount of funds going into investments and payouts to shareholders fell significantly.
This is an excellent example of the trade-off many companies face when adopting green energy policies. This, combined with the existing costs of being compliant, will make the transition to net zero a heavy price for many organizations.
However, the costs of not enforcing such regulation will be catastrophic. It is important for both policy makers and companies to understand and manage such risks.
risk management
A key first step management must take to mitigate these risks is to ensure that a company’s strategy and its sustainability efforts are aligned. A divergence between the two can often lead to inefficiencies that are otherwise easily avoided. Apart from that, companies should also take care to maintain transparency to avoid presenting mixed messages to investors, stakeholders and policy makers.
It’s also worth noting that we cannot rely solely on market power to ensure our sustainability goals are met. A successful transition also requires government intervention. Through tax breaks, price caps, subsidies, and an appropriate mix of supply-side and demand-side policies, governments can help incentivize compliance while negating the financial risks of adoption.
The transition to a greener economy is inevitable, so it is crucial that companies and organizations develop concrete plans to adapt to this changing natural and societal landscape. Managing this transition will undoubtedly bring its challenges, but will bring results in the form of a more sustainable future.
Viet Anh Dang is Professor of Finance at Alliance Manchester Business School.
