Planning For A Green Economy: The Trade-Offs Of Green Energy Measures

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It’s no secret that the transition to net-zero emissions will come at a significant cost for business. Yet, as recently demonstrated by soaring temperatures across Europe, it is increasingly hard to ignore the economic threat posed by climate change.

Climate-related disasters are already causing damage to property, equipment and ultimately the bottom line for businesses across all sectors, while basic resources like food, water and energy are also at risk.

This summer’s heatwaves across Europe have only served to reinforce the seriousness of the situation. A recent survey from Deloitte showed that almost three in 10 organisations are already feeling the operational impacts of such disasters, such as damage to capital stock and workforce disruption.

Unless drastic action is taken, it is likely that this issue will only become increasingly common, leaving business leaders in all sectors vulnerable to the changing economic and ecological environment.

Consequently, governmental and regulatory bodies around the world are beginning to implement policies to help mitigate the impact of climate change. Such initiatives will be key in our fight against global warming.

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However, recent research also shows that navigating these increasingly stringent regulations – especially measures that encourage a more sustainable relationship with energy consumption – will create an entirely different challenge.

Substantial compliance costs, exacerbated by rising raw material prices nationwide, will pose considerable policy risks to the corporate sector as they seek to adapt to the changing regulatory landscape. With this in mind, it is important for both policymakers and businesses to understand and manage such regulatory risk.

Costs of compliance

The burden of environmental compliance has grown significantly over the last few decades, making it more costly for businesses to comply.

This, coupled with the moral and financial incentive to demonstrate action in the face of climate change, has left many firms in a difficult position. The utilities sector in particular has felt the strain, with the industry’s position as one of the key drivers of global warming makes it a natural candidate for regulation.

Mitigation of emissions can take on a variety of forms, with the most common policy instrument used being carbon pricing. By putting a price on carbon, governments can capture the external costs produced by carbon emissions and tie them to their sources.

Carbon pricing schemes, such as emission trading systems (ETS) and carbon taxation have been adopted by some 40 countries across the globe, with the European Union’s own ETS representing the world’s first – and largest – carbon market.

Placing a cap on carbon production and internalising the costs produced – whether it be damaged crops or air pollution – is an effective way to mitigate the impact of climate change. However, such regulations pose considerable policy risks to the corporate sector due to the substantial compliance costs they incur.

Problems in practice

I recently took part in a research project with my colleague Ning Gao, Senior Lecturer at Alliance Manchester Business School, and our PhD student, Tiancheng Yu, to explore the unintended impact of climate policy risk on firms’ financing decisions.

This involved a detailed analysis of the impact of the Nitrogen Oxides Budget Trading Programme (NBP), which was implemented in 11 US states with the aim of reducing Nitrogen Oxide (NOx) emissions and ambient air pollution.

Our study showed that the regulation imposed significant compliance costs on power generating utilities, which were ultimately passed on to their customers.

As a consequence of the policy, electricity prices increased more than 9 per cent in the compliant states, causing manufacturing businesses to feel the strain. With energy-intensive firms impacted the most, the NBP dealt a significant price shock to their cost structures, leaving them faced with higher costs of debt, greater operational inflexibility, and higher financial distress risk.

As a response, these firms became more conservative on a wide range of financial and investment policies. Many took steps to reduce their financial leverage and public debt exposure, whilst the amount of funding channelled into investment and shareholder pay-outs dropped significantly.

This is a prime example of the trade-off many businesses will have to navigate when it comes to the introduction of green energy measures. When combined with the existing costs thrown up by compliance, this will leave many firms with a high price to pay in the transition to net zero.

However, the cost posed by failing to implement such regulation will be catastrophic. It is important for both policymakers and businesses to be able to understand and manage such risks.

Risk management

A first key step for management to take in mitigating these risks, is to ensure alignment between a company’s strategy and its sustainability efforts. Divergence between the two can often lead to inefficiencies that can be otherwise easily avoided. Aside from this, firms should also make sure to maintain transparency to avoid presenting investors, stakeholders, and policymakers with mixed messages.

It also is worth noting that we cannot just rely on market powers to ensure that our sustainability targets are met. A successful transition will also require government intervention. Through tax breaks, price caps, subsidies and an appropriate mix of supply- and demand-side policies, governments can help incentivise compliance while negating the financial risks posed by adoption.

The transition to a greener economy is inevitable, so it is critical that firms and organisations form tangible plans to adapt to this changing natural and societal landscape. Navigating this transition will undoubtedly present its challenges but will yield results in the form of more sustainable future.

Viet Anh Dang is a Professor of Finance at Alliance Manchester Business School.