There are three strong forces at work in the global effort to control carbon emissions:

1. Government regulation of emission production
2. Use of prudential regulation of financial institutions to control investment in fossil fuel production in the name of risk management
3. Use of shareholder activism to attempt to control emission production beyond government regulation

While the recent COP 26 conference made it clear that none of these efforts has so far “worked”, it is likely that the near failure of COP 26 will spur the actors forward.

In my opinion all three of these strategies will not work and will introduce many known and unknown externalities that will reduce the welfare of many. Flying into Glasgow pretending that the world is aligned on carbon reduction is a convenient fantasy, but not a realistic approach.

The only useful solution to the problem of carbon emissions is control of carbon consumption at the national level. That can only be accomplished by an integrated carbon tax regime. While my main focus will address Canada, Other countries will have the same issues.

The Current Strategy

It is generally assumed that we have a carbon tax regime in Canada.[1] In a number of Provinces there is a carbon tax as well as an Output Based Pricing System (“OBPS”). In several Provinces there are “cap and trade” alternative systems. In almost all of the Provinces there is a bewildering set of exemptions and other rules that allow a number of industries to be effectively exempt from carbon control, or significantly reduce the effectiveness of carbon control, mostly because of significant externalities (mostly global competitiveness of industry) or because industries are politically sensitive (farming etc.). In addition, it is not well understood, but most of the Canadian regimes deal with only combustion-based emissions and not all emissions and many of the structures do not deal honestly with the full cycle emission profile of many products (electric vehicles, biofuels and biomass being cases in point).

The systems that we have are staggeringly complex and obviously, from the historical emissions profile of the country, not effective. For those interested in this complexity a useful summary is provided by Sarah Dobson, Jennifer Winter and Brendan Boyd. Fair warning, it’s a tough read.[2]

The net result of the excess complexity of our systems is both an ineffective response to carbon emissions as well as a bewilderment on the part of most individuals who have been under the impression that the Federal Government “commitments” on GHG’s actually mean something.

The degree of complexity as well as the lack of useful coverage of GHG emissions by policy is down to a quite simple issue. Really effective carbon control is politically extremely difficult and under carbon emission controls  (versus consumption controls) hard to accomplish in an open economy that needs to compete globally.

Part of the reason that the process is politically difficult is that the various levels of government have maintained a fantasy that the energy transition can be painless and that it will be a producer of jobs, not a destroyer of lifestyle.[3]. The fact is that energy transition will be long, painful, and costly. Our standard of living will stagnate or decline. The magic of our market economy is that the costs and benefits of existing energy production and consumption will over short periods of time, maximize economic efficiency (in the absence of government intervention). Moving from a very efficient use of available energy supplies (albeit with an un-costed externality of carbon production) to a less efficient supply will reduce wealth. How fast and how far will be determined by the speed of transition as well as the speed and effectiveness of technological change.

Therefore, our existing carbon tax, with its refund of costs to voters has been designed to make all voters think that the transition is relatively painless and that “someone else is going to pay for it.”

The combination of a low carbon tax, ineffective OBPS and a staggering number of exemptions has been politically effective in keeping governments in office, but it is hard to see the benefits to the environment, supposedly the main purpose of these rules.

The focus of our climate control systems on emissions rather than consumption brings with it both complexity as well as ineffectiveness. Large industries in Canada would be devastated by a very high tax carbon emission system as they have to compete on a global market with a wide range of competitors that have less difficult regimes. Industries that are largely exempt in Canada due to the focus on combustion rather than total emissions would also be devasted in trying to compete with unregulated industries in other countries.

Over and above all of this is that vast amounts of the commodity infrastructure of the world involves fungible product. Reduce oil production in Canada? Fine, we will just import from Saudi Arabia! Net effect on the planet – neutral to negative after transportation. Time after time the absurdity of trying to control emissions on a national basis has been clear. And in the aftermath of the nearly failed COP 26 it should be clear that there are too many development priorities in the world, including importantly the serious issues of energy poverty to continue to do what we have been doing and feel that we are really contributing.

Which brings us back to carbon pricing and a carbon tax. Almost all economists would agree that carbon pricing is the most efficient way of dealing with the reduction of consumption. Similar to the HST it is a very efficient and fair tax and similarly to the HST can be modified to deal with low-income payers. Most importantly it is no where near as distorting to economic growth and calculation as income taxes or employment taxes. And reduction in consumption is the only technically feasible way of addressing carbon reduction in the near term before more technologically advanced solutions are developed. The only way to fund effective technological solutions is to make the price of carbon high enough that there will be profit in reducing consumption and producing useful energy alternatives.

Carbon pricing of individual consumption through a carbon tax – must be directed to  offsetting reductions in destructive taxation such as income tax and employment tax[4]. Even with strict fiscal neutrality an effective carbon consumption tax will have a huge hill to climb:

1. It will be very apparent that the energy transition is extremely costly and will result in a reduction in standards of living. And because an effective carbon tax must be implemented on individual consumption it will be obvious that voters are going to have to pay, not just “the rich” or “those greedy corporations.” Similar to the HST, which we are now used to, standards of living will have to adjust. If the system is completely revenue neutral at the level of marginal personal and corporate income tax rates as well as employment taxes, of course there will be offsets that will reduce the pain. Useful governments will want to keep substantially more individuals off the income tax rolls as part of the redistribution of the carbon tax. This may have economic efficiency benefits as well.

However, governments have spent decades convincing us that the transition will be both painless and costless to the vast majority of voters. It will be a very brave political party that decides to tell the truth. This party is not in evidence in 2021.

• The second major issue is the externalities of an open economy. The structure of the OBPS is intended to deal with these externalities, but it does so in a very cumbersome way that protects some industries more than others and exempts some from transition entirely especially non-combustion-based emitters. By moving the entire system from production emissions to consumption the nation can control what it can control, without harming export related industries.

How can that be?

A consumption-based carbon tax needs to be applied to each good that an individual consumes. The carbon tax cost of a litre of gasoline must be the same whether it was originally in a barrel of oil from Alberta or Saudi Arabia. The carbon tax applied to Canadian pasta or imported Italian pasta must reflect the carbon content of the product.

This structure has two corollaries:

• Each consumed product must have a process to reflect the carbon content of production. This will be exceedingly difficult and will take a huge effort to accomplish. Each retailer and importer will have to have a process to assess the carbon content of a consumer product. It is likely that in a transition period each imported product will be assumed to have the same carbon content as the Canadian product. This will get more sophisticated over time, but not easily. Assessing the coal content of a Chinese made toy is not a trivial exercise. We currently have a similar system for HST on imported product, but of course the calculations are much easier in the case of the HST as it is an ad valorem tax.
• The carbon tax regime will have to become integrated, similar to the HST system. A similar system of taxes and input credits will have to be developed around the HST framework so that the tax is efficient and falls on the end consumer, rather than intermediaries. When the sales tax was replaced with the HST this system became very streamlined and effective. The other similarity to the HST system will be the number of zero-rated products (such as exports) as well as the number of exempt products. One would hope that the number of exempt and zero-rated products would reduce over time as the system of carbon tax rebates for low-income Canadians is expanded by both tax refunds and elimination from income tax rolls.

It is important that exports from Canada be zero rated for carbon tax purposes. This will allow Canadian products to compete with global products on a similar basis in the export markets. For those countries with their own carbon process the Canadian import would hopefully be taxed in a comparable manner. Through the HST-like input credit system, the exporter would not be disadvantaged. Similarly, it is important that an import into Canada have the same carbon regime so that a barrel of Canadian oil and Saudi oil will have the same tax result to a Canadian consumer, even if not the same price result.

Critics will say that Canada will continue to produce carbon intensive goods that other countries may not tax in the same way and therefore Canada is “not doing its part.” But the real goal is reduction of carbon consumption and in this respect, Canada would lead with a significant consumption-based carbon tax.

Prudential Regulation

A number of prudential regulators, most notably the Bank of England[5] have introduced sweeping regulations, often in the form of “guidance”[6] or as the Bank of England quaintly puts it a “Dear CEO Letter” that purports to guide regulated entities on the “right way” to address climate risk.

It is clear from the blizzard of guidance from the Bank of England that they have gone far from the appropriate scope of prudential regulation in conscripting financial institutions into the climate “emergency” response. In my view the approach that the Bank seems to be taking is reckless.

I can understand why the Bank may be going in this direction. Its staff are believers in the “climate emergency” and they are not confident that there will ever be voter support for the efforts required. They are, in my view, usurping the role of Parliament to pass required legislation.

Climate risk can be parsed into effects of

• climate change on the physical world,
• transition effects from government policy; and,
• consumer behaviour.

Physical Risk

Banks and other financial institutions are used to dealing with physical risks. Floods, fire, and other physical risks are either assumed or devolved to insurers. And in some cases, entire areas of the market are simply abandoned. As the physical effects of climate change evolve, we can expect that banks and insurance companies as well as asset management firms will react in a risk mitigating and profit maximizing way. However, the fact is that risks to financial institutions from physical changes are not existential, no matter what the rhetoric[7]. Property and casualty insurers have short books. It is true that in some markets claims are up dramatically, especially in areas where buildings have been built on flood plains or houses have been built too near to forests without appropriate forest floor management plans. But these companies can adapt quickly, pricing in elevated risks and cutting too risky areas of the market off completely. This is a natural part of risk management and will eventually lead to sound building, forestry, and location practice. It does not appear that the premium to GDP ratio in the global insurance industry is increasing. This suggests that as far as insurance markets are concerned, climate and other risks are generally well controlled.[8]

Shareholders of banks and insurance companies as well as asset management companies will quickly deal with management teams that are not paying attention to these risks. Their business is risk management and external advice, while welcome, should not supplant the judgements of Boards and management teams.

The impact of prudential advice is likely to exacerbate issues of physical transition in the insurance industry by implying a higher risk than is warranted by the market. This will occur if boards of directors of insurance companies are convinced by regulators that risks are higher than they are, thus increasing prices or reducing coverage faster than the changes in the physical world would suggest.

Government Policy

Government policy with respect to climate change is a significant risk. While to date actual climate change regulation and legislation has fallen far behind the climate “emergency” rhetoric of most governments, it is possible that after the near failure of COP26 governments will feel more pressure to ”do something” and the likelihood is that there will be both intended and unintended consequences to such government action.

However, the direction of prudential “guidance” in this area is mostly misplaced. While prudential regulators have focused on exposure to fossil fuel investment and lending, those areas of the market have shown remarkable resilience and asset managers that were enticed to dis-invest have missed a significant near-term opportunity.[9] The fact is that reduction in fossil fuel consumption is a very long-term process. The International Energy Agency predicts peak oil and gas production to occur between 2030 and 2040, with the risk weighted to the end of the decade, unless drastic political measures are taken beyond those that have already been announced.

The typical Canadian gas well enters its third decline rate[10] at about 45 months.[11] For oil wells the fourth decline rate is typically entered after 45 months.[12]. The fact that oil and gas production does not peak until 2040 and that decline curves are so steep means that significant amounts of capital will need to be applied to the fossil fuel industry over the course of the next 12 to 15 years to even maintain current production. The US Energy Information Administration projects rising oil prices over the course of the next few decades with Brent and WTI prices exceeding $150 /bbl. (nominal) through 2045[13]  While oil and gas wells outside of OPEC will likely require more expensive cost structures, it would appear that there will still be incentive pricing in place and thus adequate returns to capital employed.

It would therefore appear that investing and lending to the fossil fuel industry will continue to be required and profitable. Political changes could accelerate transition, bending the oil and gas consumption curve down. However, given the short lifetimes of typical wells, and the rapid payback at current and projected prices, risks look entirely manageable.

Where prudential regulators are likely correct in their approach to risk is the possibility that political change will reduce economic activity. If political change overshoots the capacity for technological change, there is a high possibility of higher unemployment and reduced economic activity that could affect growth, consumer confidence and the resilience of the retail consumer. Thus far, governments have been careful not to make the transition draconian and have supplied subsidies to the transition process mainly through budget deficit spending.[14] However, the potential for the transition to be financed out of tax revenues or inflation is a substantial risk. By definition, this energy transition is negative for growth as higher cost joules are substituted for lower cost joules. If the transition is long enough, economies can adapt and in the fullness of time, technological change can bring transition the energy price down without the need for subsidy spending.

At most financial institutions, political risk is the number one risk. Prudential regulators pointing this out is likely a useful reminder to Boards of Directors.

Consumer Behaviour

Consumer behaviour is a consistent risk and opportunity for most retail facing businesses. Consumers not only buy your product, but they buy your reputation each time they make a transaction. Companies have been dealing with reputational risks for some period but in the era of TikTok and Instagram reputational matters are more sensitive and prone to global reach.

Climate change is a significant issue for wide areas of the consumer economy, but especially for the young. In addition to the other areas where your reputation might be at risk such as equity, diversity and inclusion, climate change is a major influence on buying activity. Prudential regulators pay significant attention to reputational risk and well-run organizations have significant efforts to monitor and enhance reputation. While a company’s approach to climate action is a part of reputational risk, it will vary significantly depending upon the retail component of its business and the degree to which it is perceived to be part of the problem or solution to climate change.

It is difficult to see how a prudential regulator could be of any significant use to a regulated entity other than to remind the Board that reputational risk is important.

My conclusion is that the efforts of some prudential regulators are mis-placed, bordering on taking on a political role themselves. Legislators have every opportunity to legislate approaches to climate change. Financial institutions have the obligation to obey the law and manage their businesses prudently. But when prudential regulators try to step into the empty shoes of the legislator, all is not right.

Climate Activist Investors

Similarly, to some prudential regulators, activist investors, especially those with significant market share in passive investment product (such as ETF’s and index funds) are treading on dangerous ground in bringing their activism to influencing votes for the Board of Directors.

As with some prudential regulators, activists are attempting to make corporations go far beyond the existing regulatory framework and far beyond the normal risk management approach that has served most corporations well. By definition, the challenges that are made by activists are not compliance with law or regulation, they are challenges to make changes that legislators are reluctant to make and that reflect only the warped risk-reward approach of the activist. Activists do not seem able to apply rational costs of capital to the potential future costs of climate disruption. The fact is that the net present value of climate change costs is low even if eventual costs accelerate.

Because the activist tends to go after large corporations in the public markets in the OECD, there is a large component of the capital markets (private companies, National Oil Companies, and others) that are largely out of the blizzard of activism.

The recent attacks against Exxon and Shell are cases in point. Both of these companies are responsible corporate citizens, providing sound energy solutions in a very responsible way. Compared to a wide range of smaller private competitors, these companies are at the forefront of environmental responsibility. However, they are under attack for not making the “transition” investments in sufficient size and speed and are castigated for investments in their base energy businesses. We might agree that the Boards of these companies (similar to other energy companies) have not been sufficiently focused on returns to capital employed but encouraging them to divest fossil fuels and make substantial investments in solar, nuclear or wind, where they have no competitive advantage does not seem to be sound. And where the divestment policy has been successful, obviously there is zero change to the investment into fossil fuels as the acquirors of the projects will simply continue to make useful investments in a legal product, just with a lower cost base than would be the case with a Shell or Exxon. Nothing has happened other than a transfer of value from a large public company to a smaller one or to private equity or to National Oil Companies.

The activist approach continues with a focus on GHG emission reporting. There is a whole industry, supported by accountants and consultants that would like all companies to report their Scope 1 and 2 (and eventually Scope 3 emissions). In a significant percentage of these companies, their emission profile is of extremely limited risk to shareholder value and therefore immaterial. However, activist pressure is being brought to bear to make reporting of emissions, risks (whether material or not) and targets (whether useful or not) as part of corporate disclosure. There are a few frameworks involved: CDSB, IPIECA, TCFD, ICEAW, SFDF as well as the imminent SEC rules that haven’t earned an acronym yet. The CSA has also put out some rules for comment.

The result of this flurry of activism is that public companies are rushing headlong into reporting immaterial matters and making large and unsubstantiated claims that they will be “net zero” whatever that is supposed to mean. Going private has never looked so good.

As noted above, climate risks take an exceedingly long-term in emerging for most corporations, especially the physical risks. The focus of activist shareholders on fossil fuel and other companies that will be around and producing for decades under any reasonable view of the future is not appropriate.

There is another good question as to whether in their zeal to be seen as active, the large passive shareholders are not fulfilling their fiduciary duty to unitholders in their passive and ETF funds by distracting management from a more realistic view of risk and return.

Eventually there is likely to be a class action suit.

Conclusion

In my view governments need to start to play a more active role in the legislation of change. If carbon is to be controlled, it should be focused on the consumer who would be required to vote for the tax. Subcontracting the effort to reduce carbon consumption to either prudential regulators or activist index shareholders is ineffective and will bring a number of intended and unintended consequences, none of which will be useful for maximization of well-being for the planet.

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[1] Opinion: Is carbon pricing Liberal policy? For the most part, it’s anything but – The Globe and Mail

[2] THE GREENHOUSE GAS EMISSIONS COVERAGE OF CARBON PRICING INSTRUMENTS FOR CANADIAN PROVINCES Sarah Dobson, Jennifer Winter and Brendan Boyd, The School of Public Policy Publications, University of Calgary, February 2019

[3] THE “GREEN JOBS” FANTASY: WHY THE ECONOMIC AND ENVIRONMENTAL REALITY CAN NEVER LIVE UP TO THE POLITICAL PROMISE Jennifer Winter and Michal C. Moore The School of Public Policy, University of Calgary, October 2013

[4] Carbon tax should not provide any additional net government funds – even for R&D. The possibility of direct or indirect corruption and rent seeking is too high a risk. The current system provides huge opportunity for governments to attempt to pick winning technologies in the search for “ribbon-cutting” shows.

[5] Climate change | Bank of England

[6] Letter from Sam Woods ‘Managing climate-related financial risks’ | Bank of England

[7] Empirical evidence of declining global vulnerability to climate-related hazards – ScienceDirect

[8] • European insurance: total premium to GDP ratio 2019 | Statista

[9] Eric Nuttall: We are about to hit a production wall setting us up for all-time high oil prices | Financial Post

[10] Decline and depletion rates of oil production: a comprehensive investigation | Philosophical Transactions of the Royal Society A: Mathematical, Physical and Engineering Sciences (royalsocietypublishing.org)

[11] CER – Canada’s Energy Future 2017 Supplement: Natural Gas Production – Appendix (cer-rec.gc.ca)

[12] Ibid.

[13] U.S. Energy Information Administration – EIA – Independent Statistics and Analysis

[14] The Cost of Subsidizing Green Energy Contracts for Industrial and Large Commercial Ratepayers (fao-on.org)