ESG & Leadership

The following was the material I wrote in preparation for my Masterclass with upGrad, on the 06^th July 2023. 

We are living in the age of climate change.  In business, the primary risk exposure for the intermediate to long-term is carbon taxes and carbon credits.  There is a lot of talk and speculation on carbon credits, but a lack of hard information.  Governments all over the world are implementing carbon taxes and pivoting towards carbon neutrality.  This is not a cost, but an opportunity. 

Leadership is not merely the art of commanding.  Leadership is the exercise of influence to effect preferred outcomes.  Corporate leadership without ESG leadership is inadequate corporate leadership.  Consider Tesla, for example.  They are the largest automobile manufacturer by market capitalisation, but they make money from their ESG initiatives, not just selling cars.  This is by design, and they are not an outlier. 

Businesses need to embrace the carbon market, because every industry has some exposure to it.  It requires strategic planning to be ahead of the curve and implement policies and actions to mitigate risk exposure, while growing revenue in this area. 

The Irish playwright, George Bernard Shaw, was allegedly quoted in 1942 as saying, “England and America are two countries separated by the same language.”  I believe that before we talk about something, we need to define what we are addressing, because we often have this situation where people have entire conversations, using the same terms but meaning different things. 

ESG abbreviates “Environmental, Social, and Governance”.  ESG investing and initiatives refer to a set of standards and values for a company to screen potential investments.  In our current context, it has increasingly been used to refer to our carbon footprint and exposure to carbon tax.  The environmental criteria address how a company safeguards the environment.  It includes corporate policies addressing climate change.  That is what we are focusing on because to talk about ESG investments and policies would take more than an hour. 

Carbon credits, technically known as carbon offsets, are essentially permits to pollute.  Carbon credits allow the owner to emit a specific amount of greenhouse gases, including carbon credits, for a specific period.  One credit permits the emission of one tonne of carbon dioxide or the equivalent greenhouse gases.  The term is “Co₂e”.  This is one half of the cap-and-trade regime.  The other half is, of course, the reduction of emissions. 

Climate change is a reality.  We strongly believe that it is the collective interest of humanity to address it, in order to maintain the quality of life, protect the most vulnerable among us, and secure our future.  We believe it is in the interest of companies to aggressively pursue any and all viable efforts to minimise our global carbon footprint, within our companies, and across our collective value chains.  Addressing climate change is expensive.  Not addressing climate change is unfathomably more expensive. 

Deloitte Touché Tohmatsu Ltd., commonly referred to as Deloitte, the British multinational professional services network, estimates that unchecked climate change could cost the global economy US$178 trillion over the next 50 years.  It is difficult to sell anything when the customer base is degraded. 

ESG leadership refers to leadership in managing risks and opportunities related to ESG criteria.  This is not just about creating a policy framework to manage ESG, but to secure a strategic position by recognising the risks, identifying the opportunities, and taking action before the rest of the market.  If you are following what others are doing because they are doing it, that is not leadership.  That is following the trend.  That is not inherently wrong, but it could be dangerous if there is a lack of understanding of the subject matter. 

Consider Tesla.  In 2022, Tesla’s revenue from automotive sales was US$67.2 billion, while its revenue from the sale of regulatory credits to other automakers was US$1.8 billion.  How much does it cost to create those carbon credits, versus the cost of producing one car?  The carbon credits are created incidentally, meaning we can argue that almost all of that US$1.8 billion revenue is profit.  The same cannot be said for the US$67.2 billion from automotive sales.  Tesla has secured an ESG leadership position and made billions over the years by taking advantage of the system. 

Tesla positions itself as a leader in the electric vehicle market and the carbon credit market.  Tesla claims its solar panel installation business and its EV business generate carbon offset credits by reducing greenhouse gas emissions.  These credits are sold to other firms, primarily automakers, which struggle to meet emissions standards set by regulatory bodies like the California Air Resources Board (CARB).  Strategically, what does this mean?  It means Tesla is actively taking money from its competitors to fund itself, depriving these competitors the funds to develop products, services and marketing campaigns to compete.  That is the sort of market leadership we are looking at.  It is a brilliant strategic position where they have strengthened themselves at the expense of competitors. 

In Sun Tzu’s “Art of War”, Chapter 11 talks about the nine types of ground.  There are many different quotes, depending on the translation, and text, but one of my preferred goes something like this: “Know your enemies, know yourself; your victory is certain.  Know heaven, know earth; your victory is complete.”  It is always important to understand the lay of the land, especially political and regulatory exposure for international business. 

Firstly, there are two main categories of carbon markets: voluntary and compliance.  Within these categories, there are various types of carbon credits: 

1.      Renewable energy credits (from replacing fossil fuels with renewable energy plants);

2.      Energy efficiency credits (from implementing energy efficiency measures);

3.      Afforestation and reforestation credits (green carbon);

4.      Methane capture credits (typically from farming and mining);

5.      Agricultural and soil management credits (such as from crop rotation); and

6.      Industrial process credits (such as using carbon capture and storage). 

Most of the time, when we see any discussion on carbon trading, such as with Verra and Gold, it is invariably about the voluntary market.  The voluntary market is not the future.  The future is the compliance market.  When the cap-and-trade system was established under the United Nations Framework Convention on Climate Change, what they were doing was essentially introducing a new commodity market. 

As we gradually pivot towards the compliance regime, carbon taxes exposure increases because nations need to meet their 2030 and 2050 pledges.  Many of them are far behind.  The UK is one of them.  The US is another.  Others, such as Israel and Malaysia have stated they are unable to meet their pledges.  What does that mean?  That means somebody else must pay for that.  That “somebody” is you and I. 

It is expected, as per previous discussions, that four industries will be among the first to pay a higher carbon tax because they have the highest carbon footprint.  They are maritime transportation, airlines, mining, and oil and gas.  From there, it will be expanded to manufacturing, logistics and construction.  Regardless of the rollout, everyone has to pay, and the cost will go up. 

The carbon markets play an extremely important role to complement efforts to transition to a low carbon economy or achieve net neutrality of carbon emissions.  Any pivot towards reducing net emissions is expensive.  This is particularly so for companies that are in sectors of the economy where carbon footprint is difficult to mitigate, where technology has not become commercially viable, or where the nature of the industry is simply inimical to reducing net emissions.  In these cases, purchasing carbon credits is the only viable option.  We are harnessing market forces to facilitate further investment in viable solutions at other points of the economy.  The intent is to reduce overall cost by taking advantage of economies of scale in sectors where the technology is economically viable and can be deployed widely. 

There is a danger, through the voluntary market, that carbon credits have been used by some to forestall active efforts to address climate change or subvert the entire intent of the system.  , because these purchases fund the deployment of climate solutions in other sectors.  Taking stock of the industry since the setting up of the UNFCC, there is greater emphasis on green carbon credits in the voluntary market, particularly from forests.  As demand for carbon credits continues to grow, people with access to land are encouraged by financial as well as environmental concerns to plant paulownia and other plans in order to earn from more than just harvesting timber.  The issue is the impact on diversity by simply planting paulownia trees.  Another contention is that the voluntary market lacks the rigorous verification and validation to prevent what is essentially greenwashing.  On one hand, it is a step towards reforestation.  On the other hand, the lack of oversight means the system is subverted. 

The voluntary market has a perception problem with the market integrity.  On the 18^th January 2023, the Guardian published an article accusing Verra of grossly overstating the emissions reductions associated with its “avoided deforestation” credits. Investigative journalists at SourceMaterial partnered with the Guardian and claimed that only 6% of Verra’s avoided deforestation credits represented real emissions reductions.  This led to the invalidation of around US$1 billion worth of carbon credits, and the CEO of Verra stepping down. 

On the 21^st March 2023, reports came out that Verra suspended the issuance of credits from an award-winning project in Kenya, after serious questions were raised about its validation and methodology.  Survival International released a report on the 16^th March 2023 saying that the offset, called the Northern Kenya Grassland Carbon Project, could not accurately count its carbon savings.  The Northern Rangelands Trust, the Kenya-based conservation group that managed the offset, criticised the Survival International report.  The project claimed to increase carbon storage in the soil of northern Kenya’s savannah grasslands by managing the grazing patterns of livestock herds.  At COP27, it was awarded the Triple Gold distinction by the Climate, Community & Biodiversity Alliance.  Survival International’s investigation found that third-party validators hired to assess the project had raised more than 100 “findings” before Verra ultimately decided to verify the carbon credits it generated.  The voluntary market is losing its credibility, as more such cases of greenwashing and malfeasance come to light. 

Maj. Gen. Carl Philipp Gottfried von Clausewitz was a Prussian general and military theorist.  He wrote that war is politics by other means.  Business is war.  It is about seizing market share, and whether we admit it or not, this is a zero-sum game.  For you to gain market share, someone must lose it.  You can either fight for what there is, or you can find a new market and seize that strategic advantage. 

ESG leadership is about finding the blue ocean.  Kim Chan and Renée Mauborgne from INSEAD wrote a book about the Blue Ocean Strategy, which is an apt name for our topic.  The Blue Ocean strategy is about creating and capturing uncontested market space, rendering competition irrelevant.  That is what Tesla did with their carbon credit sales.  In contrast, a Red Ocean are all the industries in existence today, the known market space.  The sharks are feeding, and the ocean is red.  There is a cycle of increased competition for diminishing returns.  How many companies treat ESG initiatives as part of their branding strategy, for market optics, instead of viewing it as inherent to the core strategy of the company to seize market share, by utilising the “ground” of Sun Tzu’s “Art of War”?  How much money is wasted with no significant impact on the bottom line? 

That opportunity is found in carbon sinks.  As we move towards 2030 pledge deadlines, carbon credits will increase in price.  At every COP, regulatory pressure increases, and there is renewed emphasis on addressing the carbon footprint.  We cannot all be Tesla and start building EVs and solar arrays.  The obvious solution is moving up the value chain.  Instead of merely looking at initiatives that create carbon credits as a consequence of business activities, it makes financial sense to actually invest in a carbon sink as a means to transfer risk. 

There are two kinds of voluntary carbon credits: green carbon and blue carbon.  Green carbon is from planting trees such as paulownia.  It takes five years or more to get your carbon credits.  Blue carbon is from sources such as mangrove and seagrass.  I believe that the future is found in blue carbon, specifically seagrass.  0.2% of ocean floor is covered by seagrass, but 10% of the ocean’s carbon is absorbed by seagrass.  One hectare of seagrass can store twice the carbon of a terrestrial forest.  Seagrass sequesters carbon 35 times faster than a terrestrial forest. 

Why does this matter?  Consider this: last quarter of 2022, the EU Emissions Trading System (EU ETS), the largest of the six compliance markets, traded carbon credits at around US$70.  Today, they are trading at almost US$100.  By the end of next year, we are likely looking at anything from US$120 to US$140 per carbon credit.  Those are conservative numbers.  There are not enough such carbon credits on the market.  Once it becomes increasingly compulsory, how much do you think you have to pay? 

The solution is to invest in projects that can ensure their access to carbon credits, while increasing market supply.  This is also an opportunity for these investors to support objectives beyond mere abatement.  We are talking about amounts in the low millions of dollars, in an environment where many tax jurisdictions have massive tax incentives for ESG projects.  It works, you get carbon credits.  It fails, you write it off as an ESG investment for a tax break and exit. 

What began with the voluntary market must now pivot to a compliance market.  As long as this remains in the voluntary market, there is a danger of greenwashing and subversion of the system.  The compliance market is the foundation of decarbonisation efforts, and the reduction of our collective carbon footprint.  The voluntary carbon markets are unlikely to expand quickly enough to incentivise the level of reduction necessary to keep us on track to net-zero emissions by 2050.  The value of voluntary carbons is too low to be a financial instrument, let alone support a secondary market. 

This is first step in market leadership in the ESG sphere.  What we are doing is moving up the value chain, to secure a resource we know will grow in value due to the current political and economic conditions.  But big corporations are already doing that, and it is not enough. 

Unlike the voluntary market, the compliance market is regulated by mandatory international, national or regional carbon management regimes.  The voluntary market functions independently of these compliance markets, by enabling companies or individuals to purchase carbon credits to meet their own emissions goals.  Compliance credits may be purchased voluntarily by non-regulated entities, but voluntary credits are not allowed to fulfil compliance market requirements because they are created under a less stringent verification and validation process. 

It is obvious we need to raise the overall quality of carbon credits.  This means pivoting away from the voluntary market towards the compliance market.  The lack of quality credit supply is actively hindering further development of comprehensive efforts to support large-scale decarbonisation.  Within the voluntary market itself, there is a scarcity of Carbon Dioxide Removal credits, the so-called removal credits.  There is an excess of junk-quality carbon credits that need to be bought in massive quantities to meet the carbon tax of individual organisations.  This negatively impacts capital investment into carbon credits, since the view is that credits have little to no value. 

The system was always conceived to eventually have credits that are financial instruments in their own right.  The next stage of the evolution of carbon credits is investment-grade carbon credits.  Now, we have options, we have futures, we have an entire secondary market.  The next evolution of a compliance exchange is more like something we now see in the Chicago Mercantile Exchange. 

This session has given you an example of how Tesla secured market leadership at the expense of their rivals.  This session has have put forth a cogent contention that securing market leadership requires an investment in some form of carbon sink project.  This session has put forth the argument that the next stage in the development curve is an investment-grade carbon credit that will be traded on a compliance exchange.  The question then, is what can a business do in the intermediate term?