This blog post originally appeared on Burgiss.com. MSCI acquired The Burgiss Group, LLC in October 2023.
The previous posts in the “Climate Transition Risk” series discussed the financial materiality of greenhouse gas (GHG) emissions in private portfolio companies and estimated profitability losses if private companies had to pay a carbon price on their energy bills in the form of an emissions tax imposed at the energy-supplier level (i.e., upstream).
In this post, we explore how a global carbon-price floor may impact costs and earnings before interest, taxes and amortization (EBITDA) margins for over 54,000 private portfolio companies within our data set (i.e., downstream).
Carbon pricing regulations: a brief introduction
Carbon pricing is an increasingly common climate-policy tool used to meet regional, national and subnational emission reduction targets, either through a carbon tax or an emissions trading system (ETS). Examples include the EU ETS, China’s national ETS and the Swedish carbon tax. While a carbon tax defines a price-per-tonne of carbon-dioxide equivalent (tCO2e), an ETS sets an emissions-reduction target and allows market forces to set the carbon price. According to the World Bank, an estimated 23% of global GHG emissions are subject to a carbon price under 47 national and 36 subnational jurisdictions. Globally, carbon prices can range from less than USD 1/tCO2e to over USD 100/tCO2e.[1]
For the purposes of our analysis, we assume that all private companies are subject to the current carbon-pricing regulations that exist in their respective geographical locations and sectors. For example, all private power companies in the EU are assumed to be subject to a carbon price of EUR 86.53/tCO2e under the EU ETS.
The analysis uses carbon-price data from the World Bank’s Carbon Pricing Dashboard, which outlines existing regulations and associated carbon prices at the regional, national and subnational levels. Based on the geographical locations and sectors of these regulations, an estimated 9% of the global private company count within the Burgiss Manager Universe (BMU) may currently be subject to a carbon price.
Material vs. non-material risk
Financial materiality, the relevance of a specific ESG factor to a company’s financial performance, business model and enterprise value for investors’ returns, is central to our analysis. For example, GHG emissions can be relevant and financially material to carbon-intensive companies due to growing regulatory restrictions and associated compliance costs.
Using the Sustainability Accounting Standards Board (SASB) Standards, we divide the private companies within the BMU into one segment with financially material exposure to climate policy and risk (“material”) and another with “non-material” exposure. In valuation terms, only 8% of the BMU had material exposure to climate risk, as well as — unsurprisingly — a Scope 1 carbon intensity 20 times higher than that of the non-material segment, as of Q3 2022. While climate-transition risks can be estimated for all private companies, we only focus on the “material” subset.
Estimating climate-transition risks by asset class and region
The downstream approach uses Scope 1 carbon-intensity estimates (in tCO2e/USD million revenue) from private companies to examine how an increase in a carbon price (in USD/tCO2e) could impact their profitability, measured by changes in EBITDA margins (EBITDA/revenue). Essentially, this approach estimates the carbon-emissions cost per USD 1 million of revenue.
The exhibits below illustrate the output from our model estimating changes in EBITDA margins from a USD 75/tCO2e carbon-price floor, in terms of the fund’s asset class and the locations of the portfolio companies.[2] At this price floor, and after accounting for any existing carbon prices, distressed-debt and real-asset funds appear to be facing the highest levels of climate-transition risks, according to our model, while venture-capital funds are on the opposite end of the scale. Results suggest that private companies in funds that focus on distressed debt and real assets may see average declines in their EBITDA margins of 5.6 and 3.7 percentage points, respectively.
The elevated climate-transition risks in these two asset classes may be fueled by the high carbon intensities of the underlying portfolio companies, which also may currently be subject to low carbon prices.
Climate-transition shocks were more likely for distressed debt and real assets
At the regional level, Latin America and Africa host some of the most-carbon-intensive private assets in terms of Scope 1 emissions. In Africa, carbon-price coverage was among the lowest globally, while carbon prices in Latin America were relatively low compared to the region’s elevated carbon-intensity averages, as of Q3 2022.[3]
Across private companies with emissions that are financially material to investors, Europe’s Scope 1 carbon intensity is comparable to that of North America, the Middle East and the global average, according to our model. However, because of Europe’s relatively elevated carbon prices and carbon-price coverage, the adverse impacts of climate-transition risks and EBITDA margin losses may be limited to only 0.3 percentage points in our scenarios.
Climate-transition risks were highest in Latin America and Africa
Pulling back the curtain on carbon pricing
Globally, carbon pricing schemes are on the rise and may result in a noticeably higher cost for carbon-intensive companies. The introduction of (or increase in) a carbon price could result in eroding earnings and squeezed margins, as well as financial pains that can eventually lead to valuation write-downs and lower returns for investors. Using climate-transition risk models — both upstream and downstream — investors can work to put a climate price tag on private assets and compare exposures across asset classes and regions.