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Climate Change And Equity Capital Allocation

Last week I shared some notions on climate change and debt capital allocation. This week I would like to focus on the rapport between climate change and equity capital allocation.

Every year Blackrock BLK ’s CEO, Larry Fink, shares his company’s Engagement Priorities in respect of their target investment universe. In March of this year, the priorities were identified as governance, corporate strategy and capital allocation, compensation that promotes long-termism, human capital management and environmental risks and opportunities.  Regarding the last, the priorities are rich in principles, but lack capital allocation detail on how corporations could be rewarded or incentivized.

This week BP’s CEO Bernard Looney unveiled a plan to boost BP’s renewable power generation to 50 gigawatts (GW) while shrinking oil and gas output by 40% compared with 2019 by 2030. Earlier in February, BP’s CEO admitted that the world’s carbon budget is finite and running out fast, which was a first for a fossil fuel executive. The carbon budget has currently been set at 1,060 Gigaton CO2. Looney added that there was a need for a rapid transition to net zero and to achieve this ambition trillions of dollars would need to be invested in rewiring the world’s energy system. 

So how would BP’s disclosures impact Blackrock’s Engagement Priorities and what would an environmental risk apprehensive equity capital methodology look like?

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Current Process


Currently, broker-dealers allocate equity capital to institutional and retail investors in a carbon footprint agnostic manner.  BP and Unilever can raise equity capital, via secondary offerings, everything else being equal, in the exact same fashion and at similar conditions. Their carbon footprint and its impact on the referenced finite carbon budget are fully ignored. The same applies for Initial Public Offerings.

Allocation And Cost Of Equity


The process of equity capital allocation is primarily driven by valuation multiples and the Capital Asset Pricing Methodology (CAPM). This model was developed by William Sharpe from Stanford University in the 1960s. Sharpe received the Nobel Prize for his contribution in 1990. CAPM allows for approximating a cost of equity capital for any firm, using a (risk-free) interest rate, a correlation factor between firm specific risk and market risk (called Beta), as well as market premium as inputs. This cost of capital is subsequently used to discount the future stream of cash-flows and, cumulatively, these flows yield a firm value. A share price can be derived when that firm value, adjusted for debt, is subsequently divided by the number of outstanding shares. As one may observe, there is no notion of carbon footprint. 

Carbon and Planetary Boundary Footprint Margin


One could expand the CAPM formula and add a Carbon and Planetary Boundary Footprint margin of a certain magnitude, say 4%. The size could be made dependent upon the level of the remaining carbon reserve (see above), the evolution of CO2 ppm, the state of the nine planetary boundaries, or a combination of the listed variables. 

This Carbon and Planetary Boundary Footprint margin could substantially increase the cost of capital for recalcitrant corporations, failing to engage in carbon footprint transition strategies or more nimble, circular economy oriented, initiatives. The added margin may also mortgage share price evolution and may impact share price performance related to remuneration packages for corporate senior executives. But the overarching objective would be to re-allocate capital to firms implementing carbon-low or neutral strategies in order to preserve the constrained carbon budget. 

Emerging ESG Disclosures


With the advent of Task Force on Climate Related Disclosures (TCFD), firms have to represent their degree of preparedness towards carbon lower intensity, including compliance with Environmental, Social and Governance (ESG) objectives. This emerging disclosure framework is complemented by several concurrent pursuits. Harvard Business School, under the stewardship of Sir Ronald Cohen, George Serafeim and Robert Zochowski III, released a new valuation approach, called Impact Weighted Accounts. Additionally, Sustainalytics, a Dutch company belonging to Morningstar, has now made ESG research and ratings on 4000+ companies publicly available. In a similar vein CDP, a NGO, rates companies on the back of disclosures, detailing the extent of their carbon footprint. And shortly, a new instrument called Tracking Real Time Atmospheric Carbon Emissions (TRACE), combining satellite data and AI, will be added to the assessment tool box to identify significant human-caused greenhouse gas emissions from the level of a fishing boat 24/7.

Margin Mitigation


The collected data points and ratings could be consolidated into a corporate universe of best in class, broken up into four segments. The bottom quartile performers would be faced with a 4% charge, while a company ranked among the top quartile would benefit from a 3% reduction, leaving a residual 1% footprint charge, unless a third party grants full carbon neutral certification. Referring to the earlier example, Unilever would be singled-out for its carbon footprint efforts and be able to source risk capital, everything else being equal, at a much lower cost of capital than BP. Yet BP could be rewarded with a larger mitigation factor if CEO Bernard Looney would be successful in pivoting BP’s business strategy into a broader portfolio of renewable energy assets.

The permutation potential is legion, but the overriding objective is to target a simple and straightforward capital cost adjustment to account for the use of fossil fuel, the degradation of the planetary boundaries and the erosion of natural capital resources, fully ignored to date. Danone, the French leading food company, is already anticipating capital allocation as a function of carbon footprint. On the occasion of its Q 4 2019 earnings release, Danone introduced a Carbon Adjusted EPS methodology, which incorporates the cost of carbon offsets, in its EPS calculation.  

Conclusion


The broker dealer’s fiduciary duty is to represent that the retail and institutional investor client base is being offered fair value for their investments. There is a timely opportunity for organizations like Blackrock and ShareAction to reassess the relevance and pertinence of the current broker-dealers’ equity capital cost methodology, dating from the 1960s and making full abstraction of externalities. 

What would it take for CEO Larry Fink to take a visionary lead and report about the environmental risk adjusted equity allcoation methods in their March 2021 Engagement Priority report? It might be a small step (all data are there) for Blackrock but a giant leap for mankind.

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