Transcript
Speaker: This podcast was recorded for publication on the 1st of February, 2023.
Speaker: All the disclosures and disclaimers associated with it must be viewed on the link attached to your media player.
Speaker: Hello everybody, welcome to the ESG Brief and our first edition of 2023.
Speaker: I'm your host Jack Reed from HSBC Global Research.
Speaker: Today we're focusing on the latest efforts by the European Union to speed up the decarbonization of industry, specifically sectors that collectively account for roughly 20% of all EU emissions.
Speaker: James Ridge is our new head of environmental, social, and governance research for the European, Middle East, and African region.
Speaker: And he's here to talk about his report on one of the latest climate acronyms to rise from the lawmakers, CBAM, the high-stakes EU carbon border adjustment mechanism.
Speaker: We'll be looking at the impact of this mechanism on a number of industries, but we'll have a special focus on cement makers in Europe.
Speaker: James, first of all, thank you very much for joining us.
Speaker: Pleasure to be here.
Speaker: So you've just recently joined the ESG team here at HSBC.
Speaker: Tell us a little bit about your background before we get started.
Speaker: Well, for the last 12 years, I've been working at London School of Economics at the Grantham Research Institute with Lordstern and other academics who are also practitioners.
Speaker: It wasn't a totally academic exercise.
Speaker: We worked a lot with governments advising them on how to set out the economics of transition to a low carbon economy.
Speaker: And now I've come to HSBC and we're applying that knowledge of transition and policy to sectors and companies.
Speaker: Okay, and it's no coincidence, perhaps, then, that your first report from HSBC is all about carbon and carbon trade in Europe.
Speaker: Exactly.
Speaker: So, you know, Europe's been a leader in climate policy for many decades now.
Speaker: It's shown the world how you reduce emissions.
Speaker: It's shown the world...
Speaker: And how you do efficient policy to make that happen.
Speaker: And we know that one of the most innovative policies that EU has led on is the European Union emissions trading system, which establishes a price on carbon.
Speaker: And that's been underway for years.
Speaker: That started in 2005 and now it's a very, very developed system.
Speaker: And there's currently a very, very big reform process going on in the European Commission and Parliament.
Speaker: That's going to adjust the legislation underlying Europe's carbon policies, including the European Union emissions trading system, to be in line with the stronger emissions reductions targets that Europe set for itself.
Speaker: Okay, now before we get too deep, let's lay out a quick background to the EU emission allowances.
Speaker: So as we talk about in the report, for many years, trade-exposed emissions-intensive industries and the companies in those industries have received their emissions allowances for free.
Speaker: Instead of having to purchase them in the market, they're currently trading around 80 euros a ton of CO2, they've been given these permits for free.
Speaker: And so what is the EU's concern here?
Speaker: So by giving companies free allowances, research shows that it dents their incentive to invest in decarbonisation.
Speaker: The companies claim otherwise, but research shows that they're not investing in reducing their emissions.
Speaker: And the European Union has now decided that it's going to phase out that policy again.
Speaker: Now, the current subsidy these industries are receiving is around 20 billion euros a year.
Speaker: So that's a pretty big subsidy that's going to be removed and taken away from these companies.
Speaker: And that removal is going to start in 2026, and it's going to be phased in.
Speaker: And so by 2034, none of these industries will receive free permits anymore.
Speaker: And what industries are we talking about in this report?
Speaker: So the industries we're talking about are iron and steel, cement, aluminium, fertilizers, electricity and hydrogen.
Speaker: They're very emissions intensive and they're also trade exposed, so they trade with the rest of the world.
Speaker: And where does this issue of so-called carbon leakage come into the reforms you're looking at here?
Speaker: There's been a common complaint of industry over many years, and that is that the European Union's ambition on climate and emissions reductions is going to hurt industry and especially emissions intensive industries, which trade with the rest of the world.
Speaker: And so the risk that companies talk about is something called carbon leakage.
Speaker: So carbon leakage means that there's a transfer of EU production.
Speaker: So if you're producing a ton of steel in the EU, you might shift that to another country with lower emissions reduction ambitions.
Speaker: So you might reduce one ton of emissions, for example, in the EU, but actually you've shifted your production to another country, which may even have dirty production and ease and increase global emissions by more than one ton.
Speaker: So they call that emissions leakage, or it can be when EU products are replaced by more carbon intensive imports.
Speaker: So let me make sure I understand the thinking here.
Speaker: The EU reforms its system of emission allowances, enter CBAM.
Speaker: Subsidies eventually come to an end.
Speaker: Carbon emission costs become prohibitive.
Speaker: And voila, these sectors suddenly start investing in decarbonization.
Speaker: And that's what will happen because they'll face the full carbon price signal and it will be worth their while to start to invest in emissions reductions technologies, which will reduce their emissions and mean they don't have to buy as many permits, which are going to become increasingly expensive in the future.
Speaker: What is it that investors are interested in in relation to this?
Speaker: Well, investors want to know the impact of the policy on these sectors and specifically on companies within these sectors.
Speaker: They want to understand how it's going to affect the value chains.
Speaker: Uh, and, and that gets quite detailed and quite complex.
Speaker: And in the report, we, we focus on one industry cement and we have a look in detail at how this carbon border adjustment mechanism and the phase out of free allowances is going to impact the cement industry.
Speaker: The manufacturing of cement, it's CO2 intensive, but it's also incredibly local.
Speaker: The manufacturing of the cement usually happens quite close to the point of use.
Speaker: Exactly.
Speaker: And so it's not until you actually look into the details of the sector where you actually start to realize what's going on and how sector-specific and company-specific this is.
Speaker: So if you look at the cement sector in Europe, for example, there's actually little threat of carbon leakage.
Speaker: By that you mean there's little threat that they're going to import the cement from somewhere else.
Speaker: Exactly.
Speaker: And if you look at the share of imports in total consumption in Europe, it's been going up a little, but it's still below 10% of total production.
Speaker: The imports are mostly limited to Italy, Spain, and Greece and countries like this.
Speaker: a risk of any significant increase in imports is actually very low.
Speaker: Also because the port capacity in Europe is controlled by the established European producers.
Speaker: And you can't do very much by road because, you know, transporting cement is over long distances is not viable.
Speaker: So the carbon border adjustment mechanism itself is only likely to have a very small impact on the cement industry.
Speaker: So if that is the case, what is all the fuss about?
Speaker: Why is industry against this policy?
Speaker: You know, our view is that it's the loss of the subsidy.
Speaker: So for the cement industry, they're going to lose a subsidy of about $8 billion a year in withdrawal of the free allowances.
Speaker: So they're getting more than 30% of the annual allocations of permits?
Speaker: They get a very, very significant share of the free allocation to these CBAM covered sectors.
Speaker: And, you know, there's been a lot of discussion about whether they should be receiving these free allocations because research shows they've, you know, it's resulted in substantial windfall profits to these.
Speaker: companies and that's enabled them to maximize their gross margins and instead of using this benefit from the free allowances as we said earlier to decarbonize it's actually had a perverse impact and it's allowed these industries to maintain inefficient installations in Europe and actually increase the export of dirty clinker here to Africa where they actually have cleaner production processes.
Speaker: And when does the pain of this transition from free allowances to investing to decarbonize really start to bite for these companies?
Speaker: Well, that's a very good question.
Speaker: So there's a lot of research that shows companies start to invest to comply with the policy even before the policy comes into force.
Speaker: So I think we might start to see investment ramping up very quickly to decarbonize in these industries.
Speaker: But having said that, the policy in October this year starts a reporting period.
Speaker: So companies simply have to report across various dimensions, but the financial implications and the financial part of the policy doesn't start to apply till 2026.
Speaker: And then it will be phased in as free allowances are phased out.
Speaker: And so free allowances will be completely phased out by 2034.
Speaker: So at that time, the CBAN will be fully operational.
Speaker: But your view is that the cycle of investment that is needed to meet the cost is going to begin sooner rather than later.
Speaker: Yeah and then there's evidence it's already started so there are some companies we identify like CRH and Wholesome who are already investing in clean technologies to reduce the emissions on cement production.
Speaker: And so this policy will simply give them greater incentive to ramp up those investments.
Speaker: In some of the smaller players in the industry
Speaker: may not be able to afford this.
Speaker: And so we think there could be some consolidation in the European cement industry with some of the smaller players either deciding to merge with some of the majors or exit the industry.
Speaker: But what it's going to mean for everyone who remains is quite a substantial structural transformation.
Speaker: And as we say in the report, there are certain companies which are better placed to do that.
Speaker: You have to look at each company separately to see the specific impact.
Speaker: Some have operations in emerging markets.
Speaker: Hopefully, I think the idea the European Commission would like is for companies here to export their low-carbon technologies to developing countries.
Speaker: James, your report title includes the phrase, sifting through the noise.
Speaker: What is the noise?
Speaker: Well, I think there's a lot of noise from industry because this is going to be a structural adjustment and it's going to be painful for some companies, even companies well-placed.
Speaker: And so companies have said that they've come up with all sorts of reasons and some of it just scare tactics without foundation, massive loss of jobs and...
Speaker: production will shut down in Europe.
Speaker: So I think there's many dire predictions for employment and output from various industry bodies, but when you look at the European Commission modeling it shows that there actually won't be an impact on output and these processes are dynamic and
Speaker: And most of the industry analysis is pretty static.
Speaker: But when you look at the modeling, it shows that this policy will reduce emissions.
Speaker: It's much better to control for emissions leakage, and it won't have any impact or very, very insignificant impact on output and employment.
Speaker: Okay, so you've laid out the case for these industries having to cut their emissions.
Speaker: And not to diminish that goal, but beyond meeting it, what's the impact?
Speaker: Well, there's going to be many benefits beyond emissions reductions.
Speaker: It's part of a much bigger picture of structural change over many decades that is going to fundamentally change the way we produce and consume.
Speaker: It's going to lead to quite substantial changes in consumer preferences.
Speaker: And I think that's something that's often ignored.
Speaker: Consumers in time, for example, when they build a house, they're going to want to purchase green steel.
Speaker: They're going to want to use green cement.
Speaker: So the demand is going to shift for green products.
Speaker: And so the location of where those green products are produced is going to be determined by where you can get the abundant clean electricity that will feed into these modern electric production processes to make the goods.
Speaker: James Ridge, thanks so much for your time.
Speaker: Pleasure to be here.
Speaker: So that's our latest edition of the ESG Brief.
Speaker: Remember, we are one of three podcasts produced by the team here at HSBC Global Research.
Speaker: The other two are really super weekly productions.
Speaker: Under the Banyan Tree, which is Asia-focused, and Macro Viewpoint, our global review of the top macroeconomic research.
Speaker: All three of these podcasts are accessible on Apple and Spotify through the HSBC Global Viewpoint channel.
Speaker: Thanks for listening, and we'll be back soon.
