Although corporate liability for carbon emissions has been overshadowed by louder calls for governance reform, it has risen inexorably on the shareholder's agenda (Exhibit 1).¹ Large institutional investors, such as Calpers and the pension funds of New York State and New York City, are pushing companies to report their carbon "footprint"—the total amount of carbon dioxide that they and their suppliers emit—and to define their risk exposure to regulations that limit emissions. The Carbon Disclosure Project,² a group representing institutional investors managing $10 trillion in assets, has sent questionnaires to 500 of the world's largest companies (including airlines, automobile manufacturers, insurers, power generators, retailers, steelmakers, and technology companies) asking them to explain their emissions policies and strategies. The project then publicizes the response (or lack of one) for investors to note.

This intensifying level of scrutiny isn't simply a call for environmental stewardship, although that might play a role. Rather, it is born of concern that over the next 5 to 15 years the way a company manages its carbon exposure could create or destroy shareholder value. The companies with the most to lose, at least initially, are those whose production processes generate a lot of greenhouse gases, particularly carbon dioxide. Businesses (such as airlines, auto manufacturers, and logistics companies) that make or rely on products that generate carbon dioxide must also be wary (see sidebar, "Managing product emissions"). Even companies that fall into neither category must pay close attention. Rising input costs—for energy or transportation, say—will affect companies of every stripe, from retailers that consume energy in their stores to consumer product companies that design packaging, and investors will increasingly hold them responsible for managing emissions. Managers who fail to respond to calls for more transparency and better planning will face greater public censure or even charges of breach of duty, say shareholder activists. They might also find the share price of their companies discounted in capital markets.

The new pressure may come as a jolt to executives, many of whom are unsure how to respond in a climate of regulatory uncertainty. The United Nations' Kyoto Protocol, which requires industrialized countries to reduce greenhouse gas emissions to about 95 percent of their 1990 levels by 2012, went into force with Russia's ratification in late 2004. But several key players—particularly the United States and Australia—haven't signed on (Exhibit 2). In the absence of universal ratification, individual governments at the supranational, national, regional, and state levels are coming up with their own regulations on carbon emissions: the European Union's Emission Trading Scheme comes into force in January 2005, for example, and state and regional governments in Australia, Canada, Japan, the United States, and elsewhere are also setting new rules. The particulars differ, but the bottom line is the same: emitting carbon and other substances will become more expensive, and shareholders want to know how executives plan to manage these costs.

Although all companies will experience the consequences of increased regulation, the big emitters will be the first to feel the pressure. Companies in the cement, oil-refining, power, pulp and paper, and steel industries will likely soon be subject to cap-and-trade schemes³ in Europe, North America, and Japan—and, eventually, in the developing world—as countries and regions try to meet the goals of the Kyoto agreement. When programs come into force, executives in these industries will have to weigh the trade-offs of maintaining their current emissions, buying allowances and credits, or reducing their carbon output and selling their allotted credits. Understanding the cost of emissions in these industries will in turn help executives from others to identify areas in their own supply chains where costs are likely to rise. Companies in all industries, whether or not they emit carbon in their production processes or produce goods that emit carbon, should set up new tracking and reporting processes to keep shareholders informed. Many companies will also need to work with regulators to shape the rules and make them as clear as possible.

The economic impact

For big emitters, the direct costs of emission credits are relatively easy to understand: in a cap-and-trade scheme, companies that exceed their allotted level must purchase additional credits or allowances at open-market prices from their competitors.⁴ Companies thus have an incentive to cut their emissions, and the incentive grows if they reduce emissions below the cap, because they can then sell surplus credits to companies that are over the limit. Decreasing the need for credits—through smart investments in cleaner technology, for example—will thus become an important strategic consideration, as will using import barriers or other means to fend off competition from companies (often in less regulated countries) that have lower emission costs.

We studied the likely impact of regulation and emission costs on the economics of several carbon-intensive industries in Europe⁵ and found surprising differences among them—differences that are also likely to characterize other regions. Carbon regulation, for example, will raise costs for all European steel producers, but those that face greater competition from cheaper imports, such as makers of flat-steel products (used for car bodies), could suffer more than makers of long products (used in construction), which are less exposed to foreign substitutes. Cement manufacturers might actually benefit from carbon regulation: their emission costs will mostly be covered by allocated allowances, and since the threat of imports in cement is fairly low they will be able to pass on to customers any costs they do incur. Some cement producers could do even better by investing in a more carbon-efficient process that uses slag, a by-product of steel production. In fact, the value of slag is likely to rise owing to this demand, thereby helping to offset the cost of carbon regulation in the steel industry.

Oil refiners face a mixed prognosis. Reduced demand for common residual fuel oil (which is used to generate power in some parts of the world and emits more carbon dioxide than do other fuels, and far more than natural gas) should help keep down the price of heavy crude oil. That could benefit the more complex refiners, which can convert it into motor fuels. However, a drop in demand for petroleum would hurt the entire industry.

These dynamics show why companies in industries whose production processes emit a lot of carbon should compare their competitors' exposure to carbon caps with their own. As they do so, many will revisit their strategies. Some oil companies, for instance, are going to find that certain investments—such as updated refinery technology to convert cheaper, heavier crude oil into motor fuels—will begin to look attractive. Other types of companies will look hard at whether they can go on conducting business as usual: for example, steel mills using basic oxygen furnaces that emit high levels of carbon dioxide to produce flat and rolled products could be better off shutting down production and selling carbon credits.

For companies in all industries, the efforts of big emitters to comply with and thrive under cap-and-trade schemes will have a number of implications. One is that the price of energy, insurance,⁶ and carbon-intensive commodities such as steel, processed minerals, and paper is likely to rise as regulators impose caps on greenhouse gas emissions (Exhibit 3). Another is that executives could find that carbon regulation inspires new growth opportunities, which might arise in low-emission versions of familiar products (advanced diesel engines or natural-gas power generation, say). The opportunities could also involve emerging substitute technologies, such as carbon sequestration (removing emissions from the production process and then storing them underground or injecting them into oil and gas wells to improve yields) and advanced technologies that convert coal into cleaner-burning liquid or gas fuels. Some companies might consider changing their portfolios to sell products with a lower carbon footprint, though such analyses are complex. More greenhouse gases are emitted during the manufacturing processes of cars made of aluminum rather than steel, for example, but these cars, being lighter, burn less fuel and so generate less carbon dioxide over their lifetimes.

Move to reduce emissions

Given the high probability that heavy carbon emitters, depending on where they operate, will sooner or later become subject to cap-and-trade regulations, and the intense interest of shareholder groups in the meantime, these companies should immediately try to cut emissions by taking "no-regrets" moves. Some are straightforward: fixing leaks, reducing waste, and keeping up with preventive maintenance. But before executives decide on any complex and long-term move, they will have to compare the cost of two alternatives—reducing emissions or buying more credits—by factoring the cost of carbon emissions, as a financial variable, into their capital-investment planning. Heavy emitters, like all other companies, will also need a sourcing strategy to manage the impact of carbon regulation on the cost of key inputs, such as electricity.

In addition, executives will have to understand where the emission boundaries fall within the value chains of their companies and how they can make choices that minimize their exposure to carbon-induced risk. An aluminum producer, for example, can reduce its own emissions by switching to processes that emit lower levels of greenhouse gases or use less electricity. It can also influence emissions further up the value chain by purchasing either electricity from a "green" power generator or the emission credits it needs from the market (thereby creating a demand for other companies to generate those credits) and by providing incentives to suppliers or even funding their investments in cleaner processes. The company might take these steps not out of altruism but because it could then label its aluminum "carbon reduced" or "carbon free." Eventually, consumers might demand carbon-reduced cars because banks and auto insurers, spurred by a desire to reduce the damage that climate change wreaks on their own portfolios, offered better terms for such vehicles.

Less heavy emitters will also want to evaluate the amount of carbon they emit and consume. In 2002 Colgate-Palmolive, for example, began estimating the emissions (mostly generated by purchased electricity) from its manufacturing and research facilities and asked a third party to verify the findings. It also redesigned its packaging to reduce the amount of fuel needed to transport finished products.

As a company works toward a sustainable approach to the carbon issue, it develops an internal culture and skills that help it meet regulations when they are implemented, thus potentially gaining a competitive advantage. In 2004 Shell Canada and its partners, for instance, won approval for expanding operations in the oil sands of Athabasca, in Alberta. The reason, in part, was that the company had already improved on environmental targets set by regulators and was more experienced than its competitors at communicating a project's environmental impact to community leaders and at involving them in its decisions.

Track and report financial risks

Most companies, regardless of their carbon footprint, will have difficulty responding to shareholders' calls for more transparency and accountability on carbon emissions, especially because reporting standards for carbon monitoring are not well defined. Almost every company above a certain size, in nearly every industry, must learn how to account for the quantity of carbon dioxide emitted from or consumed by its business.

Financial analysts, who have been calling for more transparency, are helping to develop global reporting standards to aid in the rating of companies. In Europe's utility sector, for example, several new variables make it possible to measure carbon emissions against production or revenue,⁷ although these variables are still new and their relationship to the more common financial metrics is untested. Other efforts to quantify the risk induced by carbon emissions include the investment guidelines that the finance initiative of the United Nations Environment Programme will publish in the summer of 2005 and the Goldman Sachs Energy Environmental and Social Index for leading oil companies. The index includes five measures of climate change⁸ and ranks companies accordingly, but it offers only a general link to corporate valuations. Ceres, a coalition of US companies, investor groups, and environmental organizations, uses a similar method to analyze oil refiners. These approaches highlight differences among companies, thereby helping to identify leaders and laggards, but have yet to quantify the connection between movement in the indexes and the long-term performance of a company's shares. Companies in heavy-emitting industries will probably be the first affected by standards for measuring carbon accountability. But executives from all industries should be involved in the development of these standards in order to ensure that they are efficient and that the accounting is logical.

Help shape regulations

Uncertainty about future regulations is the biggest risk in the carbon equation: executives need long-term assurances on credits and emission levels to factor them into plans for expensive capital investments. Both the Kyoto Protocol and the EU's Emission Trading Scheme set preliminary goals, but it is unclear what will happen thereafter.

Working to delay or derail regulations sends the wrong message to concerned shareholders and could leave management unprepared for inevitable changes in the regulatory environment and in the resulting industry economics. By helping to shape the regulations, executives can reduce the level of uncertainty and make the rules as clear and fair to their industries as possible. In Germany, for example, some chief executives in the power industry saw the Emission Trading Scheme as a threat to the financial health of their companies, which relied on coal and lignite to generate electricity. But by working with regulators, these executives won a four-year window of opportunity for transferring the allowances of the old plants to cleaner new ones, thus subsidizing their construction. Policy makers like the arrangement because the new coal plants emit less carbon dioxide than their predecessors, at a cost three to four times lower than that of heavily subsidized wind-power plants. Environmentalists like the almost 30 percent reduction in carbon dioxide emissions.

As heavy-emitting industries gird themselves to comply with cap-and-trade schemes, and as investor groups begin to pressure all big businesses to disclose their emission policies and strategies, companies in every industry must act preemptively rather than stonewalling or merely reacting to regulations. In this way, executives can show that they understand the risks from their companies' carbon footprint and are working to reduce the exposure.