Opinion: The new greenfields thinking

Climate change poses yet another governance challenge for directors. Dr Chris Mitchell explains why vigilance and engagement are crucial for boards.

The new green-fields thinking

In a rapidly changing world, directors are required to reconsider old issues in new ways and are confronted with entirely new challenges. By definition, with new challenges, there is a relatively small pool of experience and expertise from which boards can draw.

The introduction of carbon trading to Australia by way of the Government’s proposed Carbon Pollution Reduction Scheme (CPRS) promises to be one of these new challenges.

In these circumstances, the attractive strategy is to try to draw on experience, look around and develop rules of thumb and effectively assume that what is coming has close parallels with what has happened elsewhere or at another time.

The risk is that such analogues have limited value.

For example, several commentators have argued that the introduction of the CPRS represents the biggest economic reform since the introduction of the Goods and Services Tax (GST). Can these two reforms be compared?

The GST was economy-wide and nearly all businesses were directly affected by its introduction. By contrast, the CPRS has economy-wide implications, yet relatively few companies will be directly liable under the scheme. The GST tax rate was known ahead of time, yet the carbon price remains unknown, although capped at $40 but rising by five per cent each year.

The CPRS has implications well beyond tax. For instance, it creates new financial products under the Corporations Act 2001 and the Australian Securities and Investments Commission Act 2001, so boards of companies, simply through being liable under the CPRS, will also need to consider the commercial and compliance aspects of being required to trade new financial products.

Responding to the CPRS requires green-fields thinking by boards.

Even though the “wisdom of crowds” has been a recent fashion in management circles, the “mindlessness of the mob” can equally apply. Here are a few of the more likely issues directors will need to consider.

The framing risk – seeing the CPRS only as an environmental issue

The CPRS arises as a response to the profound issue of global climate change. However, even though its origins might be environmental, the CPRS is actually a governance challenge: requiring strategic, commercial, financial and compliance attention.

Boards that develop strategies only through the lens of the environment will not position their company well. However, companies that interpret the CPRS solely as a commercial issue also risk being blind-sided by sudden policy changes as governments continue to respond to underlying community concerns.

The knowledge risk – accepting advice without scepticism

Boards will need to satisfy themselves as to the quality of advice they receive from management and consultants. This will be difficult as expertise comes from a relatively small pool of specialists with the attendant risk of group-think.

The current example is an emerging consensus rapidly becoming perceived wisdom: because there is no limit to the number of international compliance permits (CERs) that can be used to discharge obligations under Australia’s scheme, the local permit price and its economic impact will be set by the global price of emissions, driven by the Clean Development Mechanism.

If only it was that simple! The longevity of the Clean Development Mechanism, from which CERs are generated, is far from guaranteed in its current form.

Internationally, there was a strong view that the use of CERs and other “flexible mechanisms” must be supplemental to domestic action. The US, currently sitting on the sidelines, will almost certainly re-emerge as a powerful force within the international negotiations and the market.

These factors could easily turn around, driving significant increases in the international carbon price. Moreover, there is every reason to expect massive volatility in the local carbon price as the market begins to understand the available products, methods to reduce exposure and the dynamics of carbon supply and demand.

The strategic risk – losing sight of the medium term

The CPRS is being introduced during a time when the economy is softening and industrial activity is declining – Australia’s greenhouse gas emissions will not be growing the way they have in recent years. In fact, with a marked slowdown, emissions growth may fall of its own accord over the next few years.

This economic outlook, together with the CPRS design having very modest targets, especially during the first few years of its life, means a soft start. Initially, carbon prices are likely to be low. This brings a risk that boards will see the CPRS as a non-event.

The reality is that around 2015, with the reduction in structural adjustment assistance measures, an economy growing strongly again and a scheme cap beginning to bite, carbon will become scarcer. The price will rise.

Beyond this, science continues to challenge us as evidence emerges that scientists have been in error – most likely underestimating the pace of climate changes.

The relevance risk – ‘not liable’ does not mean unaffected

Facilities that emit more than 25,000 tonnes of greenhouse gas – an estimated 1,000 entities – are to be directly liable under the CPRS. Directors of companies that are not liable may well breathe a sigh of relief.

However, the “upstream” design of the CPRS means any business that requires significant energy (electricity, gas or transport) or construction material will be affected through the supply chain.

For example, at their February meeting, the nation’s energy ministers agreed that there be a proposal put to the Council of Australian Governments “that it amend the 2006 Australian Energy Market Agreement to specify that, where retail prices are regulated, energy cost increases associated with the CPRS shall be passed through to end-use customers”.

Energy and carbon, along with water, are the lifeblood of production and thus the economy. Water scarcity driven by population growth, development, consumption and climate change, will drive further price rises; carbon itself is to be newly priced through the CPRS, and energy (electricity and gas) have to rise in response to multiple interactive drivers: technological change, energy market reform, the effects of climate change, concerns about energy reliability and the need to reduce greenhouse gas emissions.

As one of these drivers, the carbon price may be important. The Government’s Treasury modelling for the emissions reductions closest to government policy forecast the carbon price starting at around $23 a tonne CO2e in 2010, rising rapidly to around $44 a tonne CO2e by 2020.

Vigilance and engagement

There is little doubt that climate change poses yet another governance challenge, although many directors may still have to be convinced.

Climate change and the introduction of the CPRS is not just another issue on the agenda. It is a matter where experience is thin and surprises will be many. Directors need to assess the situation themselves, work from first-principles rather than simply accept received wisdom and be prepared to innovate.

During its introductory phase, the CPRS’s policy makers are rapidly introducing requirements for senior company officers and boards.

In one example, companies lodging documents under the emissions-intensive trade-exposed assistance program component of the CPRS are required to produce CEO and other senior officer sign-off, together with a statutory declaration attesting to the accuracy, completeness, and quality of the return and level of cooperation provided to the quality assurance provider.

Further, the introduction of legislation will not be the end of the story. Important details, material at the company level, will depend on the scheme’s regulations. Vigilance by boards and engagement by directors is essential.

Dr Chris Mitchell GAICD is an executive director of CO2 Group, a former director of Greenfleet Australia and previously the Foundation Director of the Centre for Australian Weather and Climate Research