Category Archives: greenhouse gas

A 1960s Economic Model for Sustainability Value

Innovation can create “extra-normal profits” – profits higher than the normal expected ROI based on the risk. But these extra-normal profits are short-lived and disappear once the innovation has been adopted by competitors, thereby equalizing the playing field. You may know these by the term “first mover advantage” – something intangible. But there is a 50 year old economic model for this, known by a far more difficult-to-pronounce name – Schumpeterian profits,  after German economist Joseph Schumpeter.

In April 2004, Yale Economics Professor William D. Nordhaus penned what has become a widely referenced Working Paper for the National Bureau of Economic Research (NBER). Then in 2015, Xie Fan School of Economics & Management at South China Normal University followed up with a study more specific to sustainability matters (more on that paper later).

To summarize Nordhaus, innovation generally leads to reduction in the cost of production without a concurrent reduction in the price charged for the product, meaning increased profit for the innovator until such time as others “appropriate” the innovation and create more or less equal competition. An example of this is patents – once a patent expires, other companies can sell essentially the same product, driving prices down, along with the “extra-normal” profits of the original patent holder. Very simply, the longer a company can hold on to its innovation on an exclusive basis, the longer it can maintain those higher profits. Nordhaus presents a formula for calculating specific values. Looking at historical data from 1948 – 2001, he estimated the Schumpeterian profits (i.e., the extra-normal profits only) to range from -1.3% (during the major recession of the 1970s) to a high of 6.3% of total corporate profits.

We reached out to Nordhaus to see if his paper has been updated and the applicability to sustainability. He answered that no update has been issued. His response about sustainability reflected a limited (and perhaps erroneous) concept of sustainability as relating primarily to environmental protection. This is important in one respect that we won’t delve into here (it relates to the social value of innovation), but in our view is less of a factor than the direct production cost reductions achieved from business-focused sustainability initiatives.

Xie Fan explored whether innovations related to CO2 emissions regulations in China had an economic development benefit as well as an environmental one. Fan’s summary states that

… first of all, the environmental regulation affects the total factor productivity growth in China’s pollution-intensive industries; in the second place, the environmental regulation does not promote producer’s scientific and technological innovation level in China’s pollution-intensive industries; in the third place, the environmental regulation has reduced Schumpeter profits in China’s pollution-intensive industries.

In the end, we see that both Fan and Nordhaus offer complementary  models for sustainability value. In our view, Fan’s point is that once an environmental issue becomes regulated, compliance innovation may not provide Schumpeterian profits, although this seems to contradict the famous Porter Hypothesis. Yet applying Nordhaus to discretionary sustainability business innovation, short term extra-normal profits are to be expected and can be estimated with his formula.  But doing so may also involve reducing transparency in order to maintain exclusivity of sustainability innovations.

All food for thought.

 

 

 

 

 

Environmental Risk and Sustainability in World Economic Forum’s Global Risk Report 2014

The World Economic Forum (WEF) has published its Ninth Global Risks Report.  We look forward to this report every year.  This year, a number of items caught our attention related to environmental management, sustainability, human rights and risk assessment methodologies.

  • Environmental management.  Man-made environmental catastrophes did not make the Top 10 risks, but it was noted.  In the Global Risk Landscape (Figure 1.1), man-made environmental catastrophes was rated slightly lower than average impact with slightly than higher likelihood.  At the same time, it was included in the Interconnections Map (Figure 1.4).  The map not only shows the perceived connectivity of the risks, but also weighted the strength of the identified linkages.  We find it interesting that man-made environmental catastrophes have:
    • Medium strength connectivity to climate change;
    • Medium strength connectivity to water crises; and
    • Weak connectivity to biodiversity loss and ecosystem collapse.
  • Sustainability.  WEF is working on a sustainability-adjusted Global Competitiveness Index (CGI) that “captures the extent to which prosperity is being generated in a sustainable way, taking into account environmental stewardship and social sustainability.” (Box 1.6). 
  • Human rights.  The Report does not list human rights or labor conditions at all.  There are weak implications in the report’s discussions of income inequalities, urban poor living conditions and social instability.
  • Risk assessment and management.  Risk management practitioners, including those in the EHS/sustainability realm, may find the discussions on risk assessment methodologies (Parts 2.5 and 3) particularly insightful.  Among the more important points is the potential for cognitive bias in the risk assessment process.  Box 2.5 presents a number of risk management solutions, with which EHS and sustainability professionals should already be familiar.

World Economic Forum Releases Global Risks 2012

As it has done each January for the past 7 years in conjunction with its annual meeting in Davos-Klosters, Switzerland, the World Economic Forum (WEF) has released its annual review of Global Risks.

We have enjoyed the previous years’ report and find them incredibly interesting, primarily due to the insights provided about linkages and correlations of risk areas.  This year’s report – as did the 2011 report – contains a “microsite” that allows a meaningful interactive user experience in exploring the risk topics/geographies and related linkages.  Click on the Data Explorer tab to the right of the Report Viewer window – the controls are highly intuitive.

The Report goes well beyond HSE and sustainability matters to be sure, but well worth mentioning here and the time spent reviewing the report.

EHS Journal Article on Sustainability, Financial Valuation

Recently, Elm posted a piece discussing comments from Kevin Parker, the CEO of Deutsche Asset Management, an investment firm with three-fourths of US$1 trillion under management.

We expanded that original post for EHS Journal, who just published it.  The expanded version dives deeper into trends in the past decade supporting Parker’s assessment of why capital markets are bullish on carbon-intensive investment opportunities even in light of this era of sustainability.

View the article in its entirety here.

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WalMart’s Hot Air

Yesterday, the world’s largest retailer and its cadre of sustainability advisors released the 61-page Walmart Supplier GHG Innovation Program: Guidance Document.

Elm has read through this document and provides a brief overview of what we think are several important points.  What follows is a combination of excerpts from the document combined with Elm comments.  Not all of these points are implementation “how-to’s”.  Some of our comments reflect potential problems that should be evaluated by suppliers who are impacted by Walmart’s supplier sustainability initiatives.

The program will initially focus on the following product categories:

Animal feed, apparel, candy, cheese, frozen food, fruit, grains, household detergents, meat, media, milk, motor oil, pharmaceuticals, produce, sanitary paper products, snacks, soap & shampoo, soft drinks & beverages, televisions, and vegetables.

GIVING CREDIT WHERE CREDIT IS DUE (TO WALMART)

In past articles, Elm discussed our view there is a true business risk – rather than competitive advantage – to first-mover adoption of GHG reduction programs.  We had anticipated that such risk would be rooted in regulatory requirements.  While that may still be a concern in the longer term, it appears now that the more significant risk relates to Walmart suppliers.  The retailer has specified that no credit will be given to reductions that are not directly related to Walmart’s GHG program, such as reductions required by law or reduction programs that began prior to 2010.

Further, to get a sense of how little the supplier appears to be in the overall process, take a look at the graphic on page 9.  Of the 6 steps in the Opportunities Identification, Prioritization, and Engagement Process, only one (Step 5 – Engage & Implement) includes the suppliers as an “actor” in the process.

Generally, for a project to count towards Walmart’s reduction goal, it can either be a carbon reduction for a product that Walmart sells or a reduction at a facility/process that supplies Walmart.

The reduction achieved must also be “additional” and beyond business as usual (BAU) in terms of emissions accounting. Specifically, the activity must:

1. Demonstrate that the initiative is truly additional, meaning that the action would not have otherwise happened without Walmart’s influence, and

2. That the initiative represents performance beyond BAU, indicating that the improvement is well beyond existing business trends and has the overall impact of emissions reductions within a product category.

Walmart is accounting for carbon reductions that occur by comparing a new product, or change to a facility, to a baseline. The baseline is determined by an assessment of the “business as usual” (BAU) case. BAU is defining what would have been the carbon emissions of a product or a facility if Walmart had not encouraged, introduced, or catalyzed the implementation of an innovation. It is important to note that the carbon reduction claims, rules for quantifying reductions, and monetization within this document are written under current regulatory standards in the U.S. If Federal or other laws change that effects the guidance prescribed in this document, they will be re-assessed at that time. This includes, but is not limited to: public reporting on carbon emissions regulated by the SEC, regulations set by FTC for marketing claims, carbon tax or cap and trade legislation or regulation by EPA, or carbon reporting by EPA.

MORE COOKS IN THE KITCHEN

As if manufacturing sites don’t already have enough folks wandering the production floor and telling them how to make product….

Generally speaking, Walmart can reduce product life cycle emissions by either influencing the development or design of the products them selves and/or by improving the facilities and processes used to make and transport products.

UNDER THE INFLUENCE

The document speaks in terms of Walmart’s “influence” on suppliers in order for GHG reductions to qualify.  The use of such a loose term may create potential conflicts in the future.

For a project to qualify, it must have happened because of Walmart’s influence, showing additionality. This does not exclude projects that were also influenced by other entities, programs, incentives, etc.

The Walmart Project Champion must be able to prove that the project would not have happened at the time it did without Walmart’s involvement. In this project, Walmart’s influence on the project is deemed as “additionality.” Additionality for products means that for a lower-carbon product:

  • Walmart directly influenced the development or redesign of the products, or
  • Walmart influenced the increased sales of the product.

Influencing the product directly means that Walmart engaged with a supplier to design or influence the design of a new product that is more carbon efficient. For instance, if Walmart encouraged a supplier to re-design laundry detergent to have a lighter-weight package than is currently offered, this would be influencing the redesign. If Walmart sought out a new detergent that was concentrated or eliminated specific raw materials that are more carbon intensive to extract, then this would also be an influence of the redesign.

And to further the point above about Walmart’s attempt to become involved at the production floor level:

For facilities and processes, additionality means that:

  • Walmart directly contributed to the improvement of a facility or process, or
  • Walmart influenced energy management.

GET A LIFE (CYCLE)

Product-based reductions require that a complete lifecycle analysis (LCA) be executed by either the supplier or as part of an industry effort. To claim a reduction, the LCA must be compared against a defined baseline of a reference product.   And of course that reference is selected by WalMart.

Reductions may be identified in any phase of a product’s life cycle. A product’s life cycle includes the following primary stages:

  • Raw material extraction
  • Manufacturing
  • Packaging
  • Distribution
  • Usage
  • Disposal

The WalMart Champion must identify a reference product against which to benchmark this product. The reference product may be another product that serves a similar function. As a reference product may vary significantly from the product in question in terms of technology, materials, or size, it is important to compare them on this basic level of function, also known as a “functional unit”. This is particularly crucial for products whose impacts greatly depend on how they are used at the consumer level.

For each product, the Champion must define and describe the methodology used to calculate the baseline and forecasted reduction potentials. The Champion may use a methodology that is best suited for the calculation, but documentation and an explanation is required. Suggested life cycle and corporate accounting methodologies include ISO 14040 and ISO 14064 standards, WRI/WBCSD ’s GH G Protocol Corporate and Product Life Cycle Reporting and Accounting Standards (currently in draft form), and British Standards Institution’s PAS2050 (see Part 5 for additional information).

ClearCarbon will quantify the difference between a “BAU” case and the impact of the project from a product improvement perspective solely. The difference between the two, or the delta, will be calculated at the initial submittal based on projected trends for five years or until December 31, 2015, whichever comes first.

BAU in this context would appear to include any existing GHG programs – or those that become regulatory requirements between 2010 and 2015 – and therefore become incorporated into the baseline, so no credit is given for those reductions.

SHOW ME DA MONEY

Walmart will not resell, retire, or trade carbon reduction claim s under this Program.  Additionally, the carbon reduction claims may not be “exclusive” to Walmart. It may be the case that Walmart will help a supplier, through this Program , to achieve a carbon reduction project that the supplier also wants to report publicly. In this case, both parties (Walmart and the supplier) may state a claim of reduction. Since the reduction is not being sold or traded there is no legal claim over the reduction that would make it exclusive to Walmart or to the supplier. The supplier may monetize (sell, trade, etc) carbon reductions at their discretion, though Walmart will not be involved in these transactions.

But per comments from CEO  from Mike Duke, the supplier should expect Walmart to demand that the economic benefit from monetization be reflected in the product pricing to Walmart.

GHG reductions that come from facility or process based projects require different financial value accounting than product GHG reductions. Quantifiable financial value to customers may include savings to the customer on energy or resource consumption during use of the product, resulting in lower energy bills and lower carbon emissions.

Financial value to the Walmart supplier might include the following:

  • Fuel or electricity savings at a factory or facility level translated into cost savings through industry averages (e.g., average price of kWh x total kWh saved), or
  • Material savings from reduced input purchases or a switch to cheaper materials/inputs.

In some instances either product or project based initiatives will result in a savings to the customer or a benefit to Walmart that are not financially measureable. In these cases, a qualitative description of the positive impact should be included in the worksheets. Benefits to suppliers and businesses may include:

  • Improved business conditions,
  • Public relations opportunities, or
  • Increased positive stakeholder engagement.

The document contains no recognition of or reference to the economic value of EHS risk reductions for WalMart or the supplier.  But beware about claims of financial benefits – as indicated above WalMart intends for those savings to be passed on to WalMart by the suppliers.  Suppliers may find benefits in claiming “savings to the customer or a benefit to Walmart that are not financially measureable.”

THE BIG HOLE

The guidance is written in a manner suggesting that all suppliers manufacture their products at their own facilities.  A massive gap seems to exist relative to contract manufacturing.  Fascinating, given the astounding number of products sold by Walmart that are manufactured in China on behalf of a Walmart supplier.  Perhaps the company has lost sight of the fact that overwhelming cost pressures they impose on their suppliers has driven much of the actual manufacturing off-shore to third party contractors over which the Walmart supplier has no direct operational control.  And what about the overall supply chain GHG impact of the consumer having to more than 1 of a particular item after the initial item breaks/fails prematurely due to poor quality (like my daughter’s new $1 calculator that broke after less than 24 hours after purchasing it at WalMart)? I wonder if the retailer will take responsibility for something like that.

Well, There You Have It…

NYT reports that Washington has abandoned hope of issuing carbon legislation this year, including cap-and-trade.   The inaction is also dragging down regional/state programs as well, including the well-hyped RGGI trading program.  This shouldn’t come as a real surprise to anyone.

But it does continue to increase the business uncertainty surrounding emissions in the US.  Tune in again next year.  Or the year after….

Incubating Environmental “Black Swans” In the Nest

Our last entry discussed the concept of “Black Swan” events, a term created by noted author Nassim Nicholas Taleb to describe an event that is (a) so low in probablility that it is unforeseeable and (b) so catastrophic in impact that it changes history.

Certainly, risk assessments are predictive in nature and no one can predict the future with complete certainty.  But in our view, one of the best tools available for risk assessments is an open mind.    This can be a challenge in the EHSS world as we generally have engineering and other technical backgrounds.  We have been trained to seek absolutes and eliminate uncertainties.  At Elm, we believe that involving external support helps to identify and explore events (and their related exposures) that are relevant but get “technically rationalized” by internal staff.

With the BP oil spill and the December 2008 Kingston, Tennessee coal ash pond failure, we began thinking about some of the Black Swan events discussed with clients in the past.  Below are a handful of EHSS Black Swan risk events that we have discussed with clients over the past years – and some that are currently on our mind.

  • Radical change in EPA’s regulation of coal ash management (discussed several years before the Kingston event, and vehemently opposed by the client)
  • Catastrophic failure of GHG emissions trading market
  • Dramatic failures/errors in GHG footprint calculation methodology
  • Nationalization of privately-owned CO2 emissions assets
  • Regulation and class-action level public concerns over chemical content of consumer goods
  • Waste disposal liability for and public pressures about exporting electronic wastes
  • Dramatic increase in OSHA/EPA enforcement – frequency, severity and targeted industries/sites
  • Major expansion of pollution exclusions/limitations in insurance policies
  • Increased success of US-based NGOs in successfully obtaining US venue for lawsuits concerning EHSS allegations for non-US sites/projects/activities
  • Unprecedented shareholder and SEC pressure on public companies related to EHSS matters
  • Increased importance of EHSS in supply chains and procurement decisions

Perhaps these seem far-fetched to you or your company.  But if that is the case, the egg of that – or another – Black Swan is quietly incubating somewhere in your organization.

Another Major EU Carbon Trading Fraud Under Investigation

Bloomberg.com reported that earlier this week, European authorities launched a major investigation of several large companies that are thought to have played a role in a system of fraud and tax evasion that may have impacted 7% of the total CO2 emissions trading market for 2009 in the EU.

Prosecutors and tax investigators yesterday searched Deutsche Bank, HVB Group and RWE AG in a raid on 230 offices and homes to investigate 180 million euros ($238 million) of tax evasion. The probe targeted 150 suspects at 50 companies…

Yesterday’s raids were the biggest related to a fraud that may have tainted an estimated 7 percent of European Union carbon trades in 2009…

About 400 million metric tons of emission trades may have been fraudulent last year, or about 7 percent of the total market, including futures transactions, according to estimates from Bloomberg New Energy Finance.

Europe lost about 5 billion euros in revenue for the 18 months ending in 2009 because of value-added tax fraud in the CO2 market, according to Europol, a European law-enforcement agency.

CNBC Airs Feature on “Carbon Hunters”

Last night (April 20, 2010), CNBC aired an hour-long TV segment on the burgeoning industry labeled “carbon hunting”, the practice of finding, aggregating, marketing and selling carbon credits.

While the story illustrated successful projects, it also highlighted a myriad of risks in the carbon trading industry.

Check your local TV listings for the next airing.

Are Your Internal Accounting Processes Ready for the SEC’s Climate Risk Interpretive Guidance?

Sure, there are some business risks that are readily identifiable to conform to the SEC’s Climate Risk Assessment Interpretive Guidance.  Things like:

  • Property damage from storms and sea level changes
  • Increased costs related to new pollution controls and fuels
  • Changes in customer procurement requirements.

But read about the supply chain constraint that the UK energy company E.ON brought forward in a Reuters report:

Lack of investment in the vessels used to build offshore wind farms could hinder Britain’s ambitions to shift to renewable energy, the head of E.ON UK’s Robin Rigg wind project told Reuters at the operations center in Workington, northwest England.

Britain aims to install 32 gigawatts (GW) of offshore wind by 2020, enough to meet a quarter of the country’s electricity needs, and although there has been investment in turbines factories and ports, a lack of vessels could curtail targets.

“The targets are very ambitious and the supply chain isn’t there for it to materialize. It definitely has to grow,” Ian Johnson, Robin Rigg offshore wind farm project manager said. “Aside from turbines, vessels to install equipment are expensive,” said Johnson adding that a lack of predictability over upcoming wind farm projects in the past had caused a squeeze on construction vessels as builders rush to use the small stock already built.

Vessel builders in the past have asked: “When’s the next project going to come along? Where’s the continuity for me in the supply chain?”

Reliance on third parties – over which you have little control – to implement business plans could be an overlooked risk in the context of the Interpretive Guidance.  Further, entering into long-term contracts or guarantees with third parties to ensure infrastructure for deployment create additional financial risks.