Climate trade-off: cost of carbon versus capital
The cost of capital is rising not only in the West, but also in India, as signaled by the sharp rise in our central bank’s main policy rate on Wednesday. Like the US Fed, our Reserve Bank has been caught behind the inflation curve and had to tighten credit in the name of price stability; local banks must now pay 4.4% on funds taken from its repo window. Lenders should raise their own rates in response. Yet what matters in business is not just the cost of borrowing, but how easily that rate can be beaten by annual returns. By this calculation, large investors aren’t exactly lacking in opportunity. Higher debt, for example, is unlikely to deter Indian cement companies competing for Holcim’s assets in India. Around 65 million tonnes of cement capacity could be up for grabs as the Swiss major reorganizes its portfolio to offload what doesn’t fit with its 2025 climate adaptation plan. Adani, JSW, Dalmia and Aditya groups Birla would be in the fray for Holcim factories run by Gujarat Ambuja and ACC, each producing a product whose demand is expected to swell as the emergence of our economy materializes. While such an acquisition is a perfectly legitimate game for profit expansion, it is also part of a trend that has been flagged as a global concern: climate arbitrage.
Making cement involves calcination, a process not only laden with carbon emissions but also difficult to decarbonize on a large scale. Its value chain also has other dirty processes, and while pollution controls exist, this fundamental difficulty has prompted rethinking for companies exposed to regulatory rebuke and shareholder repudiation. As the imperative to go green gains global investor approval, new standards take effect and corporate targets are set for emissions caps, a global asset reshuffle to carbon-intensive began. So far, much of it has gone into the coal mining, oil and gas sectors. By one estimate, oil majors offloaded nearly $200 billion of fossil fuel assets between 2015 and 2020, with more divestments to come as companies based in Western jurisdictions chart clean paths to the profitability. Other sectors seem headed in the same direction. Buyers of high yield and high yield assets are not hard to find. As long as the products produced are still in daily use, the bargains would likely be available to those with less climate pressure. In theory, a global market for carbon credits could iron out the value vagaries of this transition, but none has yet emerged. Amid a patchwork of varying climate rules and investor sensitivities, what is emerging instead is a chance to exploit those loopholes. What is risky for one investor may be less risky for another. This makes room for big business.
BlackRock chief Larry Fink expressed specific arbitrage concern last year after the US-based investment firm put its portfolio on watch for climate risks. The private sales that took companies away from open markets, he argued, would deepen the planet’s crisis by increasing opacity rather than declining emissions. The basic problem, however, stems from green plans that preempt the reality of use, which disrupts supply and demand for assets and distorts valuations. Game-theory solutions call for collective action, with a cap-and-trade system based on carbon pricing. Politics buffs have called for a global framework to stop a reshuffling of assets that doesn’t leave the planet safer. Even when bargains appear, the cost of carbon must enter into our rate versus return calculation.