By: Virin Mukherjee; Edited by: Shagun Khetan
Scarcity is the pillar of economics, acting as both a reason for the existence of the discipline and its fundamental problem. There is a scarcity of resources available to the growing population of Earth, and there is a scarcity of time for nations to act in order to check rising temperatures. Thus the question arises: what are we doing about it?
Economics is also a science of systematically representing incentives, and this article will explore the three major current incentive structures towards sustainability prevalent in the economy, or climate finance assets. The first is the carbon credit, followed by the plastic credit and lastly the ESG rating of a company.
1)CARBON CREDITS: AN ECONOMIC INCENTIVE FOR SUSTAINABILITY
First, it’s important to know the historical basis on which carbon credits are based - the Paris Agreement(2015). The Paris Agreement is a legally binding international treaty on climate change, focused on ensuring the famous cap of 1.5℃ increase in temperature by 2100 to prevent irreversible environmental damage. Since 2020, countries have been submitting their national climate action plans, known as nationally determined contributions (NDCs), in accordance with the Paris Agreement. Successive NDCs, for 2030 till 2050, are meant to reflect an increasingly higher degree of ambition compared to the previous version. The agreement is such that it would be ambitious for all participating nations to reach their respective goals by their respective deadlines. It is a heavy task.
To ensure each country meets their own NDC, they have to focus on distributing this contribution to all economic units within it. Thus, big corporations have set targets to label themselves as carbon neutral or a net-zero emitter. But are those corporations, for example Reliance, who designate a label of carbon neutrality by 2035 to themselves, really stopping all their emissions? Obviously not. These declarations are made possible through a financial asset known as ‘carbon credit’, or ‘carbon offsets’.
One credit represents a reduction of a metric tonne of CO2 from the atmosphere. This can be earned by a firm through a verified and certified project to quantifiably reduce their emission, and bought by another corporation as a right to emit a metric tonne of CO2. Thus, this asset acts as an incentive to reduce emissions for firms who are managing their emissions and also a payable fine for a firm that is exceeding its emission limits. When a credit is traded for this purpose, it becomes an offset and is no longer tradable. A firm can be carbon-neutral if it owns as many carbon credits equal to its CO2 emissions in metric tonnes.
In this way, the Voluntary Carbon Market (VCM) was set up. The VCM is a free-trade platform for carbon credits, comprised of companies, governments or NGOs, valued at $2 billion in 2021 (four times its 2020 value). By 2030, it could be valued anywhere between $10-40 bn . Private firms can purchase offsets for resale or investments as well, making it a fully open market “Carbon pricing can be an effective way to incorporate the costs of climate change into economic decision making, thereby incentivizing climate action.” said Jennifer Sara, Global Director for Climate Change at the World Bank.
The demand for carbon credits is majorly influenced by environmental regulations operating in that area. Due to regulations gradually tightening in California and Oregon, demand for credits increased thus dragging up the price with it.
Growth rates for the voluntary carbon market throughout the years to come, will also depend on how well we respond to climate demands. Considering the increasing number of corporations embracing the ‘carbon neutral’ label, the growth can be tremendous. The value of a metric tonne of CO2 was $34 in 2023, $42 in 2024, and is expected to go to $93 in 2030 according to our current rate of sustainability investments The value of this asset is derived from how its price will be determined by our emission reduction performance, because good performance will lead to high supply of carbon credits in the market and thus a deduction in its price (demarcated by the $20 carbon credit price by 2030 under the ‘high quality scenario’ in the following image), while bad performance will lead to high demand for credits and thus an increase in price ($93 carbon price according to estimates of current sustainability investment rates).
With the value of carbon credits still rising, companies are incentivized to earn them instead of having to purchase them. The global South can earn money by investing in carbon offsets, and become leaders in carbon credit supply. Brazil, Peru and Colombia in South America and India, China and Cambodia from Asia have emerged as big suppliers of carbon credits by driving billions of dollars of investment into renewable power generation, use of efficient devices like LEDs or high-grade ACs and fridges, water efficiency in agriculture and afforestation. The West, with more saturated carbon markets and more stringent regulations operating throughout the last decade, consists of credits that have mostly been generated and traded. Thus, the global west will be driving the demand for carbon credits.
2) PLASTIC CREDITS
Plastic credits are fairly similar assets, which represent an amount of plastic waste that would not have been treated otherwise, that is collected and recycled. This system however led to several instances of ‘greenwashing’ by corporations, which means seeming to be committed to sustainability by managing external waste but ignoring their own production process. For example, a firm could earn plastic credits by certifying that they recycled plastic from a random landfill, making them seem sustainable even though their own business practices might not be.
Thus, India used its own system of Extended Producer Responsibility (EPR) which focuses on the production process of the corporation and designates as percentages the amount of plastic that they put out into the environment that has to enter a recycling process. I will use the example of Reliance Industries again - now as a testament to the EPR system; RIL achieved recycling rate of its PET (Polyethylene terephthalate - the commonly used plastic) products to 85-90%, one of the highest in the world.
3) ESG Rating as an incentive toward sustainability, driven by pressure from investors
The third part of my answer to how sustainability investing for a company is being incentivized as an economic decision is through the demands of its stakeholders - a high ESG rating.
The ESG rating of a company is supposed to provide a comprehensive overview of how a company deals with its effect on the environment(E), how it deals with employees(S) and how it administers itself(G) - thus providing sustainability reports from each angle of a company’s practice.
Apart from conflict or general inflation, the primary drivers of FDI in the post-COVID world have become ESG and supply chain sustainability. The UN’s Sustainability Development Goals, or SDGs, find representation in these ESG frameworks. According to McKinsey’s survey, 85% of the chief investment officers they interviewed said that ESG is an important factor in their investment decisions. This is due to the linkages made by analysts between a bullish stock value and high ESG rating of a company, because high ESG ratings signify waterproof (secured against unsustainable practices) supply chains of a company, and correlate it to cash flow in the short as well as long term.
A supply chain consultant, Proxima, found that companies without sustainable supply chains will attract less investment and see share prices drop over the next decade. The survey, conducted among investment managers based in the UK and the US, revealed that 84% of the responders believe that issues with supply chain sustainability and a lack of ESG standards are a financial threat to their investments.
In India, a document called Business Responsibility and Sustainability Report (BRSR) introduced by SEBI is mandatory to be submitted by the top 1000 listed companies in India by market capitalization by 2027, which includes their supply chains as well. This document, requiring similar data points as that for an ESG rating, mandated the inclusion of MSMEs and local suppliers in the sustainability process as parts of the supply chain, and put out a transparent and holistic view of the company’s commitments. A good BRSR report can thus be understood as a good ESG rating as well.
Moreover, BSE and GRI (Global Reporting Initiative) put out a linkage document between the BRSR and the GRI 101 - a global standard for economic, social, environmental impact and biodiversity commitments in 2017 - which since then has helped Indian companies report on a global framework. This will help listed Indian companies to go beyond domestic requirements, and set a stronger foundation for its wide range of stakeholders.
Mentioning all these incentive structures without evaluating outcomes will certainly leave this article feeling incomplete. Fortunately, some time has passed since the top 100 listed companies in India have submitted their BRSR report for FY 22-23, giving us some data to see how well it’s working.
BRSR COMPLIANCE-BASED SUSTAINABILITY PERFORMANCE IN INDIA:
PwC has analyzed BRSR data for the top 100 listed companies in India in FY 22-23 and came up with the following data:
Additional relevant data:
62% of companies provided training on ESG issues to their value chain
60% of companies conducted health and safety assessments for their value chain
54% of companies assessed their value chain against environmental indicators
26% of companies reduced their water consumption in FY 22-23
30% of companies reduced their waste generation in FY 22-23
These statistics do not reflect adequate incentivization and investment into sustainability keeping in mind India’s net zero target by 2070, but surely demonstrate sincere efforts from multiple corporations. Additionally, more of the top listed Indian firms submitting this document as this decade progresses are definitely expected to drive more awareness and stronger commitments towards sustainability.
To conclude, incentive structures like carbon credits, plastic credits, ESG and BRSR are shifting economic focus towards renewable and efficient business practices; ultimately it’s our task to be aware of and strengthen these systems even more so that we reach our ambitious but necessary targets.
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