Investments aimed to reduce carbon emissions

(1)

Investments aimed to reduce carbon emissions

– A Survey of the incumbent companies to analyse the drivers for such investments.

Master Thesis (D-level)

Industrial and Financial Management

School of Business, Economics and Law

Gothenburg University

Spring 2007

Tutor: Anders Sandoff

Authors:

Carl Otto Hansson 811222

Maria Eistrand 821004

(2)

We would like to take this opportunity to express our gratitude towards all the people that in one way or another have contributed with their competency and knowledge to the creation of this thesis. Without their support and positive attitude this study would have been hard to accomplish.

Most of all we would like to thank our interviewees that have set apart time to answer our questions in a truly positive and reliable manner even though we are well aware of their

“tight” schedules.

Special thanks to Anders Sandoff for his genuine encouragement and solid competencies of our topic that has given us the necessary guidance to finalize our thesis.

Last but not least we would like to thank our parents that have supported us with necessary encouragements when we were low on inspiration.

Gothenburg 2007-05-31

(3)

The Kyoto protocol was signed in 1997 and was a clear step towards finding a solution of the overhanging climate issue. Corporations emitting green house gases around the world are now facing challenges and need to find strategies that better align the company’s interest with the ones of the society. The carbon market, a sub-component of the Kyoto Protocol entered public consciousness with the launch of the European Union’s Trading Scheme (ETS) in 2005. The system should give companies an incentive to invest in measures to reduce carbon output by making their own processes more efficient.

This study focuses on certain possible financial as well as non-financial drivers for such investments:

EU-ETS as a mean of control, financial profitability of an investment and attained strategic advantage of an investment. The study aims to bring clarity to what extent these three components are drivers for carbon reducing investments.

The purpose of this study is to bring clarity to the evaluation process prior to an investment deriving from the company’s compliance with the emission targets set by the National Allocation Plan (NAP).

We wish to shed light on and gain a better understanding of Swedish companies’ behaviour and the rationale around carbon reducing investments.

As EU-ETS has a financial impact on a company we have chosen to divide the stipulated components into financial and non-financial drivers. The financial components have therefore been analyzed in a climate policy model while the non-financial component has been analyzed in separate.

Having analyzed the different components of EU-ETS, Financial Return and Strategic values we can conclude that the driving forces for a “green” investment can not be easily pointed out as one single factor but is rather a mixture of these elements. The different components are all to a various extent interdependent.

The financial return is evidently the natural driving force in all investments and we conclude that this is also valid for “green” investment, yet the required return of “green” investments may be somewhat flexible as accepting slightly lower rate of return.

EU-ETS can be viewed as a strong force encouraging both long-term investments and short-term investments. However the system still mainly functions as a driver to comply with the emission targets set for the particular company. Finally we can also conclude that the system could constitute an even more significant driver for investments if the system eventually will be applied globally.

Further on our study show that strategic value gained along with improved environmental performance is not so much a driver for companies to realize investments but rather a hygiene factor. This implying that companies constantly consider the strategic implications of a green investment but they do not fulfil an important decision criterion for an investment. At this stage the highest concern within companies is rather to comply with current targets than to actually make “pro active” investments aimed to strengthen their long term profitability.

(4)

1. Introduction

Climate change is one of the most serious issues facing the planet. Scientific evidence shows that temperature changes are likely to have profoundly negative consequences for human society, the global economy and the world’s natural systems. This poses risks and opportunities to which investors and companies must respond.

1.1 Background

In today’s society it can hardly escape anyone that we are presently experiencing a climate change that is affecting every human being in one way or the other. Everyone bears their own responsibilities and it is logical to believe that the concern of the environment is going to be an essential element in our future way of living. In the center of attention is the releasing of greenhouse gases (GHG)¹ emitted from energy production or from industrial processes. In addition there are so called non-energy emissions which derive from agricultural activities and changes in land use. The consequences of the rising levels of greenhouse gases will eventually disturb the balance of the energy that comes from the sun and energy escaping back into the atmosphere. Less energy will be able to leave the planet which in turn will give rise to elevated temperatures, rising sea-level and a more erratic climate. The Kyoto protocol was signed in 1997 by the major industrialized countries (current exception U.S. and Australia (2007)) as a clear step towards a solution of this overhanging issue and a firm signal to all parts of society to constantly consider the impacts of the climate change. In this new context, corporations emitting green house gases around the world are now facing challenges and need to find strategies that better align the company’s interest with the ones of the society. For corporations it is essential to understand how they can “reap the benefits” of the climate change, as mentioned in Newsweek article “Living with global warming”, given the Kyoto framework. As Ingo Ramming, managing director of the Emission trading team at Dresdner Kleinwort (2006) puts it;”GHG emissions are increasingly central to corporate strategy”.

Ramming continues to further emphasize that “green investments” could be profitable as the associated emission trading can actually create real value in terms of improved cash flows and better earnings.

1.2 Regulatory and policy framework

The regulatory regime is often associated with governments and their ability to permit, prescribe or prohibit private actors’ behavior. This approach is often refereed to as the command and control where the government presents legally binding environmental performance targets or different “best available” production technologies that companies ought to use. The government further monitors and reassures that these standards are complied and sanction those out of compliance (Potoski and Prakash 2005).

1 Carbon Dioxide, Methane, Nitrous Oxide, Chloroflourocarbon, Hydroflourocarbon and Perfluoromethane

(7)

1.2.1 Kyoto Protocol

In December 1997 there was a consensus among a majority of the industrialized countries that a firm response to the climate change is required. The document was called the Kyoto Protocol and aimed to substantially reduce the collective emissions of six key greenhouse gases. The industrialized countries (Annex I²) ought to reduce their greenhouse gases with at least 5 % during a period of 2008 to 2012. The data of the current set targets for each country can be found in Appendix 1. However, already in 2005 the involved countries had to show

“demonstrable progress” in terms of cut downs in the three most important gases - carbon dioxide (CO ), methane (CH ) and nitrous oxide (N O) (UNFCCC, 2002).

1.2.2 Clean Development Mechanism (CDM)

As stated in Point Carbon (2006) the CDM is a project-based mechanism which incorporates the Annex II countries, i.e. developing countries, to take part of the Kyoto commitments. The basic idea is to encourage the Annex I (industrialized) countries to undertake emission reduction projects in developing countries which in turn will benefit the investors by attributing certified reduction units (CERs). These units can later be used for the company (investor) to meet its individual compliance targets (IETA, 2006). Furthermore, in order for the project to be valid, it must be additional, implying that the project would not have been implemented in the absence of the CDM conditions. This allows richer countries to invest in clean energy projects in developing countries and thereafter claim tradable carbon credits for reducing the global greenhouse gas emissions.

1.2.3 Joint Implementation (JI)

The Joint implementation is similar to the previous described CDM, as both mechanisms aim to encourage launching new projects that will contribute to reduce carbon emissions.

However, a JI project is a co-operation between two industrialized countries (Annex I) where one part acts as the investor/buyer and the counterpart acts as the host/seller. The outcome of these projects will then generate Emission Reduction Units (ERUs) that, as in the case of CDM, can be used by companies or countries for compliance.

1.2.4 Climate strategies under Kyoto Framework

The carbon market, a sub-component of the Kyoto Protocol first entered public consciousness with the launch of the European Union’s Trading Scheme (EU-ETS) in 2005. The EU-ETS

2Australia, Austria, Belarus, Belgium, Bulgaria, Canada, Croatia, CzechRepublic, Denmark, EuropeanUnion, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Latvia, Liechtenstein, Lithuania, Luxembourg, Monaco, Netherlands, NewZealand, NorwayPoland, Portugal, Russian Federation, Slovakia, Slovenia, Spain, Sweden, Switzerland, Turkey, Ukraine, United Kingdom of Great Britain and Northern Ireland, United States of America

(8)

system gives companies in energy-intensive industries permits to produce a certain amount of carbon dioxide. If they want to emit more, they must buy permits on the market from companies with a surplus. This gives companies an incentive to invest in measures to reduce carbon output, either by making their own processes more efficient or by investing in projects that reduce emissions in developing countries under Kyoto’s Clean Development Mechanism and Joint Implementation schemes.

Studying the topic of EU-ETS and relevant theory on the subject we found that there are many different options available on how companies can handle this policy instrument.

According to Pinkse (2006), there are a number of strategies on how firms can comply with the set targets; a company can either internally transfer allowances between installations or improve its own processes in order to release less carbon dioxide. Externally firms could either purchase additional allowances or invest under the flexible mechanisms CDM and JI giving the company an additional number of allowances.

However, the bottom line is whether companies should “make” or “buy” vis-à-vis the emission reduction compliances. Corporate strategies tend to bias towards either one of these strategies. If measures and investments, made to reduce emissions³, are easily implemented to a relatively low cost, the “make” alternative is the logical strategy to choose. Conversely, there are companies with such complex production processes that required investments are more costly, leaving them with the solution of buying allowances to comply with the targets.

However, companies have realized that the EU-ETS system not only represents a market offering allowances to individual firms with a shortfall but equally offers business opportunities with its flexible mechanisms; CDM and JI (Pinkse and Kolk, 2005).

1.3 European Union Emission Trading Scheme (EU-ETS)

The first step to create a scheme for GHG emission allowance trading within the EU community was established by the European Union in 2003. The EU members agreed to reduce theirs emissions of greenhouse gases with 8 % compared to 1990 levels during the years of 2008 to 2012. The trading scheme, which currently includes some 12,000 large industrial plants, will enable companies exceeding their compliance target to buy allowances from “greener” companies. However, in several member states there is a current surplus of allowances which are driving the carbon prices down and equally risk underpinning the credibility of the scheme (Point Carbon 2006). As Jennische (2007) further points out there is a need for accurate and fast information about the situation of the actual number of allowances that could potentially be on the market. As experienced in year 2005 when it was revealed that all countries had been given a surplus of allowances, there was an instant drop in the price of European Union Allowances, EUAs.

3 Further on Referred to as Carbon dioxide emissions.

(9)

The EU-ETS is divided into two time phases where the first phase stretches from 2005-2007 and second period running from 2008 until expiry of the Kyoto Protocol in 2012. The first phase can be regarded as a “preparatory” stage to help the parties comply with the targets set for the second phase, as these coincide with the targets set by the Kyoto protocol. The EU- ETS is a component created separately within the EU community in order to meet the targets set by the Kyoto protocol (a reduction of 8% on average through 2008-2012) (Point Carbon 2006).

As earlier described, the EU-ETS system created a carbon market where allowances can be traded between firms depending on their needs. Approved by the European commission, each country has been given a National Allocation Plan (NAP) stipulating the maximum amount of allowances issued in each country and equally the allocation plan for each individual sector (around 55% of the total allowances in EU is allocated to the power & heat sector) (Point Carbon 2006). The NAP is in turn based on historical figures of released emissions in each region.

1.3.1 The Swedish situation

According to Jennische (2007) the EU-ETS comprehend 710 installations in Sweden where the major part is represented in the power and heat sector. Installation with a greater thermal input exceeding 20 MW will be included in the second period. The annual number of allowances that Swedish companies will receive is estimated to be 25.2 millions. This number is based on the average emitted emissions during the base period which was 1998 to 2001. For the first phase (2005-2007) companies received allowances equivalent to 95% of emissions from base period, leaving many of them with a surplus of allowances. The individual distribution may differ between for example the energy sector and pulp & steel industry. The energy sector is often not suffering from external competition and the switch to renewable sources is often easier to implement which has resulted in a much tighter allocation to this sector. On the other hand, the pulp and steel industries are operating in a highly competitive environment and other countries may not have the same restrictions in terms of released emissions. It is equally perceived that measures do reduce carbon dioxide emissions are generally harder to implement in these industries. Therefore these industries have been allocated a relatively generous amount of allowances.

However, for the second phase (2008-2012) the number of allowances distributed will further diminish to 90% from the base period. Pointed out in a report from Swedish Environmental Protection Agency (2007), the EU-commission intends to further cut down the number of allowances to Sweden. Given the fact that Swedish companies exercised only 19.4 million allowances in year 2005 and will receive allowances equivalent to 25.2 million annually through 2008-2012 (3 million of these are intended for expected new installations), the EU- commission is planning to further cut down the total number of allowances with 2.4 million.

Furthermore, the report states that there has been an over-allocation (a surplus of 12%) of

(10)

allowances in Sweden for 2006. It is also revealed that there has been a total increase of 500 000 tons of CO2 emissions between the year 2005-2006 in Sweden (Swedish Environmental Protection Agency, 2007).

(11)

2. Problem orientation and purpose

In order to gain a better understanding for the rationale behind carbon reducing efforts we wish to look closer on how companies handle a policy instrument such as EU-ETS. Are there any other incentives for a firm to reduce its emissions a part from regulatory goals set by governments?

2.1 Problem discussion

There are no doubts that the launching of EU-ETS in 2005 has forced many European companies, taking part in the system, to change their approach towards carbon emissions. The system has sometimes forced companies to completely restructure organizations and create new departments within the firm. The heat and power sector and heavy industries, such as the steel and paper industry, are the most affected sectors when looking at reducing carbon emissions. As already mentioned, there is now a price of carbon dioxide, leaving companies with a number of different strategy options. According to earlier investigations the most common strategy among Swedish firms to handle a shortfall of allowances is internal process improvement (Swedish Environmental Protection Agency, 2007). This means that there are companies that have realized investments that has improved their production process and consequently also reduced their carbon emissions. We already know that it is very difficult to estimate the future cost of carbon over the next 10 years as there is no earlier record of performance for emission allowances and currently, the national allocation plans for the second phase for all European participants are being negotiated. This implies that companies have to make assumptions on what the future cost of carbon dioxide will be, this adding quite a lot of uncertainty to an investment - uncertainty that would have to be compensated by other factors contributing to a successful outcome of the investment. Thus, it is this rather complex environment in which companies need to make sound investment decisions taking future expectations and changes in regulations of climate policy into consideration.

We believe that one important mechanism in order to reduce emission is to simply adjust the level of released emissions internally within the company. Internal process improvement or substitution, for example switching from fossil fuels to natural gas or renewable energies, is a strategy already widely used by the targeted companies of EU-ETS.

As we already know that internal process improvements have been made by Swedish companies, the question is therefore, were these investments only made in order to reduce emissions or did the originators have any other incentives when deciding to implement new more carbon efficient technology? In order to understand the rationale and fundamental drivers of a certain investment, in this study related to investments reducing carbon dioxide emissions, it is of great importance to look into several aspects that might influence the decision of such an investment. Identifying the drivers of an investment and to what extent they influence the decision process is important in order to identify and clarify if there are business opportunities or other business advantages missed out on. Also, by studying the

(12)

decision process, and identifying the strongest drivers, we can perhaps learn how companies can be supported and encouraged in truly committing to “green” investing.

We have decided to focus on three possible components affecting the decision process of a

“green” investment. The first component that we believe could possibly lead the way for many investments is EU-ETS as a policy instrument. This system has partly been designed to encourage companies to realize carbon reducing investments and we are asking to what extent this system really is encouraging investments? The reason for choosing EU-ETS as a possible driver, among other means of control, is due to its market-based character which possibly could in the future, constitute a global policy instrument. The second component derives from a discussion around the characteristics of investments. As we recognize an investment, it should generate certain profitability. We therefore wish to argue that carbon reducing investments – “green” investments regardless of the initial purpose, should to some extent also be profitable. However, as these investments were initiated to reduce the level of carbon emissions, one may question whether they should hold the same level of profitability? In this context we have chosen to include the financial return of a certain investment as a component affecting the investment decision process. Finally, as a carbon reducing investment is an environmental friendly measure we were interested in finding out to what extent this measure has developed and perhaps even turned into a strategic advantage within companies. To break down the questioning even further, we want to know whether this possible advantage is evaluated or even considered in the decision process of an investment.

Research on the relation between environmental friendly activities and economic performance has been contradictory. Some theory suggests that there lie business advantages in communicating a companies’ environmental work to customers. By gaining an improved public image, a firm can create a stronger competitive position within its industry (Klassen &

McLaughlin 1996). Historically, investments made as an environmental protection measure have been viewed as a drag on financial performance, almost as a necessary evil (Vance, 1975). So the question arises; what comes first? Good financial performance or good environmental performance? Does a firm that attains good environmental performance also gain advantages over competitors? The belief that environmental performance is an important component of competitive advantage has found acceptance by a growing number of important academic and business leaders. However, in recent empirical findings (Financial Times, 2007), an international survey asking senior executives if they thought carbon reduction would enhance their image; only 15% saw a marketing opportunity in reducing carbon emission and only 7% saw it as a way of differentiating their products. This survey confirms that there are business opportunities “being missed” by many companies. So our question is;

Do Swedish companies investing in low carbon technology realize the potential boost in profits by communicating these measures?

(13)

2.2 Purpose and Research Question Purpose of study

The purpose of this study is to bring clarity to the evaluation process prior to an investment deriving from the company’s compliance with the emission targets set by the National Allocation Plan (NAP). We want to shed light on and provide the reader with a better understanding of Swedish companies’ behaviour and the rationale regarding carbon reducing investments. We also want to know what attitude Swedish firms have towards carbon reducing investments and how they evaluate the importance of them being carried out without including the main purpose of reducing carbon emissions into the evaluation procedures.

Research Question

Considering the earlier mentioned different strategies that a company can apply when complying with emission targets, we have chosen to further explore the character of the internal process improvement investment. Our main question will be to identify to what extent certain stipulated components influence companies when undertaking investments that have the main objective to reduce carbon dioxide emissions.

Are the following components important drivers generating a green investment, if yes, to what extent:

• EU-ETS as a policy instrument and the flexible mechanisms CDM and JI

• Financial return of investment

• Strategic advantage of improved environmental performance

The first two components are interrelated in the sense that EU-ETS will affect the financial return on a “green” investment. We therefore consider these two being of quantitative character. The last component is solely of qualitative character. Our study will mainly take a structure according to these components, as well as the presented findings will follow the order of these components.

(14)

To further breakdown the research problem we wish to look into what the typical criterion are, financial as well as non-financial and the rationale that these investment decisions are based upon?

(15)

3. Methodology

This chapter seeks to motivate the choice of methods and explain the outline for this thesis.

Creating a scientifically valid but also relevant thesis we need to apply a certain set of methods. Models developed in order to comprehend the research problem will be presented and critically revised.

3.1 Approaching the problem

The idea of writing a thesis on the European Union Emission trading scheme and issues related to the system was developed on an early stage. The climate problematic and the international debate on carbon dioxide reducing policies were stirring up at the point of starting our research. Therefore we decided to deepen our knowledge on the topic and look into potential research problems. After a great amount of extensive research on the topic, the idea to investigate the potential business opportunities that there are for companies joining the EU-ETS system seemed fruitful and interesting. As quite a few potential opportunities allowing companies to take advantage of the trading program was suggested in articles and literature we decided to further develop a model serving as a platform for approaching the research problem. The problem of finding what really is underlying an investment decision at a company taking part of the climate change mitigation.

3.2 Methodological perspective and outline of the study

In order for a study and its content to be relevant it needs to be presented in such a way that it is easily comprehended by the reader. Making it clear to the reader also implies presenting the outline of the study to make sure the reader is following the discussion. Not only is it important to sketch the outline of the study but also to explain from what angle or perspective one is tackling the problem.

Andersen (1995) suggests that there are three different perspectives when trying to describe a scenario in business studies; the systems perspective, the analytical perspective and the actors’

perspective. The systems perspective describes the relationship between causes and possible events and how one event can be related to one or several causes. The analytical perspective clarifies the direct relationship between cause and effect. A theory is examined and will either be confirmed or rejected. Finally the last perspective described by Andersen is the actors’

perspective. When realizing a study from an actors’ perspective one tries to explain and interpret the actors’ reality. Our aim is to describe what the main purposes of a process improvement investment are within companies complying with the EU-ETS. In order to gain a clear picture of what the drivers dominating the decision process are we have chosen the actors’ perspective as a methodological approach. We believe that this approach is the most

(16)

suitable for our study as we are interested in the reasoning behind an investment decision.

In order to clarify the outline of our study we have developed a methodological model where revised theory treating our problem and empirical findings will be structured according to our earlier presented model of problem approach. It is important to keep in mind that EU-ETS and Financial return as components in this model are being treated and analyzed as quantitative possible drivers. The strategic aspect and possible “soft values” is considered a qualitative component. The empirical findings will be based on both primary (direct observations) and secondary data (data already produced) (Eriksson & Wiedersheim-Paul, 2001).

Figure 1. Methodological model

3.2.1 A qualitative research

The purpose of this thesis is to study what drivers in addition to the driver of reducing carbon dioxide emissions are affecting companies when undertaking a process improvement investment? Also what financial, non financial as well as strategic incentives are firms basing their decision on when investing in more energy efficient processes? With this problem definition, this logically suggests a qualitative approach of our study. According to Holme et al. (1997), the major difference between a qualitative and a quantitative approach is how the researcher chose to conduct the study and present the results. The qualitative approach intends to create a better understanding and give a more general picture of a problem whereas the quantitative approach is more structured, formalized and aims to explain findings with a

(17)

certain validity of a problem area. The choice of research method will naturally vary depending on topic and purpose of the study. A study can also be carried out using a combination of different research methods such as a qualitative approach when collecting data and a quantitative approach when analyzing the results.

3.2.2 Literature studies

As climate change and climate related issues are intensely discussed there is a great amount of information on the topic to be found in daily press as well as weekly business reviews. The difficulty has been to separate good material from less relevant due to the varying quality.

Important material for this research was found in industry reports from trade organizations and non-governmental organizations (NGOs) such as United Nations agencies or non-profit organizations like International Emissions Trading Association (IETA). Reports conducted within these organizations are often published and available on the internet. Looking at previous academic research, our material was mainly collected from searching in databases such as Business Source Premier and JSTOR. Key words when searching for relevant information was; climate policy, GHG management, green investment and environmental strategy versus economic performance. We found that many interesting articles and published academic research could be found by searching in lists of references of already attained material.

3.2.3 Choice of method

We are interested in finding out what the original incentives are of investments from the stage when it was first initiated. We considered that the best suitable method for collecting this qualitative data was by conducting interviews. We considered interviews being the most suitable method to tackle our research problem as we needed detailed answers of questions, such as what instruments companies use when they calculate on investment projects. As the majority of our interviewees were situated outside of Gothenburg and its suburban area we were forced to conduct telephone interviews. According to Ejvegård (2003) it is of high importance that the interviewers are very well prepared and are equipped with a structured set of questions in order to attain relevant information.

3.2.4 Selection of interviewees

Our first tool of finding relevant companies was to search on a list provided by Swedish Environmental Protection Agency of all installations taking part of EU-ETS from the date of introduction. As we wished to draw conclusions from our study we had to look at companies with somewhat similar point of departure. A prerequisite for a company to be considered for our study was of course that they had realized an investment or was planning to realize a carbon reducing investment. Finding information on whether companies had done this type of investment was very difficult. By searching websites and interviewing persons with key competencies in the area of EU-ETS we were given advice on interesting companies to research for our study. Other ways for us to find information about possible candidates and

(18)

whether they had made investments was to read daily press on business activities in certain sectors and articles on environmental management. After having stipulated the investment criterion we continued the selection process by looking at companies of somewhat similar size. The yearly turnover of the company therefore became a criterion. We decided to look at companies exceeding 1 billion in yearly net turnover, indicating that our companies would all be large corporations.

Investigating incentives for carbon reducing investments, it became a prerequisite for a company to be highly affected by the set emission targets. Therefore we decided to make the number of given allowances to each company a second selections criterion. Choosing companies with yearly allowances in the hundred thousands range we could say with great certainty that they were affected by the new regulations. For information on the number of allowances and yearly net turnover see Appendix 2.

As already mentioned it was crucial for us to find companies that either already had realized investments or was about to realize an investment. If following stipulations are true for a firm, it qualifies as a candidate for interview;

• Have made an investment that has had carbon reducing effects

• Is currently considering an investment that will have carbon reducing effects

• Holding number allowances in the range of 100’000

• Have a yearly turn over exceeding 1 billion SEK

The three components that we discuss and analyze during this thesis imply, as already mentioned both quantitative and qualitative approaches. We experienced that it can be difficult to find a person within a company that holds responsibility for all the different implications of an investment. Usually the person responsible for environmental strategies at a company is not responsible for providing investment specific details of an investment.

Therefore it was crucial for us to spend time finding the best suitable person to interview. If a person is considered not capable of answering a question due to their specific area of competency we would simply search for complementary interviewees within the company. In most cases reaching the person in charge of environmental issues would eventually lead us to the person that covers our area of interest. A list of the interviewees will be provided in the list of references.

As indicated in the methodological model (figure 1), our research and its empirical findings will mainly be based on primary data but also on a fair amount of secondary data. Everything adding value to our study on what factors that could generate an investment we considered important.

(19)

3.2.5 Drafting of questionnaire

Designing good questions and in what order they appear is important for both the validity of the study and to assure correct interpretation of the following questions in the interview. It is also essential to prepare questions that are truly useful to the research. Before completed, every question and its relevance have to be considered and discussed. According to Paterno (2000) questions should be open-ended and neutral in order for the interviewer to obtain unbiased answers. One should also try not to put own judgements into questions or add meaning to them. As interviewers it was sometimes difficult to follow this advice when some of our questions needed to be further developed in order for the interviewee to correctly understand. This was a critical situation when trying to not put a certain meaning into the questions.

Our questionnaire (See Appendix 3) is divided into three different parts, once again following the structure of our research problem model. The first part includes questions looking to reflect how companies manage EU-ETS. Further on we asked the interviewees for more information on already made investments or investments planned to undertake in the near future. In this section we include the questions regarding the financial aspects of a “green”

investment. The third section of our questionnaire concerns the strategic perspective of a green investment and how well this perspective is taken into consideration within the firm.

We conclude with one question directly pointing at the main problem of this thesis and one concerning the future of carbon reducing investments.

3.3 Interviews

As an interview contains more than just the actual interview we had to prepare background information on all firms as well as research on possible investments made by the firms.

Knowing that all interviews were to be conducted on telephone we also had to study literature describing interviewing techniques and in particular how to conduct an interview without actually having eye contact with the interviewee. Also reliable methods of data registration during the telephone interviews were something we had to study.

3.3.1 Preparations of the interviews

Before starting interviewing we developed a fact sheet for each firm including not just basic data about the particular company but also what type of production processes the company is working with. This was made in order to fully understand what type of techniques and what a possible process improvement would mean to the production process as a whole.

3.3.2 Conducting the interviews

One of our interviews were made on a personal basis visiting the interviewee at his office while as already mentioned the remaining interviews were made over phone. This makes it even more crucial for us as interviewers to create a pleasant atmosphere and good connection from the very beginning. At first, all interviewees were contacted over phone, following by an

(20)

introduction of our thesis over e-mail. Further on we contacted the interviewees once again over phone to schedule an interview and to assure that they had received our questionnaire and taken part of our introduction. This communication process increased the level of trust that should be established between interviewer and interviewee. The interviews followed the order of our questionnaire with almost no exceptions. According to Holme & Solvang (1997) qualitative interviews are characterized by letting the respondent lead the interview in his or her direction. Given that the interviewers have a limited amount of time and also want complete answers to their research questions they should try to work through the conversation accordingly to the planned outline of the interview. Conducting a qualitative interview sometimes requires a lot of flexibility and openness but also sensitivity towards the situation from the interviewer. As this can be even more difficult when interviewing over telephone we put more emphasis on explaining our idea of work and also why we found the company of interest, before actually carrying out the interviews. All interviews were carefully documented both by recording and taking notes during the course of the interview.

3.4 Validity and reliability

Validity and reliability are crucial components of measuring the quality of the study. Validity shows how well the chosen method serves its purpose of measuring what was intended to measure. According to Björklund, Pålsson (2003) the validity of the research can be augmented by illuminating the obtained data from different angles. For example, in case of using interviews as choice of method the validity can increase using explicit, not biased questions. Another possible measure of testing the validity of the research is the use of triangulation. This is a validity measure where various sources and methods are used in order to have the attained information verified (Befring, 1994).

We consider the validity of our thesis fairly high. Firstly we have used explicit questions in our questionnaire not allowing us to make biased presumptions. We also consider the validity to be high as we noticed already after having conducted 5 interviews that there was a certain pattern in the answers. Initially we were aiming to conduct at least 15 interviews, however during the course of the interviews we discovered, as already mentioned, a certain point of saturation after only 5 interviews. Due to this fact and a high number of “drop offs” we finally concluded 7 interviews. Therefore we believe that the low number of interviews may indicate a lower validity. Additional criticism towards our study is that the majority of our interviews were made by telephone. This could entail difficulties when it comes to interpreting information provided by the interviewee.

Concerning our research problem and approach model of the stipulated three components;

EU-ETS, Financial Return and Strategic values, we are aware of the deficiency in this approach model. As already mentioned, the three different components are divided into financial as well as non-financial possible drivers. However, the dimensions and implications of these components are not equivalent in the sense that they represent such diverse

(21)

characteristics. Yet, from early on we considered these components as individually capable of being a driver of “green” investments.

Björklund (2003) states that in order for a study to hold a high reliability one should obtain the same results if the study was repeated using the same methods. Reliability measure the trustworthiness and the usability of the study and to what extent the results are constant and precise (Befring, 1994). We believe that if our study was repeated, using the same methods, one would obtain the same result, which in turn indicates a high reliability. Also, as we conducted phone interviews we put great trust into the recordings of the interviews. The recordings of the interviews allowed us to return to the interview moment in order to understand and interpret the information properly and correctly. All interviewees wished to take part of our study before officially finished to give comments on their contributed information. This automatically implies a somewhat more objective and careful approach towards the obtained information. We spent a great deal of time finding the person holding the information required for our research problem, this in order to bring good reliability to our study. However we believe that the answers provided regarding strategic values of a “green”

investment might not reflect the actual reasoning around environmental strategies within the company. Environmental strategy is a sensitive topic as all companies wish to be positioned in the forefront of environmental work, which entails that the interviewees are inclined to give a somewhat exaggerated positive answer. Due to this we consider the reliability of the collected data of this section slightly lower.

.

(22)

4. Theory

In this part we will present relevant theory that will give the reader a solid understanding of the various theoretical aspects of our chosen topic. The theory will also lay the base for us to conduct a sound analysis. We have chosen to mainly use literature and articles as a source of theory building of the given research problem.

4.1 Structure of theory

In our problem discussion we have clarified that we want to know how EU-ETS as a climate policy, financial and strategic aspects are evaluated in “green investments”. All these components are potential drivers for such investments and it is therefore of great importance to present theory describing and explaining the various valuable perspectives and rationales of the three aspects.

We will present some key areas that touch upon the investment climate under EU-ETS, the associated financial aspects and the strategic perspective of “green” investments. Except for the financial aspects there will be a general discussion where the presented theory will be interpreted in the light of our research problem. The different theoretical standpoints discussed have either been chosen to provide the reader with a complementary or initial understanding of the three components, or in order to provide the study with a relevant framework of analytical tools.

We will firstly describe how climate policy and regulation affect “green” investments. For our research problem it is important to understand how, for example a policy instrument such as EU-ETS, can influence mutually the macro and micro economic environment in which companies are operating in. Therefore we have chosen to present a model that describes how the development of a climate policy eventually can have an impact on the decision process of

“green” investments. Further on we will describe 4 different suggested strategies that companies can apply when facing the problem of complying with national targets of emission levels. The purpose of presenting this theoretical approach in our study is not to apply it as an analytical tool but rather to give the reader an insight of the potential alternatives available to companies.

Furthermore, we will discuss the strategic literature on environmental issues. We will clarify the various perspectives that companies may have when looking into long-term and short- term environmental strategies. In the centre of the discussion lies the environmental and financial performance and how these two viewpoints can be reconciled. In order to illustrate the relation between environmental and economic performance we have chosen to present two models on the topic. Further on various standpoints will be presented and finally we will provide the reader with a brief critical discussion around this relation.

We will lastly present the most important parts of the financial aspects of “green”

(23)

investments. The presented theory has been chosen to reflect some of the critical financial aspects by presenting the discount rate and the required rate of return. A brief discussion around the aspects will also be accompanied in this section.

4.2 Impact of Climate policy

Climate policy sets the “rules of the game” and will therefore have an influence on several factors, both macro economic and micro economic factors, that will affect the investment decision of a “green” investment. In the article by Laurikka, refereed to in Antes (2006) the author discusses the impact of climate policy on heat and power capacity investment decisions. Laurikka points out that the heat and energy sector are particularly vulnerable for the different policy instruments that aim to regulate the GHG emissions, this due to the high emission intensity (emission/turnover) in this sector. The instruments can vary from specific tradable permits to more general instruments such as taxation and various sorts of subsidies, all of them having a potential impact on the cash-flow. Laurikka further emphasize that the energy sector will to a large extent be “carbon constrained” in Europe at least, and any investment decision should be considered in the light of the financial impact of the climate change mitigation. Rajagopalan et al. (1993) created a model (Figure 2) that aims to describe the different phases in a company’s strategic decision process in the context of the development of climate policy.

Figure 2. Source: Adapted model of the Development of Climate Policy (Rajagopalan 1993) Development of Climate Policy

Taxation and generic subsidies Investment-specific subsidies

Emission caps Emission credit schemes (JI,CDM)

Allocation method of allowance

Environmental Factors

•Allowance price

•Electricity market price

•Fuel prices

Process outcomes

•Quality of the investment

•Timeliness, speed Organizational Factors

•Perception of climate policy related risks and opportunities

Decision-Specific Factors

•Availability of alternatives (fuels, heat load)

•Price of heat/cooling

•Opportunity for emission credits

•Permits(construction,Environmental)

Decision Process

Decision making methods in place;

-Comprehensiveness -extent of rationality -duration/length

Economic Outcomes

•ROI/ROA

•Market Share

(24)

Rajagopalan identifies three kinds of levels or factors that will be influenced by the development of climate policy;

1) Operational environment; uncertainty and complexity of the macro economic environment

2) Organizational conditions; Perceived opportunities and risks, past performance, past strategies.

3) Decision-specific factors; the drive for the decision, the urgency associated with the decision, the degree of outcome uncertainty and the extent of resource commitment.

In the operating environment (1) climate policy may influence factors such as electricity market price, fuel prices and allowance market price. This is in turn affecting how the organizations (2) perceive this future change and the intention to meet these problems.

Managers and board members may not realize the impact of these changes and find these policy changes to be “a short-term fashion” while others consider them to stay for a longer term. The decision-specific factors (3) reflect the location-specific risks that are associated with a particular investment. It could for example imply the generated number of allowances when establishing of a new installation. In addition, climate policy can affect factors such as, prices for the various inputs of fuel in the energy sector.

4.2.1 Climate Strategies under EU-ETS

Antes (2006) describes the various alternatives or strategies that companies face in order to comply with the regulated emission targets under the EU Emission Trading Directive. Antes (2006) identifies 4 procurement management strategies for companies to choose from in situation of short fall of allowances;

1. Reduction/avoidance of GHGs at installation X to reduce the quantity of allowances needed. This approach is already widely used by companies to respond to the classical environmental legislation and normally incorporates more efficient processes or substitution (example natural gas or renewable energies) in the company.

2. Internal creation of emissions credits through projects abroad. As already described in the earlier chapters this option was introduced in association with the Kyoto Protocol. The two mechanisms, Clean Development Mechanism (CDM) and Joint Implementation (JI), both aims to accomplish the emission reductions at places where the marginal avoidance cost are the lowest. Companies who have relatively high abatement costs at their own installations can choose to set up a new installation, mainly in developing countries where the marginal abatement costs are lower. Hence, the company receives emission credits to cover its exceeded domestic emissions.

3. Purchase of emissions allowances and credits. This option gives companies, with

(25)

emissions that exceed the level of allowances allocated, the possibility to buy the shortfall of allowances on the market. EU countries can decide on the number of generated CDM/JI credits to be incorporated in the NAP for the second period (2008- 2012). From 2008 market the allowances will expand since all the CDM/JI credits will be included.

4. Company-internal creation and trading. This strategy applies to companies that hold several installations where they can create their own market of trading allowances internally. With this strategy, large corporations that have installations in different countries (developing countries) can transfer allowances from divisions of lower marginal avoidance costs to other parts of the corporations where the same costs are higher.

4.3 Relationship between economic and environmental performance

There seem to be a split of opinion in literature on the relation between economic and environmental performance. Theory suggests that with tighter environmental regulations and the ever-increasing green conscience forces companies to develop and integrate environmental values in their long term strategy. Other opinions suggest no reconciliation between the environmental and financial performance and perceive environmental policies and regulation in a short-term perspective and in a rather static manner. In an article by Klassen and Mclaughlin (1996) an environmental management model is presented. This model departures from the argument that significant costs are associated with improved environmental management as it may require large compliance costs. However, these costs will according to the authors be exceeded by the potential benefits stemming from greater future cash flows and a better public image. The latter will in turn increase the companies’

revenues.

Furthermore, Klassen and McLaughlin (1996) point out that a climate policy or regulation, that forces a company to internalize environmental costs for example, pollution or air emissions, must be strongly considered and reflected in a company´s corporate strategy.

4.3.1 The impact of Environmental Management on Firm Performance

According to a model developed by Klassen and McLaughlin (1996), (described below, figure 3), the corporate strategy will be a fundamental force to determine the general environmental orientation of a company. The corporate strategy will also establish the amount of efforts that are directed to environmental management (choices of product and process technology such as the use of recycled raw material). The functional strategies, in terms of structural choices of plant, equipment and production planning will also be affected by the environmental orientation in corporate strategy. The corporate and functional strategies in this model will ultimately affect the environmental performance of the company. When the environmental efforts are presented to the public and eventually evaluated by the market, it will have an

(26)

impact on the financial performance. A company that can demonstrate strong environmental performance will gain market share from other competitors that fail to show the same performance (Klassen & McLaughlin 1996).

Figure 3 Source; Adapted from Klassen & McLaughlin (1996) 4.3.2 Impact of Environmental Regulation

In a review by Rugman and Verbeke (1998) the various perspectives that companies (managers) hold of environmental regulation are presented. According to a model presented below, the authors illustrate 4 different positioning strategies describing the managerial response in a time perspective and the impact on industrial versus environmental performance.

Figure 4; Source; Adapted from Rugman Verbeke (1998)

In the figure the impact on Industrial Versus Environmental Performance will be found on the horizontal axis. This represents a performance measure where industrial performance reflects the growth and profitability, and environmental performance is reflected in emission levels, pollution or other external environmental effects. In this context the companies (managers) need to determine if the environmental regulation will conflict with the industrial performance

Corporate Strategy

Financial Performance

Functional Strategies

Environmental Performance Environmental

Management

Conflicting Complementary

Static

Dynamic

1 3

2 4

Impact on Industrial versus Environemental Performance

Time Horizon Of

managerial Response

(27)

or if it can complement and eventually even increase the industrial performance.

On the vertical axis there the authors make a difference between the time horizon on which managers respond to environmental regulation. The first approach, the dynamic approach, suggests that companies will take long term environmental actions that are in line with the regulation. The second approach, the static approach, implies that companies only consider the immediate impact and do not consider the time dimension as highly important. The four quadrants can further be interpreted as follows;

Quadrant 1. Static and conflict; The company holds a short term perspective where the environmental regulation only has to be complied with. The company will have no further engagement and no investments will be implemented as this is looked upon as reducing profitability.

Quadrant 2. Dynamic and conflict; Companies holding this approach acknowledge that a dynamic response is required in order to minimize the negative impact of the regulation of the company’s industrial performance. However, they believe there is a negative relation between industrial and environmental performance.

Quadrant 3. Static and complementary; In this approach the regulation will be perceived as having a positive impact on the industrial performance. Companies are focusing on short-term investments that will enhance their “green” capabilities. The new situation is perceived as a

“win-win” situation.

Quadrant 4. Dynamic and complementary; The last approach is often referred to as the situation where substantial investments and resources in “green” capabilities generating innovation spin offs that eventually will increase the company´s profitability.

Rugman and Vibeke, conclude that is hard to determine ex ante⁴ whether industrial performance and environmental performance is complementary or conflicting and equally whether a company’s response is static or dynamic. Porter and Linde (1995) argue that companies that at an early stage adapt and design its environmental policy may benefit of having a “first mover” advantage. This will not only lead to a future competitive advantage but also to “innovation offsets”. These “offsets” can reduce the total costs and potentially also benefit the company by selling these technologies to other parties operating under similar environmental regulation.

However, Walley and Whitehead (1994) are much more critical to arguments like these and point out that this argumentation is not realistic. They emphasize that the” win –win” scenario described by Porter is insignificant and that the costs of complying with a certain regulation

4 Before an event occur or beforehand

(28)

will give rise to greater costs with marginal chance of economic payback in the near future.

The authors therefore question if environmental strategy should incorporate the “win-win”

approach.

Furthermore an interesting point of view is presented by Fischer and Schot (1994), highlighting how companies may shift from a quadrant 2 (static and complementary) to quadrant 4 (dynamic and complementary), i.e. describing how companies ought to act in order to gain the long-term advantages of major environmental actions. The authors take the example of the Canadian paper industry and the impact of environmental regulation. In this case the shift requires the company to quickly and extensively incorporate environmental concerns into strategy in order for it to have a long-term impact on industrial performance.

4.4 Financial Framework

In the report “Nordleden slutrapport etapp 2” (2003), it is concluded that the risk factor in investment decision process among energy companies is gaining an increasing focus. The Swedish energy sector has been heavily deregulated the last decades and is highly volatile.

Predictions about future costs- benefits are to a large extent depended on external factors. Due to this uncertain environment, companies might reject investments that are considered too risky to the benefit of improving the already existing installations. (Nordleden 2003).

4.4.1 Choice of discount rate

The discount rate can be considered to be the variable that describes the weighted average cost of capital (WACC) of debt and equity returns on investments. It can be interpreted as the required return claimed by the investors (both equity and debt holders) on the company’s assets and operations. Hence, companies that are undertaking projects that hold higher risks or more uncertainty will similarly create a higher discount rate (Brealey et al. 2004).

According to Hussen (2004) there might be a difference in the choice of discount rate between state-owned companies and private companies. State-owned companies may require a slightly lower discount rate in comparison to their private counterparts. This, he argues is mainly due to two reasons; private companies are considered as being shorter sighted in terms of profit and equally tend to heavily discount benefits that arise from an investment. On the other hand, state-owned companies are suggested to have a long term perspective indicating a more modest discount rate for future dates. Secondly, the fact that state-owned companies are viewed as having somewhat of an eternal life lowers the discount rate due to perceived reduced risks. This opposed to private companies which undoubtedly are not “guaranteed”

eternal life (Hussen, 2004).

4.4.2 Required rate of return

The required rate of return of a project is often referred to as the opportunity cost of capital.

This is a highly important element which shows the rate of return offered by alternative

(29)

investment options, i.e. the return foregone by investing in the project (Brealey 2000).

The required rate of return of investment projects in the energy sector is not easy to estimate as suggested in “Nordleden slutrapport etapp 2” (2003). The specific risk of an investment is often estimated by looking at other actors undertaking investments with similar risk structure.

As this report suggests, the problematic with energy suppliers lies in the difficulty of comparing the energy sector with other sectors with similar characteristics. As no “proper”

alternative investment is available it is difficult to estimate what the next best alternative (opportunity costs) is to these specific energy investment projects. In addition, the ownership structure of energy companies is sometimes dominated by municipal and state interests that to some extent can complicate the extraction of the alternative rate of return. This due to that the value of an investment made by a state-owned company can only be put next another state- owned companies’ investment when comparing rate of returns. This somewhat unclear evaluation framework is increasing the risks to state-owned companies (Nordleden 2003).

(30)

5. Empirical Findings and Analysis

In this chapter all empirical findings from interviews will be presented from an objective perspective. These findings will later on in the chapter be analyzed and accordingly compared to what the theoretical findings suggest.

5.1 Structure of the Empirical findings

The structure of the empirical findings will be based on the construction of the questionnaire (see appendix 5), which in turn derives from our problem definition model. In the questionnaire we have divided the questions into three different areas that together will give us relevant information to our research problem. In order for us to understand the drivers of carbon reducing investments we naturally need to know the characteristics of such investments. Therefore, we dedicated a part of our questionnaire to the nature of a “green”

investment; the purpose, the decision criterion, the financial aspects of the investment and finally the origins of the investment. As the financial aspects of a “green” investment partly represent the nature of an investment we have chosen to present these findings within the section called “Green investments”.

The empirical findings will describe the different attitudes and approaches towards the three areas;

• EU-ETS

• Green Investments (Financial aspects)

• Environmental Strategies

In the first section we will present how companies manage the EU-ETS system, for example what compliance strategies they undertake. In addition we investigate whether companies consider the system to offer any business opportunities. The second section called “green”

investments comprises both the nature of a “green” investment as well as the associated financial aspects. The third section, Environmental strategies, will focus on the strategic environmental values and how these values are perceived within the company and consequently are reflected in the decision-process.

5.2 EU-ETS

As we are equally interested in how EU-ETS affects companies’ investment behavior, we also consider it of high importance to map out the general knowledge of the system as such. Do the investigated companies recognize that ambitious compliance of the targeted levels could be long term beneficial and equally offer a business opportunity in the system or do the companies focus on short term solutions to comply with the targets?

Investments aimed to reduce carbon emissions