BIG TALK OR REAL ACTION? READING THE TEA LEAVES OF CLIMATE REGULATION

As investors seeking to profit from a systemic transition in the global economy from a high environmental impact footprint to a low environmental impact footprint, we are continuously returning to a framework for analysis defined by the dual economic and environmental sustainability constraints. Within that framework, there are additional constraints created by regulation, technological, politics, and geopolitics. A holistic understanding of these constraints helps us focus on the facts on the ground; it helps us understand what is instead of just understanding what people think ought to be.

Political and regulatory constraints will play an important role and the longer countries go without meaningfully addressing the issue, the more significant that regulatory impact is likely to be. To date, the Biden Administration has talked a lot about climate change and indeed tried to promote the importance of addressing climate change. Still, the administration has done very little. At this early stage in the administration's life, that is understandable and not a critique. Running a government is a tricky business with many demands, especially during a pandemic. The climate agenda for the administration is in its infancy, with the only significant outcomes in executing that agenda being reentry to the Paris Climate Agreement and a new National Determined Contribution (NDC) as required under the Paris Agreement.1

The new NDC pledges to reduce US greenhouse gas emissions by 50% - 52% by 2030 compared to a 2005 baseline. It is a more aggressive commitment than the Obama administration in the original US NDC (26% - 28% by 2025) and assumes a significant acceleration of decarbonization from the current trend. The US is currently on track to reduce emissions by about 30% relative to a 2005 baseline by 2030. Most of the additional emissions reduction relative to the current trend arises from the administration's goal to decarbonize the electricity system by 2035, a goal outlined in the administration's $2.3 trillion infrastructure proposal.

How this goal will be achieved is unknown. What is known is that "energy efficiency and clean electricity standards" will play a key role. We suspect that the details will remain limited until negotiations with Republicans yield something that the thin political majority the Democrats currently have can get through Congress. The negotiations between Republicans and Democrats are a very real political constraint on what can be accomplished between now and 2035. Absent cooperation, we expect that European regulations will be more likely to impact US multinationals than US regulations.

Federal Clean Energy Standards

Historically, Clean Energy Standards (CES), or Renewable Portfolio Standards (RPS), have been policies that have enjoyed bipartisan support, with bills submitted regularly over the last few years written by both Republicans and Democrats. The reason for this historical bipartisan support is that a CES tends to offer electricity suppliers maximum flexibility to meet standards as they see fit and is economical for the individual producer. The flexibility is created via the combination of well-established timelines for targets and compliance deadlines and multiple approaches for firms to meet their obligations under the standard. Most systems currently employ a variety of Emissions Credits and Alternative Compliance Payments.2 Each year a load-serving entity begins its year with a mix of electricity-producing assets that generate a certain number of Emissions Credits and a requirement to make demonstratable improvements in its generation portfolio emissions by developing and then retiring a certain number of credits.

The viability of the assumption that CES will receive bipartisan support seems unlikely. Should a CES bill be proposed under the current administration, it seems highly likely to be challenged on economic grounds by the Republicans in the House and Senate. Should the political dynamics shift following midterm elections, and the Republicans propose a CES bill, as they did, for example, in 2010, it will likely be opposed by the democrats because it does not go far enough. Either way, the political calculus seems to favor the status quo or extremely low impact policy.

Some analysts suggest that a CES bill could be forced through Congress and overcome any Senate filibusters via the Budget Reconciliation process, but this appears to be a less certain path than it is given credit for being. It is not impossible, but it is not necessarily a done deal either. From an investor's perspective, thinking through the possible futures, it is essential to recognize that the ability to pass legislation via reconciliation depends on the views of a single person, the Senate Parliamentarian. Given that it depends on one person's opinion, in this case Elizabeth MacDonough, who has served as the Senate Parliamentarian since 2012 under both Republican and Democratic leadership, it is difficult to say with great confidence what she might decide.

A recent study by the Evergreen Collaborative and Data For Progress outlines three potential CES policies that the authors believe would abide by the so-called "Byrd Rule" and thus qualify for consideration in the Senate via reconciliation:

Federal CES Option 1: On the Books ZEC System: Zero-Emission Credits would function as "cash-like-assets," and load-serving entities would need to demonstrate compliance with an increasingly stringent portfolio emissions standard by obtaining (via open-market purchase or internal generation from the operation of renewable power) an ever-increasing number of ZEC relative to the overall electricity they deliver to retail customers.

Federal CES Option 2: Reverse Auction ZEC System: ZECs would be purchased from load-servicing entities by the federal government at levels sufficient to meet the annual clean electricity requirements nationally or regionally, depending on how standards are structured geographically. Load serving entities would then be charged a fee equal to the product of the costs of the ZECS purchased by the federal government and the load-serving entities' share of annual retail sales of electricity.

Federal CES Option 3: Mass-Based ZEC System: Under a Mass-Based system, each load-serving entity would be provided an emissions trajectory and would be responsible every year for either reducing emissions such that they comply or purchasing ZECs equal to the difference between their trajectory and emissions released from operations.

Any of these Federal CES options would work in practice. Still, we remain unconvinced by the ability of the Democrats to overcome the political hurdle created by an intransigent Republican party. As such, we believe investors should expect very little actual progress on addressing climate change from the Biden administration. If structures that historically had Republican support seem unlikely, then much beyond that seems even less likely. There will undoubtedly be measures and steps taken by the administration to address climate change via executive orders and enforcement of regulations already on the books, but at this point, the change necessary to combat climate change is beyond what can reasonably be expected from the US political system.

Our base case going forward is that the Biden administration continues to talk a big game regarding climate change but fails to accomplish much. Should the administration somehow manage to either push clean energy standards through reconciliation or a deal with the Republicans, investors should expect the investment into the electrical grid, generating assets, and all the suppliers along the supply chain to benefit greatly. The investments necessary to accomplish the goal are staggering, and although decarbonizing the electrical grid by 2035 is not a feasible goal, nor one that we think advances the agenda of combating climate change due to its lack of feasibility, the efforts will produce significant gains for many firms in the electrical supply chain and ecosystem.

Watch Out for Europe

While the reasonable base case for the US is a stagnation of the political and regulatory agenda, the same cannot be said of Europe. Investors in energy, materials, and industry must watch Europe carefully as their regulatory efforts will be a significant economic constraint on most businesses. While some who do not invest in Europe directly might dismiss the need for this careful study, the expected rollout of an EU carbon border adjustment tax should prompt a rethink.

This year, the European Parliament overwhelmingly adopted a resolution in favor of a World Trade Organization compliant EU carbon adjustment mechanism that would prevent carbon leakage. As the parliament noted, "trade can be an important tool to promote sustainable development and fight climate change." At a very high level, the EU parliament envisions a mechanism similar to the existing EU emissions trading system (ETS) and targeting foreign firms in electricity generation and energy-intensive industries such as cement, steel, aluminum, oil refinery, paper, glass, chemicals, and fertilizer production from countries with less ambitious climate policies than the EU.

These businesses would have to buy emissions allowances from a pool of allowances created for imports at a purchase price that mirrors the current EU carbon price cost. The scheme has widespread industry support from most corners of the real asset ecosystem, as it is seen as a way to level the playing field for domestic European businesses currently subject to the European Emissions Trading Scheme.   Given the overwhelming political and business support, it seems likely that some form of the adjustment tax will pass, details of the plan will be available in July, with negotiations in the EU parliament expected to commence shortly after that. No timeline exists for the conclusion of those negotiations, and just as passing sweeping and systemic changing legislation is difficult in the US, it is difficult in the EU. Nevertheless, the odds, and thus a base case outlook, favor some form of regulation that will negatively impact business operations the world over.

The US may be a more significant emitter than the EU, but when it comes to regulation, investors must remain focused primarily on Europe, or at least focused on Europe until Elizabeth Macdonough makes her opinion on clean energy standards and budget reconciliation clear.

[1] The Paris Agreement was signed in 2015 by 196 participating countries. The goal of the Pair Agreements was to transform the development trajectories of the participating countries to align then with the aim of limiting global warming to between 1.5 and 2 degrees Celsius above pre-industrial levels.  The Nationally Determined Contributions (NDCs) are at the core of the Paris Agreement and outline the efforts each participating country are making to reduce national green house gas emissions and adapt to the changing environment. NDCs are submitted to the UNFCCC secretariat every five years, all currently submitted NDCs can be found at the following link. Upon reentry to the Paris Agreement the US was required to submit an updated NDC. The Biden administration NDC, which can be found here (along with the original NDC) outlines the following goals:

• Economy wide target of reducing net greenhouse gas emissions by 50%- 52% relative to 2005 levels by 2030.

• Deploying a whole of government approach to combating climate change.

• 100% carbon free electricity system by 2035

• Various regulatory updates targeting non-CO2 GHG Emissions

[2] Emissions Credits and Alterative Compliance Payments: Emissions credits are earned by generating clean power or through buying Emissions Credits from other generators. If a firm fails to generate enough credits from its operations, and fails to buy Emissions Credits from a third party, they can also by a compliance payment to the government.