Pricing power: Developing a roadmap for carbon differentiated markets

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Hill Vaden:

All right. Welcome back to S&P Global Commodity Insights EnergyCents, a podcast where we cover all topics on the intersection of energy and finance. This is your host, Hill Vaden here with your other host, Sam Humphreys. Sam, how's it going?

Sam Humphreys:

It's good, thank you. Hill, how are you?

Hill Vaden:

I am doing all right. I'm getting ready to go out to lunch with Tony.

Sam Humphreys:

So jealous. I want a fancy lunch too.

Hill Vaden:

I don't know if it's a fancy lunch.

Sam Humphreys:

No?

Hill Vaden:

I don't know. Tony and I come in the office pretty much every day, and so we're going to lunch.

Sam Humphreys:

Oh, that's lush.

Hill Vaden:

Isn't it?

Sam Humphreys:

Quite jealous. Yeah, how lovely.

Hill Vaden:

But it's evening or almost for you.

Sam Humphreys:

It is, and the sun is shining and there is a restaurant that all my kids are at.

Hill Vaden:

All your kids are at the restaurant?

Sam Humphreys:

All my kids are just there, the two of them and my husband, and I'll be going to join them shortly.

Hill Vaden:

Okay. I'm picturing a scene in Annie with all these kids.

Sam Humphreys:

It did sound like-

We love you Mrs. Hannigan.

Hill Vaden:

I do not have, I do not have those. That'll do.

All right. We have other kids joining us on this podcast today, there's our segue, Jonty Rushforth and Kevin Birn, who are full-grown adults speaking with us about differentiated carbon markets and some of the work they've done really on the back of a paper that was called a Roadmap to a Carbon-Differentiated Market. So we go into a lot of detail, but maybe there's some comments or some bullet points you want to pull up to the front for people to listen to.

Sam Humphreys:

Yeah, sure. So I think the main thing from this episode is they outline the roadmap as it's in the title of what is needed to create this carbon-differentiated market. So is it going to matter of how emission friendly or the emission intensity of a product is across commodities? So not just oil, not just metals and not comparing apples and oranges and what it's going to take to get there. And I think one thing that is striking is the amount of progress this is making and has made in the last five years or so. I think Kevin goes into it a little bit and I think he even says it was like a playground to start with a few years ago and now it is taking center stage at some of the big events. So it was very interesting and they go into some excellent details in explaining just the ins and outs of this. But what about you? What did you think?

Hill Vaden:

I echo what you're saying and I think that there's a lot of activity happening in this space and it seems like there's some things to watch for over the coming weeks or months that perhaps show a little bit of maturation on the idea of differentiated carbon markets. So we'll do that now.

Sam Humphreys:

Enjoy.

Hill Vaden:

All right. Everybody's gotten really serious all of a sudden.

Kevin Birn:

Going over my notes.

Hill Vaden:

We've been talking to each other for the past 20 minutes before we hit record and now we've all gotten very stern faced and serious. So hopefully we have some more fun as we start talking. But Jonty, Kevin, thanks for joining us to talk about carbon differentiated markets and some of the work that y'all have been doing. Kevin, as we were talking before we hit record that there's questions about what carbon differentiation is, whether carbon is the best word. Can you help us to anchor the setup here of what we're going to be talking about for the rest of this podcast on carbon differentiation?

Kevin Birn:

Yeah, sure. And thanks for having us here. Where to start with that question? I think if we take one step back, and I'll frame this, I think over the last 20 plus years we have seen interest from many actors in the economy in pricing carbon into the products and the companies and different market transactions, generally. Financial institutions are seeking information to assess their transition risks and their portfolio risks associated with decarbonization energy transition and climate change. We have industrial operators that are interested in how their assets compare and the products they sell or compare. And we have governments and traders trying to understand how that could impact trade and the valuation and commodities around the world.

A carbon differentiated market, which is not a market, I think, we have today, is a market where the buyers and sellers are able to compare, they can trust and ultimately choose to assign value to greenhouse gas emissions associated with the products that are traded every single day. I think in the place of that, we've seen a proliferation of compliance markets for governments trying to put those signals into the market and other measures, I should say, including voluntary measures. But the idea that there is some sort of price differential in the market is not there, but that is the path of travel we see interest in the world right now.

Sam Humphreys:

So Jonty, I'm going to jump to you. Who is driving this? Is it governments? Is it the large commodity bodies who is really pushing for this marketplace?

Jonty Rushforth:

Yeah, I think that's changed quite a lot over the last few years. If we go back two, three, four years, a number of producers had invested in upstream kit that had led to lower emissions. And you could look at examples from North Sea, from Permian, and I think they'd realized, "Okay, we've made this investment, we've had an outcome here, but actually we can't monetize it directly there. We need a market to sell into that recognizes the difference of this thing." At that time, I think there was a real struggle to find the demand side and that was one of the crucial points back in 2020, 2021. Since then, we've seen, well, the entrance of the state into the discussion, so the carbon board adjustment mechanism from Europe, but also some of thresholds that have been put out there around the world. And some of that at least is a recognition that the state of the art has changed and that you can actually start to legislate around these, what is in essence, an externality in the supply chain.

And then I think the crucial point, as well, is that we've started also to see the focus of some of the financial institutions in this area, where they're thinking about portfolio, they're thinking about emissions across the portfolio and how do you demonstrate that? And I think alongside all that, as well, you've got the fact that there's a realization that just taking the very generalized figures for carbon intensity doesn't reflect the actual dynamic reality on the ground. So that realization has started to mean, okay, it's no longer just producers. You've got governments that are realizing, "Okay, we can actually legislate in a way that is going to drive impact and outcomes." And there's trade elements to that. There's all sorts of other elements to that as well.

Then you've got financial institutions starting to realize that, "Okay, people will more and more realize because of that transparency that actually it's not as simple as saying all oil is the same or all sour is the same. You can't draw the same lines that you used to be able to draw." So that's why there's probably a greater range of stakeholders that are now driving for this than in any previous point and the direction of travel is ever greater still.

Hill Vaden:

So Kevin, can you help talk a little bit more about the stakeholders and where we are in... So part of what sparked this podcast was a paper that you had contributed to called A Roadmap to Differentiated Carbon Markets. And if there's this growing demand, is this policy dependent? Is this people dependent? I guess policy is also related to people, but what is pulling this as opposed to pushing this, I guess?

Kevin Birn:

There are a lot of different pieces. Maybe I'll just build a little bit upon what Jonty said. If you take this to an individual company's perspective, we have to understand that most global emissions are not priced by any kind of policy mechanism presently. Then that means companies, they have largely been doing things around focusing on how to improve the operational excellence or in the case of upstream, how do I go after methane and reduce methane intensity? And that's because those are on the lower portion of the marginal abatement curve. So that's the cost of decarbonization. And so that makes sense. If you're a company, you're going to spend the most efficient dollars where you can get the biggest bang in terms of environmental performance because people do care, financial companies do care and the public does care and they're doing things there. But as you chew through those things, you will inevitably work your way into more costly things that you have to do to decarbonize.

And that's when it gets difficult because those things are not necessarily value creation today. Those cost money to really deal with what a lot of people would consider is a waste product. And so making that investment decision that doesn't have a positive return on investment, so a negative return on investment, well, you owe a duty to your shareholders to generate positive returns, becomes a very difficult predicament for them to make. And there's laws that protect shareholder value at play here as well. And so there's a lot of concern, I think, in the industrial sector, but other sectors, the economy across the world, how do we continue to make progress in decarbonization without putting that at odds with our duty to maximize shareholder value? And for that to occur, you need to align the incentives. So if people care about environmental performance, then they should be willing to pay for it. That's the basic premise and presently that's not the case.

Well, okay, why is this not occurring? Well, one reason is because the buyers and sellers cannot do any discovery presently. We have standards and guidance that exist for mission accounting, but they generally are to ensure consistency through time and not necessarily to ensure comparability across companies and sectors. And so what you end up with is a lot of companies generating numbers, but they're largely incomparable and so you can't decipher what the reality is and ultimately you can't trust that as it relates to a transaction. And so there's this recognition that there needs to be standardization of harmonization of mostly, I think the focus is on product level intensity today because that's how companies actually compete for buying and selling and that would align if you can get the standardization you can do to discovery and then buyers and sellers are able to agree or not agree on if there should be a difference in price.

Now, people jump to price. I think the first impact is demand to think about. If you have two commodities and they're the same price and one has a more desirable environmental attribute than the other, you would most likely choose the more desirable environmental attribute because it doesn't cost you anything. Making that choice over and over can change demand and that's differentiation in the market. The other way to think about it is if I were to engage in a long-term contract with somebody, if I have two commodities with equal attributes, again, maybe I'd be more willing to engage in a longer term contract with one with more desirable attribute, that's still financial, something they can take to the bank and gain from it. And so it drives the incentives in there.

So I think there's a realization and when it comes to transactions and the need to mobilize capital, there needs to be better alignment on the emissions so buyers and sellers can understand and then make more informed choices. Choices affect demand, and that affects price. I think governments are realizing that because they need to ensure that these signals extend beyond their borders and a proliferation of CBAM-like policies that could be inconsistent globally could disrupt trade. And from an industry perspective, they need the alignment. So if they are lower carbon, they're able to capture that benefit by signaling appropriately in the market, and/or if they want to invest in decarbonizing to improve the environmental performance, they're able to recoup that investment by getting some sort of differentiation in the market for that.

Jonty Rushforth:

Just to add on what Kevin said there, this is the key pivot that I think we are seeing and potentially comes through, which is so much of the focus on emissions over the decades has been at the entity level or really at the country level, which is great, but it doesn't actually necessarily drive change unless you have some sort of top down outcome. The premise has been that maybe you can shame companies into having less emissions and that works to some degree, but you can either describe the world's emissions in terms of companies or you can describe it in terms of supply chains. You're covering the same amount of emissions, but you're actually attributing them in a different way.

And if you're attributing them in terms of supply chains, well, then you are actually hitting the point in the economy where choice is made and therefore, if you've got transparency around it, then all that differentiation, the demand element, and ultimately, even though Kevin says don't want to loop to price, you've got to get to price at some point and price is going to come from having that transparency and being able to say, "This choice has larger impact, this choice has lower impact."

Sam Humphreys:

So if we're looking at this today, which we are, are we talking about something from a company... So if a company, an operator, for example, has oil and gas operations, for example, in Namibia and the North Sea and they are reporting their emissions on those assets, is that equalized across their assets? So it would be one value for the commodities they produce as a whole, or is it per individual asset?

Jonty Rushforth:

No, it's per parcel of that commodity. So you're sitting there, you're a refiner in Northwest Europe or in West India and you have a choice. You're looking at 50, 60 different crews that you could bring in at any one time. Now, obviously it's a hugely complex process to actually run your LP and come to an outcome on that, but if you have an overlay on that as well, that says, "Okay, in addition to the usual specifications you're looking at, here's the actual emissions intensity," then that adds another factor within it. Now, it may be that it's not a factor that you are looking at at that time, there's no particular driving factor for you.

But it may well be that there is, particularly in the world where CBAM or others as well, where you increasingly do see some thresholds, you start to look at that and then you say, "Okay, this cargo that has come from Gulf Coast, the emissions intensity is 20 kilograms versus what I've got here that's come from a different region, it's 40. So across my whole margins and outcome across all that, I'll do my full calculations, that's going to have X impact. I will pay a little bit of a premium for that US cargo." And maybe it's 5 cents, maybe it's 10 cents, maybe it's not huge, but obviously in margin terms, that builds out across and starts to actually have a significant impact.

The analogy we often give, and you'll find it in that paper, is to sulfur and what's happened in sulfur in commodities over the last, what is it, 40, 50 years now, when you went from it was a measure of lubricity and was a good thing that was in there to realizing that this had actually an impact on air quality. And then okay, you need to measure it, you need to know it, and then you start to have some sort of thresholds applied and then because you got thresholds applied, you have differences between one fuel and another. And then because of that, you start to be able to actually generate the outcomes that lead to investment, that lead to the kit that mean the ultimate, then you've actually got a whole system that's driving towards a lower sulfur world. But it starts with initially that transparency at the product level.

Hill Vaden:

So Kevin, how do we think about this rolling out and taking shape globally? You talked about the need for consistency and if we oversimplify some of what's happening in the world that the west has been able to outsource a lot of its emissions to other countries for other products, which is part of what the CBAM is trying to address, but you got to get everybody to play in order to get the whole supply chain to allow for that differentiation. So on the backside of it, forgetting the demand, let's assume that people want to buy lower carbon things. How does all of that organization take shape to allow for that consistency?

Kevin Birn:

Well, in the paper we put together with Jonty and Eleanor as well, we lay out what we think are the key steps that have to occur, and this is going to be a gross oversimplification. This is a journey. This isn't something that's just going to happen overnight. I think the first thing we think about is the need for a sector specific quantification framework and that, to the example previously, so a crude coming out of West Indies and a crude coming out of the United States, we can make an equivalent comparison and understand and trust what we're looking at without having to dig through and understand any of the quants. It's 20 kilograms, 18 kilograms, I can make the choice quick.

Then we need a standardized reporting framework as well. So we do the quant and I just gave the example of 1820 that we tell and determine that it should be in kilograms per barrel of oil or it could be grams per megajoule. So again, we have to have standardization of how these things are presented on a unit basis. Then you're going to need a registry system, a system of registries to exchange and book this information so we can track these transactions through time. And then you need a governance organization. I think this is a really key piece too. We have to understand this is a journey and there are many commodities here and a lot of work that would have to happen.

And we also have to understand countries and exporters are different places of sophistication on this journey, and we have to meet them where they are if we want this to happen. And so through time, you're going to have to develop more guidance, more clear guidance, and you're also going to have to have something that we think is really important in this process, some sort of data quality assurance framework around with it. You're going to need verifiers to go through and provide that.

But because we expect various degrees of robustness in numbers, you can think of someone's very sophisticated, they own their supply chain, they've got meters on the entire system, they'd have a very high quality number, someone may not, and that isn't to preclude participation from someone that doesn't have that. We should help them on that journey, and that's up to the buyer and seller to agree whether the robustness of the number meets a threshold they're comfortable with. But again, that threshold, as people get more sophisticated through time, they'll perform better and better in terms of the robustness. And we need to tighten that threshold because what we want is more transparency.

I'll just change one tact here. One thing to think about, the biggest thing we often find when people do discovery on emissions, they go and put in and invest in monitoring equipment in the case of oil and gas, but others, and they start doing the math better, they find more, but they also find ways to reduce more, operational whoopses and what have you, and that drives a journey towards decarbonization that's incredibly low cost at the onset. So the first thing is upward revision and then a downward correction because they can get their hiring around it. So the discover and the robustness of this and is an important journey.

I'll make one more quick comment here is the scale of the systems. I think we have to understand how big these systems are we're talking about, these supply chains. Crude oil is an 80 million barrel per day system. I can't even fathom what that looks like, but the degrees... One penny out of $84 million in a differential is material. One kilogram and crude oil full life cycle will be north of 400 kilograms. One kilogram is 30 million metric tons. So do we think this system could squeeze the system and find efficiency? Absolutely. But it's based on the premise that we do see society generally wanting to incorporate this attribute, but the problem is we can't expect society to incorporate the attribute if we don't have the information to be able to make a choice between them.

Sam Humphreys:

There are some big numbers that I can't visualize in real terms. So where do we start now? Who's pushing this forward first? Is it coming from governments initiating policies to implement this, or is it coming from operators to establish that reporting and accuracies in their reporting first and their measurements, or is it all happening simultaneously?

Jonty Rushforth:

There's certainly a certain amount of everything everywhere all at once, for sure.

Kevin Birn:

It's having a moment, is the way I always say.

Jonty Rushforth:

Yeah, it's having a moment. But look, I think you say where do you start? There's a lot of parallel efforts and I don't think we should imply that no one's thought about all this until today. There's a whole massive amount of work happening in a huge different number of sectors. So whether you look at metals, whether you look at fuels, whether you look at upstream, all these different things, I think the issue is that there's a lack of consistency. And certainly one of the key points that we've been making is that there needs to be cross-sector consistency. There needs to be international consistency. And one of the things I think we strongly believe is the need for a coming together multinational outcome that starts to arrive at agreement on points that, frankly put, some of them may be arbitrary, but you just need an answer.

You can have arguments over boundaries and what's included and what's not, and everyone's going to have great reasons for taking their position. But if we have a consistent outcome, that's far and away the best because then we are all talking the same language. And the comparisons between supply chains, companies, sectors, all of that suddenly start to be relevant. So establishing that outcome or getting that outcome, that, I think, is one of the key challenges at the moment. The good news is, you say is it coming from industry or is it coming from government? We held a roundtable in Houston at CERAWeek in March, and one of the points that came out of that was certainly some of the folks from the industry side saying, "We think it's incumbent on the industry to be driving forward some of these outcomes because we know it's complex and we know that policymakers just don't know the state of the art. They don't have all the answers."

So it is going to be both of those working together. I think we've certainly had discussions with a number of multi-laterals that are pushing this forward, whether from the educational capacity building side or more from the let's do proof of concept, let's be more active. Ultimately, I do think that there needs to be a moment where there is some sort of body that is actually looking after that foundational standard that is pulling in all the information from different sectors. And I think we're pretty optimistic about that, that the right folks are coming together in the coming months rather than year.

Kevin Birn:

I would just add one of the things that I've seen, the space was pretty lonely five years ago. There was lots of people working on it, but it wasn't certainly getting the attention it was. Certainly, I would've never have imagined a roundtable at CERAWeek on it. By the way, there was also a carbon accounting reception, which from a lonely sport five years ago to actually be able to serve cocktails around it is a complete change of the world.

Hill Vaden:

Were there straws in the drinks at this party?

Jonty Rushforth:

You're going to mention manatees in a minute.

Hill Vaden:

Sorry, I've taken you off track of it.

Kevin Birn:

Yeah, I think one of the things we're hearing from companies is that they do see an opportunity and they're not afraid to compete on carbon and more and more we're hearing that. And they actually see that being able to differentiate themselves as being in their interest because of what Jonty talked about earlier, the degree of heterogeneity is very large. And they don't want to be considered average anymore. There's companies that invested and have positioned themselves to compete, and they want to be able to monetize the position that they feel they have in the market.

I think the other thing they see is a proliferation of compliance markets around the world. And so if you're a multinational that deals business with countless nations, having a different set of books for every country you do business in is deeply costly and problematic. And it doesn't actually spend money on the thing that those compliance markets are trying to get them to do, which is decarbonization. So alignment and efficiency and having one set of books saves them a lot of money, but also, the proliferation can also inhibit trade, and so alignment can ensure trade is protected as well.

And I think five years ago, it was a lot of people working on the right answer, the perfect answer and not necessarily knowing the end result or the objective. And I don't want to say that's true of everybody, but I think what I'm seeing and hearing today is people alignment on where we need to go and what the objective is and willing to take compromise and sacrifice on perfection to get to the objective, which is the information that buyers and sellers need to transact. So they know that's where they need to get. And so everything in between, and they've done the math for so many years, they know how to get there. So maybe we can be more flexible on the middle pieces to get the end result.

So I think the realization of what the objective is has really solidified. And I think the other thing that's playing into it on the government side is the realization that if this continues, it'll impact trade and the public purse can't pay for everything, so they need to find a way to unlock more capital, mobilize finance on decarbonization, and this has the potential to do that because if you can drive any sort of incentive into the market, it can mobilize more capital towards the problem.

Hill Vaden:

So how does this trickle down to the consumer that we see all sorts of different polls and whatever else that say, "Hey, I want to save the world, but I'm not going to pay more for gas or I'm not going to stop using a straw," or whatever it happens to be, pick the flavor of the moment? As we're thinking about carbon differentiation, is it a government and big business thing that results in increased cost to consumers, or does it save the world and reduce cost over time?

Kevin Birn:

Well, I'll give you one frame, and I like telling this example. When you go to a fast food restaurant like McDonald's and you look at the calorie count, that's an energy count. You make a choice. You make an informed choice, and sometimes you pay more to get a better calorie count, not always, but you make a choice, and you inform yourself of the choice. And sometimes I feel guilty about my choices. And I think that's what we're talking about here. In times of abundance, then you could see this becoming a differential in the market. In times of tightness and scarcity, you're going to take anything you can get in terms of when you think about energy cargos, but again, it's about providing that information to have a choice and getting people going down that pathway to being able to make informed decisions.

Jonty Rushforth:

I would slightly, not necessarily disagree, but at least say these kinds of elements in other commodities have not needed to lead to consumer choice. You don't at the pump say, "I want less sulfur in my petrol." And I don't know, maybe there should have been a moment [laughter] sulfur. And I guess conversely, there has been a period when you couldn't pick between leaded and unleaded, but you chose at the vehicle moment. So I think that actually it's not necessary to have consumer choice on this even though it's definitely possible.

Kevin Birn:

Yeah, I don't think we're disagreeing with each other. I don't think we're talking-

Jonty Rushforth:

Yeah, that's why I said I wasn't sure I'm disagreeing.

Kevin Birn:

A lot of the emission distributions we see are more like left log shaped. And so that means you have these tails of intensity that are very high, but they're generally outliers in low volume. And so you can affect significant change without changing the core of what you want to buy here.

Jonty Rushforth:

And so many of these things, it's actually you look at it... We've all seen flaring maps and like, "Oh, you seem to be burning a lot of gas there. Maybe you could just stop that. Maybe don't do... Yeah, it seems bad. Seems like a waste if nothing else." But part of the problem is there's no price on it. So if it becomes a differentiator and you can actually quite quickly take actions that are going to hit that log line as Kevin described there, then you have an outcome.

Kevin Birn:

It's an interesting analogy for you in the UK. Can you just send a little more over here, just burning it over there?

Jonty Rushforth:

Yeah, exactly. We could use that. We could definitely use that. Burning it up all up over there. But hell, this question is who pays, which I think is underlying what you're saying, is obviously important and no one's going to say, "Hey, it's free to have a cleaner outcome there in the supply chains." I do think it does drive investment. Obviously, any of these things drive investment. They drive new technologies and therefore drives growth in some ways. But I think the question is whether we're talking about stuff that's prohibitive. And at least one answer in that is this is differentiation. It's differentiation between different supply chains.

And what's apparent immediately is that newer supply chains tend to be lower intensity. And so what you might be doing is accelerating retirement of older supply chains in some instances, where actually you're therefore not talking about capital destruction in quite the same way. And actually maybe you're talking about renewal. So I think with all the energy transition, everyone wants to understand, "Okay, what is the impact on the trilemma? What's going to be the impact on actual the ability of people of economies to cope?" And the answer on this is actually we're not talking about things that currently you're not saying, "Okay, instead of using that crude that costs 60 bucks a barrel, you now have to use this one that's 200 bucks a barrel." Those aren't the comparatives. They're much, much narrower than that.

Sam Humphreys:

All right, well, just keeping an eye on time, we are going to wrap up. One question we always like to ask to finish things off, and we are recording mid-May 2025, is what is something that we should be looking out for over the next 6 to 12 months in this space? So Kevin, let's start with you. What do you think we should be watching for?

Kevin Birn:

Well, if you're in this space, you're probably going to see a ton of reports come out on it, but I suspect it will feature prominently at most climate events over the course of the calendar year and government meetings. We know it was at G20, we're hearing it might be at G7. We know it's being discussed as part of a COP stream. So I think it'll play almost every fora and you might see it more mainstream, as was the case last year that really put on the radar when Darren Woods of Exxon raised it at a COP. So I think you'll see more of that over the next six months.

Sam Humphreys:

Jonty, what about you?

Jonty Rushforth:

Yeah, for me, I think one of the most important moments will be when we have a proper cross-sectoral discussion starting to drive things. So I have full faith that we're not far off the moment when the folks that are driving this in metals, in mining, in agriculture, in fuels and upstream, where actually they're starting to talk together. And I think that'll start happening publicly soon. And when that does start to happen publicly, to me, that's the beginnings of this all coming together, really.

Hill Vaden:

All right, well, this is a great, I guess, a bit of an introduction, but the beginnings of a roadmap I did to reference the report. So thank y'all both for making time to talk with us and we look forward to watching this develop.