Wall Street Journal readers last week encountered a full-page advertisement calling for a "consensus climate solution" in America "that bridges partisan divides, strengthens our economy and protects our shared environment." Specifically, the ad encourages an escalating carbon tax that, among other things, includes border carbon adjustments (also known as "carbon tariffs"). Among the individual founding members listed of this "Climate Leadership Council" are famous environment and green energy advocates such as former NYC mayor Michael Bloomberg, former U.S. energy secretary Steven Chu, Silicon Valley investor Vinod Khosla, and former Treasury secretary Lawrence Summers. So far, so normal. Less expected is some of the names on the list of corporate founding members, including oil and gas majors BP (NYSE:BP), Exxon Mobil (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), and Total (NYSE:TOT). Four of the world's largest publicly-traded fossil fuel companies are advocating for a U.S. carbon tax, and less than three weeks after the Trump administration announced that it was withdrawing the country from the Paris Climate Agreement. The timing is unlikely to be coincidental.
It has not taken long for some observers to argue that The Climate Leadership Council is merely an attempt by large natural gas producers to use environmental law to expand their market share. Coal's carbon footprint is approximately twice as large as that of natural gas per unit of energy and, under a carbon tax, the first order of business for most coal-fired electric utilities would be to transition to natural gas. An absence of utility-scale battery storage outside of southern California has also caused natural gas to serve as a critical back-up to new renewable energy capacity, with every new megawatt of the latter being supported by more than a megawatt of new natural gas capacity. The right-wing The Daily Caller's article on the news points out that:
"A carbon tax would also encourage more utilities, at least in the short-term, to use more natural gas, which emits less than coal. BP, Exxon, Total and Shell are all heavily invested in natural gas production and trading.
Oil companies are also putting money into green energy technologies, including solar, wind and biofuels. Exxon recently announced a major scientific breakthrough in its effort to commercialize algae-based biofuels."
An article in Nature published earlier this year points out that the carbon tax would "hit coal users the hardest, followed by oil and natural gas users." A Chicago Tribune editorial argues that:
"Making fossil fuels more expensive would stimulate conservation, speed the shift of power plants from coal to natural gas and make renewable fuels more price-competitive. The result would be a steady reduction in carbon emissions, which in turn would put a brake on global warming."
The general consensus in the comments to Seeking Alpha's own piece on the advertisement has a similar perspective, with the most-liked reply (by user fhbecker) stating that "think XOM, TOT, RDS & BP will profit by replacing more worldwide coal usage with natural gas. Perhaps a good outcome."
The carbon border adjustment
Natural gas would certainly be expected to increase its market share under a carbon tax, at least during the initial years of the program. I note that none of the country's independent shale gas producers are listed as founding members, however, which leads me to believe that the real motivation behind the majors' memberships is in the details of the plan. Specifically, I refer to the fourth pillar of the ad's "carbon dividends program," which calls for "border carbon adjustments to level the playing field and promote American competitiveness."
The term "border carbon adjustment" is a euphemism for an import tariff that is applied based on the carbon footprint of imported goods. An important concern with any type of carbon constraining program, whether a carbon price via cap-and-trade or a carbon tax, is that of carbon leakage. Carbon leakage occurs when manufacturers in a carbon-restricted economy move overseas to a less-regulated economy. A prominent historical example is that of the leakage that has flowed from the European Union under its Emissions Trading Scheme to China. Leakage can even cause global carbon emissions to increase if manufacturing leaves an efficient sector for a less-efficient sector (again, the EU to China). Adding insult to injury, many of the manufactured goods are then exported to the country in which they were made pre-leakage.
Carbon tariffs mitigate carbon leakage by ensuring that all goods that exist within a market have the same tax applied to them regardless of their place of origin, much as sales taxes apply to both domestic and foreign goods. They also mitigate concerns about carbon taxes resulting in net job losses in the host country due to the outsourcing of manufacturing. Their final attribute is the one that I consider to be the most important to investors in the wake of Mr. Trump's decision to withdraw the U.S. from the Paris Agreement, however: carbon tariffs can be used as a de facto trade sanction to encourage the country on whose goods they are imposed to implement their own carbon tax (or join a multinational carbon constraint program).
Join up or pay up
Mr. Trump, by removing the U.S. from a global agreement to restrict carbon emissions, has exposed the country's exports to the threat of carbon tariffs in the destination markets. Left-leaning publications have been quick to emphasize the new risk since the start of June. Quartz writes that:
"Trump could face stiffer penalties for his decision than former presidents Bill Clinton and George W. Bush received for their U-turn on Kyoto. One way to retaliate would be to levy a border-adjustment carbon tax or tariff on American exports. If the rest of the world has agreed to reduce their emissions, the renegades could be forced to pay a price if they want to continue trading with Paris-bound partners."
Of concern to investors should be the willingness of politicians in the rest of the world from both sides of the political divide to advocate for the imposition of carbon tariffs on American exports. Former French president Nicholas Sarkozy wants the European Union to impose a tax on all American goods at the EU border. In 2009 German Chancellor Angela Merkel called for the United Nations to support the imposition of carbon tariffs on goods from any countries that "fail to back international efforts to fight global warming." More recently, Mexico's undersecretary for environmental policy and planning under the Nieto administration told The New York Times that "a carbon tariff against the United States is an option for us." Even China's government officials have said that they would consider a carbon tariff in response to an American withdrawal, which is especially ironic given that a big policy debate in the U.S. as recently as 2009 was over how to best impose carbon tariffs on goods from China and India under the American Clean Energy and Security Act.
Of the oil majors on the Climate Leadership Council's corporate founding members, only Exxon Mobil is an American firm, and its operations span multiple continents. The other three are European multinational firms with heavy exposure to the U.S. market. If these companies would benefit from increased global natural gas consumption at the expense of coal demand, they are equally exposed to the creation of new barriers to trade between one of the planet's largest economies and the rest of the planet. It is no coincidence that the other corporate founding members such as The Procter & Gamble Company (NYSE:PG), PepsiCo (NYSE:PEP), General Motors (NYSE:GM), and Johnson & Johnson (NYSE:JNJ) are also multinationals that would not necessarily benefit from increased natural gas consumption (if anything, those that are reliant on plastic packaging could actually suffer if prices increased due to stronger demand).
Admittedly, carbon tariffs are not as simple to impose under the World Trade Organization's General Agreement on Tariffs and Trade (GATT) as some in the media have made it out to be. As a general rule, a country cannot treat one WTO member any differently from other WTO members. However, there is an environmental exception, and some legal experts have argued that linking the tariff value to the carbon tax value or, better yet, applying an identical carbon tax to similar imported and domestic products without regard to their respective carbon footprints would be likely to survive WTO scrutiny. It should also be remembered that earlier concerns about the legality of carbon tariffs under the WTO existed at a time when only the European Union and the U.S. were expected to be taking steps to restrict their carbon emissions; today 149 countries have ratified the Paris Agreement and a further 48 have signed onto it.
The Obama administration's decision to join the Paris Agreement was contentious in the U.S. and his successor's decision to withdraw from it has been met with strong support from many energy companies. That said, America's withdrawal from it has exposed the country's exporters, including multinational energy firms, to the new threat of carbon tariffs. I believe that The Climate Leadership Council's corporate founders' advocacy for a carbon tax is based as much on their interest in having a seat at the table when global emissions policies are being drafted as much as it is to see the market share of natural gas increase against that of coal (if not more so). Mr. Trump's decision has created yet another layer of future uncertainty for America's exporters that their investors should monitor. This is especially true for investors in multinational energy firms such as BP (72 countries of operation), Exxon Mobil (53 countries of operation across six continents), Royal Dutch Shell (70+ countries of operation), and Total (130+ countries of operation), given their scale and nature (fossil fuel extraction and processing) of their operations.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long XLE.