Market-Based Policy Instruments to Address Climate Change

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Literature Review

This section is divided into three chapters. Chapter 3 describes the climate change challenge, and it‘s relevance to business. The risks and opportunities presented by climate change are discussed followed by some of the key drivers that are motivating companies to respond to climate change. Chapters 4 and 5 describe the key theories that are used to construct the climate change response framework. The influence of bounded rationality to industrial organisations and its impact in strategic decision making are emphasised. Multi-criteria decision aid theories and their relevance in solving multi-criteria decision problems are presented in chapter 5.

The Climate Change Challenge

The literature surveyed starts with the general challenges of climate change , it‘s effects and impacts on humanity and how the human race has organised itself to adopt to and mitigate these effects. This is then followed by a closer look at how businesses in different industries and jurisdictions are approaching climate change adaptation and mitigation. The last section of this chapter looks at climate change response within the sugar, starch and aviation industries. These three industries are relevant to the two companies used in the case study.

Climate Change History

One of the hottest topics in business boardrooms and political round tables of our time is climate change – often loosely referred to as ―global warming‖. It brings together a diverse set of stakeholders from the science communities, researchers, risk and insurance, politics, economics, and the greater public (Raymond & Brown, 2011). Although actions against climate change risks, impacts and challenges for businesses, societies and the whole of humanity have only taken centre-stage in the last twenty years, the debate has been going on for more than two centuries. Interest and studies on climate change date as far back as the 19th century (Corner & Pigeon, 2010). Scientists predict that atmospheric concentrations of carbon dioxide will soon rise above preindustrial levels to 450 parts per million, which may lead to a global average temperature increase of between 1.8 and 4 degrees Celsius (Anderson & Bows, 2008) by the end of the 21st century relative to 1990 levels. A 4-degree temperature change could cause the collapse of essential regional ecosystems (IPCC, 2007b).
A significant amount has been written (Anderson & Bows, 2008; Stern, 2006; Taviv et al., 2007) about how we know that climate change is happening and what risks exist for business. As more evidence about the reality of climate change becomes available and the rift between proponents and critiques narrows, the debates and controversies have shifted to issues surrounding mitigation and adaptation (King & Lessidrenska, 2009; Winkler, 2010). Mitigation presupposes that people can make a concerted effort to reverse or at least arrest the anthropogenic effects of global warming and climate change (IPCC, 1996), while adaptation efforts are aimed assisting humanity, communities and whole countries to survive and thrive amid all the negative consequences brought about by climate change.

Definition of Climate Change

For the purposes of this thesis, the United Nations Framework Convention on Climate Change (UNFCCC) definition of climate change was used. According to UNFCC, climate change is:
―[. . .] a change of climate which is attributed directly or indirectly to human activity that alters the composition of the global atmosphere and which is in addition to natural climate variability observed over comparable time periods‖ (www.unfccc.org).
Dow and Downing (2011) and Stern (2006) defined climate change as related to a set of natural causes such as solar radiation, volcanic activity, continental drifts and the earth‘s tilt. According to Stern (2006), the natural causes of climate change are complemented by anthropogenic actions such as emissions of greenhouse gases from industry, combustion of fossil fuels, land-use change and deforestation. This combination of natural and human-induced causes in turn leads to greenhouse effect(e.g. global warming, ozone layer depletion, changes in socio-economic conditions) and consequences (e.g. disruptions in agriculture, sea level rise, increases in the frequency of draughts/floods) which disrupt the natural order and flow of life on planet earth.

 Taking Action against Climate Change

In his research, Filho (2009) arrived at the conclusion that ―Finding practical, workable and cost-efficient solutions to the problems posed by climate change is now a world priority and one which links government and non-government organisations in a way not seen before‖. The United Nations has been in the forefront of both researches aimed at understanding more on anthropogenic climate change, as well as efforts to address the challenges it poses. A joint effort of the World Meteorological Organization and the United Nations Environment Programme culminated in the formation of the Intergovernmental Panel on Climate Change (IPCC) in 1998 – a world body that evaluates the risks of climate change. The IPCC has found worldwide acceptance and recognition since its inception (Dow & Downing, 2011; Winkler, 2009; Filho, 2009). This led to the tabling of the UN Framework Convention on Climate Change (UNFCCC), which was adopted on 9 May 1992 by the Intergovernmental Negotiating Committee, an arm of the IPCC. The stated objective of the UNFCCC is to achieve stabilisation of the concentrations of six greenhouse gases (GHG); carbon dioxide, methane, nitrous oxide, ozone, water vapour and halocarbons, which are considered to be the main causes of climate change, in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system. In early June 1992, the UNFCCC was opened for signature and entered into force on the 21st of March 1994. The UNFCCC has over 200 parties and observer states, making it one of the most universally supported and most influential multilateral environmental agreements. The South African government ratified the UNFCCC in 1997.
Negotiated under the UNFCCC, the Kyoto Protocol was agreed in Kyoto, Japan, in December 1997. The Protocol established legally binding commitments for reducing greenhouse gas emissions from Annex I countries (industrialised/developed countries) as well as outlining general commitments for all signatories aimed at meeting the ultimate goals of the UNFCCC (http://unfccc.int). The Kyoto Protocol entered into force in February 2005 and set targets for industrialised countries ―with a view to reducing their overall emissions of such gases by at least 5% below existing 1990 levels, in the commitment period 2008-2012‖ (http://unfccc.int). Negotiations on a new agreement to replace the Kyoto Protocol are on-going. Under the Bali Roadmap of 2007, a new global agreement was due to be reached at the end of 2009 in Copenhagen. Instead, the negotiations resulted in the ‘Copenhagen Accord’, which allowed both developed and developing countries to make non-legally binding commitments for 2020. Negotiations on an official post-2012 agreement are continuing after the COP 17, Durban 2011 Conference.
Although these climate change responses are national-level commitments, in practice most countries will delegate their emissions targets to individual industrial entities, such as utilities and manufacturing companies. Thus, finding practical, workable and cost-efficient solutions to the problems posed by climate change is now a world priority for business as well. Stern (2006) has reiterated the fact that a sound understanding of the economics of climate change is needed in order to underpin an effective global response to this challenge. Adapting to climate change is important (Tompkins & Adger, 2005) so as to reduce vulnerability (Dow & Downing, 2011) and to understand and map out the opportunities it presents.

The Complexity of the Climate Change Challenge

Scientific uncertainty about natural climate variability and the consequences of global warming on the natural climatic system (Raymond & Brown, 2011) is creating uncertainty about future impacts and feedbacks of climate change on social and economic structures, which further depend on human adaptation (Dow & Downing, 2011). In a warmer world, people’s living conditions will be seriously challenged. Global food security is expected to worsen as a result of climate-related drought and weather-related extremes (IPCC, 2007b), compounded by a world population that is estimated to balloon to 9 billion by 2050. For these reasons, climate change poses the greatest problem for people who are already battling with marginal conditions. Land-use change is one of the major challenges that societies will have to grapple with in a warmer world (Raymond & Brown, 2011). The area of degraded or marginal lands is estimated to increase by 17% over coming decades as a result of global warming (World Bank, 2007).
The uncertainty associated with climate change makes it difficult for the public and private sectors to respond optimally (Tompkins & Adger, 2005; Dessai & Hulme, 2007). On a governmental level, uncertainty hampers the design of appropriate mitigation and adaptation strategies. On the individual and company level, uncertainty creates difficulties in handling possible future costs arising from climate change. Raymond and Brown (2011) contended that uncertainty increases the influence of the institutional environment (i.e. influence of industry fads that come and go over time, competitors, industry associations, consumers, NGOs, regulatory agencies, and the media, etc.) and reduces the impact of economic and competitive factors (the “task environment”). Radically new technologies that are economical, environmentally benign, and virtually carbon neutral coupled with the finances, institutions and leadership is required to address the challenge effectively (Dow and Downing 2011). Given this high level of uncertainty concerning climate science, technological and market developments, and policy responses, businesses cannot easily make rational, objective calculations of their economic interests and appropriate strategic responses. The problem is not that investment decisions are taken under conditions of risk; rather, planning scenarios contain assumptions and predictions about research and development costs, technological developments, consumer behaviour, competitors’ reactions, and regulatory responses that are shaped by organisational fields and are not stable over time (Dow & Downing, 2011).

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Market-Based Policy Instruments to Address Climate Change

Cap-and-Trade

Two market-based policy instruments, emissions trading and carbon taxation have been widely accepted and adopted by many governments. Emissions allowances (caps) are tradable commodities entitling the holder to emit certain quantities of CO2 equivalents (Dubrowski, 2010). To be in compliance, entities must hold quotas greater than or equal to their cap (Bartos, 2009). Supply and demand dynamics determined pricing (Dubrowski, 2010) which has implications for business. Entities that find creative ways to keep their emissions below their limit could potentially earn revenue by selling their excess credits (Millard-Ball, 2009), while those entities emitting above their cap would earn the right to emit by purchasing quotas (Murray et al., 2009) from the cap-and-trade market, such as the European Union Emissions Trading Scheme (EU ETS), which is a grouping of 25 European Union member states or home-grown systems, like Shell‘s Tradable Emissions Permit System.
Carbon markets also offer project based transactions (Millard-Ball, 2009) where carbon emissions are traded through credits from projects birthed to offset emissions via such channels as renewable energy generation, carbon sequestration, reforestation or energy efficiency – called the Clean Development Mechanism (http://cdm.unfccc.int). Joint Implementation (JI), (http://ji.unfccc.int) on the other hand, allows financing of projects between Annex-1 countries and earns the financier the Emissions Reduction Units (ERUs) type of carbon credits. Trading programmes can be implemented on a mandatory (e.g., EU ETS or Australia‘s Carbon Pollution Reduction Scheme) or a voluntary basis (e.g., Gold Standard Carbon Emissions Reduction or the Chicago Climate Exchange).

Carbon Taxes

Taxation of greenhouse gas emissions is the second policy instrument which fixes the marginal cost for carbon emissions and allows quantities emitted to adjust accordingly (Litman, 2010). Carbon taxes are based on fossil fuel carbon content. They place a price on emissions by levying a charge on every ton of carbon dioxide or equivalent emitted, thereby creating an incentive for GHG emitters to find creative ways to reduce emissions, which is the ultimate goal of all these interventions. Proponents of carbon tax (Litman, 2010; Tol & Verde, 2009; Lee, 2008) argue that direct levying of taxes on business entities encourages firms to rethink their core business models and seriously consider alternative energy sources. They stress that there are economic benefits, both at corporate and societal level, to be realized by businesses being more efficient and innovative.
Much of the debate around carbon taxation centres around its administration by governments (Gerlagh et al., 2009; Yohe et al., 2007; Yusuf & Resosudarmo, 2007), as well as the effects that further policy actions could have on economic growth and development, particularly for the developing and least developed nations. Economists all over the world have developed sophisticated models (Nordhaus & Bayer, 2000; de Leyva & Lekander, 2003) to model the costs, benefits and impacts of different policies on businesses, industries, whole economies and/or regions.

Other Instruments and Measures

A carbon tax or a cap-and-trade system by itself will not solve this very complex challenge. Governments the world over are adopting a mix of instruments (Dow & Downings, 2011; Devarajan et al., 2009) in addition to other measures and standards that are not based on the actual amount of emissions, such as standards and regulations to increase energy efficiency, other economic instruments such as incentives and duties on energy-efficient equipment, encouraging the development and use of renewable energy. Adaptation strategies aimed at water availability and human settlements and food security (Dow & Downing, 2011; Taviv et al., 2007) are being brought into the climate change adaptation and mitigation stream.

The Relevance of Climate Change to South African Businesses

South Africa has been included with such developing economies as India, China and Russia as participants who, although not classified as developed economies, are contributing as much to climate change (Winkler, 2009; King & Lessidrenska, 2009) and could have the resources required to mitigate further increases in greenhouse gas emissions. South Africa is a relatively heavy GHG emitter, contributing 65% of Africa‘s and 1.5% of the world‘s carbon dioxide emissions (http://cdiac.orni.gov). It is ranked as the 12th heaviest emitter of GHG in the world due to energy-intensive sectors in the economy e.g. smelting, deep mining, coal-to-liquids fuel generation and a heavy reliance on coal to produce electricity (www.climate.org). The carbon dioxide emissions distribution in South Africa is due to the energy supply mix which is heavily skewed towards coal (King & Lessidrenska, 2009). Of the country‘s total consumption, about 75% is coal and 20% oil, with the balance being made up of natural gas, nuclear, hydroelectricity and other renewables (www.bni.org).
As an active participant in the Kyoto Protocol, South Africa demonstrated its commitment by developing a Long-term Mitigation Scenario (Winkler, 2008). The conditional pledge by President Jacob Zuma to reduce national GHG emissions by 42% by 2025 (www.environment.gov.za) during the 2009 Copenhagen Conference on Climate Change and the hosting of Conference of Parties (COP) 17 in November 2011 is further incentive for South African companies to seriously consider climate change impacts.
These undertakings, together with the recent introduction of climate change measures such as the SA Climate Change Response Strategy and the introduction of a vehicle carbon tax in September 2010, is indicative of the seriousness with which businesses should addressing the climate change challenge response. Climate policy in South Africa is gaining momentum and frameworks for greenhouse gas emissions reduction and trading are emerging (www.environment.gov.za). In the words of John Varley, the Group Chief Executive of Barclays, ―Climate Change is a business issue. It has joined the list of top risks and opportunities.‖ (http://www.independent.co.uk). The proactive engagement of business in climate change, Varley said, is in businesses‘ own interest. He also made the point that in today‘s integrated economy, businesses are more globalized than governments and are thus indispensable in this endeavour.
The Department of Environmental Affairs Deputy Director, Joanne Yawitch, noted that, ―Operating in a ‗carbon-constrained world‘ has brought up issues of innovation and competitiveness that businesses in South Africa need to recognise and deal with (www.environment.gov.za). Speaking at the University of South Africa‘s press Trialogue panel discussion in February 2010, Webber Wentzel Attorneys‘ partner Johan Scholtz emphasised that companies that take climate action early will be best placed to take advantage of the opportunities and protect themselves from the negative aspects of climate change. He highlighted the myriad of climate-related risks facing corporations, including: operational delay risks; regulatory; tax; reputational; insurance; and litigation risks.
According to Claude Fussler, Programme Director for the Caring for Climate (C4C) section of the United Nations Global Compact (www.caring4climate.org), businesses from all regions and sectors have already started their journeys towards energy efficiency, innovation and GHG emission reductions. Fuelled by opportunities to reduce energy costs, secure energy supply, protect business from climate change risk and damaged reputations, generate new revenues or enter into new industries; carbon management has become a strategic imperative for many organisations (www.pewclimate.org). In fact, this drive towards food and water conservation, energy efficiency and carbon reductions, combined with a proactive management of systemic climate risks, is defining a new level of environmental stewardship (Dow & Downings, 2011). Long-term investors, asset managers and analysts such as Bloomberg and Google Finance are beginning to integrate these considerations into investment analysis and decision-making such as the FTSE CDP Carbon Strategy Index (www.ftse.com) and the Markit Carbon Disclosure Leadership Index (www.markit.com). Venture capitalists and corporate R & D divisions are investing in different ―clean technologies‖.

Business Impacts of Climate Change

Exposure to climate change can be positive, negative or a combination of both, depending on the industry and the company-specific variables (Schultz & Williamson, 2005). Climate change presents both risks and opportunities for business. The impacts of these risks and opportunities vary significantly among businesses, depending on the source and exposure to greenhouse gas emissions (Reyers et al., 2011), i.e. direct emissions as a result of a company‘s own operational activities, or indirect emissions such as those along a business‘ value or supply chain, e.g. purchased electricity, resource availability, resource costs and security of supply, changes in customer needs as a result of changes in economies, or weather induced requirements (Schultz & Williamson, 2005).
Business risks from climate change include physical impacts resulting from volatile weather conditions which are resulting in extreme weather patterns (droughts, wildfires, hurricanes, monsoons, typhoons), rising sea levels, melting ice glaciers, and the resultant effects on animal and human health and well-being (Dow & Downings, 2011). A key risk for business is access to resources and risks to capital stock, such as infrastructural damage due to sea level rise. As a consequence of the above, there are negative impacts on business resources, personnel, insurance markets and corporate business models (www.pewclimate.org). Mounting legal and regulatory pressures and litigation is being augmented by country level or industry level investment risks and increasing public and stakeholder activism affecting business reputation and brand equity (Schultz & Williamson, 2005).
Opportunities and Risks
For the agile firm, climate change is also presenting numerous opportunities including revision of business models to allow for greater efficiencies in terms of materials and energy, waste, water, etc.; development of new and cleaner technologies, products and services, industries and participation in whole new industries which were non-existent a decade ago; participation in carbon markets and emissions trading giving rise to new revenues; strengthening of reputation and the brand by managing stakeholder requirements, advocating climate change response and making contributions to solving climate change issues (Raymond & Brown, 2011).
Climate change risks cut across almost every industry, whether directly or indirectly. The greatest liability in carbon exposure is in carbon-intensive sectors such as oil and gas, basic resources, utilities; heavy manufacturing where carbon costs could be direct or be due to purchased electricity or passed down through the supply chain in the form of higher prices (www.irrcinstitute.org). Some of the major risks are explained below.

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Legal and Regulatory Risks

As emission reduction requirements become more well-defined and stringent, non-compliance risks and consequent litigation risks rise. Regulatory risks are on the increase the world over as governments take heed of the calls to action through treaties such as the Kyoto Protocol; regulations; national resolutions or local government and federal regulations. These national and international commitments are creating environments where the need for dialogue (Griffiths, et al., 2007) between governments and the private sector are becoming increasingly unavoidable, resulting in policy positions that are forcing corporations to seriously consider the impacts of climate change on their businesses.
The lack of climate change legislation or the slow enacting thereof in some jurisdictions is creating discomfort within the corporate community (www.nbi.org). This has been a subject of much debate in South Africa. A key question has been posed: ―Supposing a proactive company takes action to reduce GHG ahead of legislation. Will the authorities take cognisance of the new baseline when they calculate an entity‘s emission levels and the required limits?‖

Competitiveness Risks and Opportunities

With adverse weather conditions (Khandekar et al., 2005; Stern, 2006), changes in climate may cause damages to buildings, interruptions to infrastructure and supply chains. It may also change travel and migration patterns, affecting such business decisions as location decisions and geographic markets to pursue. For example, the European Union Directive on Aviation (http://ec.europa.eu) is causing viability challenges for airlines. The introduction of climate change specifications on goods imported into the EU and the imposition of taxation on imports through Border Tax Adjustments (BTAs) poses serious trade barriers (http://ec.europa.eu). Businesses also face the obvious risks of changes in the prices of oil, gas, electricity and, where required, carbon. To mitigate these risks, companies can either reduce their exposure or hedge the risk (Mills, 2005). Such attempts to pass through carbon costs will add onto the prices of goods and services, making products uncompetitive on global supply chains.
Product and Market Diversification
The pursuit of diversification as a business strategy – the need to enter into new businesses; shift away from low margin, low growth or mature industries, distribute risk, utilise excess productive capacity, compensate for technological obsolescence, reinvest earnings into high growth industries (Carbon Trust, 2006), are key drivers for businesses to respond to climate change. By investing in efficient technologies and developing sufficient skills to support value addition e.g. significantly reducing energy costs, streamlining the supply chain and meeting stakeholder expectations, benefits will trickle to the bottom-line. Several companies are investing in research and development to come up with environmentally-friendly products with new revenue streams (e.g. SunChips by Frito-Lay: www.sunchips.com) and services which open up new markets and industries. Companies are seeking market opportunities in developing new technologies, often backed by venture capitalists and ―green capital‖. Some of those companies have grown into publicly traded, large organisations, e.g. SolarWorld (www.solarworld.de). Other investors seek specific opportunities in renewable energy assets, such as solar, wind farms, tidal waves, biomass or co-generation promising more stable growth.

Investment Relations – Risks and Opportunities

Financial markets are calling for more robust corporate disclosure of carbon intensity so as to factor the carbon profiles into capital allocation and investment decisions (www.caring4climate.org). There is also increasing pressure on businesses to report non-financial issues related to climate change, through mechanisms such as The Carbon Disclosure Project (CDP). The cost of capital will likely be influenced by a company‘s ability to mitigate exposure to liabilities posed by a carbon-constrained world (CDP, 2012). Bank-lending criteria that take cognisance of climate change mitigation have already been incorporated by leading multi-national financing institutions (www.worldbank.org). Investment decisions in assets such as power stations, industrial plants and buildings are already being driven by carbon intensity considerations. The cost of capital associated with carbon-intensive investments is an additional risk that can become more prominent in the future. Discounting of share prices for companies poorly placed to compete in a carbon-constrained world is already taking place in most of the Annex I countries (www.pewclimate.org). Thus, financial exposure from climate change affects business‘ ability to raise capital and impacts on credit ratings.

Table of Contents
Declaration of Authenticity
Abstract
Thesis Roadmap
List of Figures
List of Tables
1. Introduction
1.1 Overview of the Study
1.2 Overview of Multi-criteria Decision Analysis
1.3 The Concept of Bounded Rationality
1.4 Research Problem, Research Questions and Contributions of Study
2. Methodology
2.1 Research Methodology
2.2 Design, Instruments and Decisions
2.3 Comparative Case Study
2.4 Sampling Strategy
2.5 Mixed Method as a Strategy of Inquiry
2.6 The Characteristics of Companies Studied
2.7 The Behavioural Constructs Examined
2.8 Construction of the AHP Framework
2.9 The Research Process
2.10 Data Analysis
2.11 Integration of Findings
2.12 Validity and Reliability of Research
3. The Climate Change Challenge
3.1 Climate Change History
3.2 Definition of Climate Change
3.3 Taking Action against Climate Change
3.4 The Complexity of the Climate Change Challenge
3.5 Market-Based Policy Instruments to Address Climate Change
3.6 The Relevance of Climate Change to South African Businesses
3.7 Business Impacts of Climate Change
3.8 Drivers of Corporate Climate Change Response
3.9 Corporate Climate Change Response Strategies
3.10 The Starch Industry and Climate Change Response
3.11 Sugar Industry
3.12 The Aviation Industry
4. Bounded Rationality in Strategic Decision Making
4.1 Rational Economic Man Theory
4.2 Bounded Rationality Explained
4.3 The Case for Bounded Rationality in Industrial Organisations
4.4 Behavioural Finance and Behavioural Strategy
4.5 Why Bounded Rationality is Relevant in Climate Change Response
4.6 Procedural Rationality and Strategic Decision Making Process
4.7 Strategy as Decision Making
4.8 The Behavioural Theory of Organisations
4.9 Criticism and the Co-evolution of Normative and Behavioural Theories
5. Multi-criteria Decision Aid (MCDA)
5.1 Introduction to Decision Support Methodology
5.2 Multi-criteria Decision Aid Methods
5.3 Mathematical modelling of a MCDM Problem
5.4 Limitations of Cost-Benefit Analysis Models in Climate Change Response
5.5 Analytical Hierarchy Process (AHP) as a MCDA Method
5.6 Why the Analytical Hierarchy Process Was Chosen
6 Findings
6.1 The Cases
6.2 General Findings
6.3 Similarities in Climate Change Response Drivers and Motivations
6.4 Similarities in Climate Change Response Initiatives
6.5 Differences in Climate Change Response Drivers and Motivations
6.6 Differences in Climate Change Response Initiatives
6.7 Summary of Findings
7 Analysis and Discussions
7.1 Business Risks Driven by Climate Change
7.2 Business Opportunities Driven by Climate Change
7.3 Climate Change Response Initiatives
7.4 Technology Choices
7.5 Considering all Plausible Options
7.6 Sources of Information for Evaluation of Options
7.7 Barriers to corporate climate change response
7.8 Product and Market Diversification and Vertical Partnerships
7.9 Towards an Interpretive Model of Climate Change Response
7.10 The Corporate Climate Change Response Framework
7.11 Using AHP as a Strategic Decision Making Aid
7.12 Conclusion of the Framework
8 Conclusions and Further Study Recommendations
8.1 Conclusions
8.2 Contributions of the Study
8.3 Study Limitations and Future Research Directions
9 References
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