Brown Zombies and environmental productivity
Watching the Tides - Marchel Alexandrovich
When it comes to climate change, one implication from the US election is that it pushes global net zero further out of reach. The details of what climate policy will look like under Trump are yet to be flushed out, but it is obvious that the phasing out of fossil fuels and cutting GHG emissions will not be at the forefront of what the new administration focuses on. Lower emissions may yet materialise, if the costs of renewables continues to fall and there is action at the US state level. But at the federal level, tackling climate change will not be a priority.
Politically, Europe is in a different space. But even if its own commitment to net zero remains firm (which could widen the gap between US and European energy prices even further; see our recent Substack on Mario Draghi’s report), economies in the region, and elsewhere in the world, must prepare for the likelihood of more frequent and extreme climate related events. Which means that investors need to start paying attention to the ability of the individual governments to absorb climate-related costs, and their impact on government debt and sovereign bond yields. This idea underpins our own Saltmarsh Economics Climate Index (SECI) – which now scores almost 120 economies on climate risk grounds – and our own sovereign bond asset allocation model (send us a message if you would like to learn more).
On the specific topic of GHG emissions, in a note earlier this year we took a deep dive into the subject of EU environmental productivity. We started with two main building blocks: GHG emissions and sectoral Gross Value Added (GVA). Divide the level of emissions by euros of value added, and what’s derived is a measure of ‘emissions intensity’.
When we analysed the latest Eurostat data, two results emerged. Given that EU emissions are down almost 25% since 2011 while economic output continues to rise, the first result is obvious: every EU country has seen an improvement to its environmental productivity over the last ten years (see first chart below). What is more useful, however, is the finding that environmental productivity levels are converging.
Emissions intensity by country: 2022 vs 2012
Source: Eurostat and Saltmarsh Economics
In other words, countries with lower levels of sectoral environmental productivity are improving faster than countries with higher levels of productivity. The charts below show the weighted standard deviation of emissions intensity data across the various sectors of the euro area economy (i.e. we measure the dispersion across the 20 countries, across each of the 70 sectors of the economy).
Dispersion of emission intensity across sectors of the euro area economy
Source: Eurostat and Saltmarsh Economics
From a top-down perspective, the differences in emissions intensity provide a roadmap of how much national emissions can be reduced by when there is a convergence toward a single level of environmental productivity. For instance, if the emissions intensity of every sector in Germany, France, Italy and Spain matched the environmental productivity of the weighted euro area average, this improvement would help drive Germany’s emission lower by 11%, France’s by 6%, Italy’s by 13% and Spain’s by 18%. Or, if the bar is set higher - say, we use the 5th best level of emissions intensity as the benchmark - then the combined emissions in Germany, France, Italy and Spain would fall by almost a quarter relative to where they are.
Having come up with these estimates from a top-down macro perspective, we were interested to see the report recently published by the Central Bank of Belgium, which similarly focused on the changes in environmental productivity, but this time using bottom-up data on emissions of individual companies.
In the study, the authors split their sample of companies into two groups: those with normal emissions relative to output (the top 80% when it comes to carbon intensity) and those they call “brown zombies” (in the bottom 20%).
In their sample, “brown zombies” represent less than 10% of total value added generated. But if their output was reallocated to other firms, then the overall emissions in the economy would decline by around 40% relative to where they are under the current structure of the market.
Cumulative share of total emissions of firms included in the dataset
Source: Central Bank of Belgium
In summary, it is often difficult to square macro trends with what may be happening to activity at the individual company level, but on this occasion, the research points in the same direction. Our own work focuses on the top-down country data, and the improvements that could be made if countries with low environmental productivity in certain sectors adopted the practices of the countries with higher productivity. While the research from the Central Bank of Belgium explores the effects of reallocation of production from environmental laggards to environmental leaders at the firm level. The conclusion and implications, however, are essentially the same: with investment, even in the absence of further advancements in technology, there is significant scope for EU (and global) emissions to fall much further from their current levels.
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