CO2 arbitrage will make heroes

To avoid capital destruction, simulate a business model under a correct shadow price of carbon

When an advanced economy enacts pollution control in a certain industry, there is a surge in demand and profitability for Indian competitors who face weak pollution control. These firms don't think deeply about the sources of their triumph. They feel they are geniuses who are being rewarded by the meritocratic market economy. In the advanced economy, the product tends to be imported, and that country does not have to deal with the emissions, which harm the local people in India. A similar story will unfold with CO2 emissions, with some twists in the tale.

Consider a manufacturing task that pollutes. This may be a factory that sends heavy metals into groundwater. Pollution control in the first world is relatively sound. A multi-decade process of tightening the rules has been underway, where factories are forced to install expensive pollution-control equipment. This drives up the total cost of production in an advanced economy locale.
 

The comparable pollution control in India is generally inferior. The rules are likely to demand less and their enforcement is weak. This creates an arbitrage opportunity. It is cheaper to produce in India. This reflects pollution arbitrage and not superior productivity.
 

Nobody says this explicitly. There is just a gradual evolution on the marketplace where the products of the Indian players look competitive on a global scale. The Indian firms gain market share and profitability. The local firms strut around, saying that they are geniuses. They show a rising curve of market share in a tough and globally competitive market. The firms would be lionised by the stock market once a few years of meteoric earnings growth are obtained. The equity-market community would come up with phrases like “structural strength in profitability and earnings growth”. A reverential tone would be adopted about the greatness of the management team.

Economic agents in the first world get to import these goods at a low cost, while the people in that economy do not face pollution in their backyard. The fact that (say) heavy metals are leaching into the Indian groundwater has no impact upon the decisions of a faraway buyer. The producers located in advanced economies are decimated, but they command no sympathy as the political pendulum in the West has shifted strongly in favour of environmental protection.
 

None of this is new. This idea has been around for a while. In an ideal world, the political system has to solve trade-offs between prosperity and health, and choose an optimal level of pollution control. There should be a connection between the statistical value of a life (which is lower in India) and the gains from polluting. The limitations of the Indian state often give us levels of pollution that are not grounded in cost-benefit analysis.
 

Let's apply this reasoning into emitting CO2. Global warming is extremely politically salient in all the advanced economies. All these countries are democracies where state power is used in ways that roughly represent the views of the people. The screws are thus being tightened, through many different mechanisms, upon CO2 emissions.
 

There is low interest in the Indian state in reducing CO2 emissions. This creates a pollution-arbitrage opportunity. Across numerous industries, we will see rising global market share for Indian firms that pollute. They will score sustained growth in profits and will be lionised as heroes.

There is, however, a key difference. CO2 emissions hurt the entire planet, regardless of where they come from. This is not like heavy metal poisoning of an aquifer in India, where the adverse impact is only local. Firms in advanced economies will raise hell in their political system when they face plant closure rooted in pollution arbitrage, which does not even improve global emissions.

Politicians in advanced economies will not countenance shifting jobs from their country to a production site like India, while obtaining no gains in emissions. Therefore, carbon-border taxation in advanced economies will happen. There will be recrimination, friction, delays and a gradual phase-in — which will create a moment of glory for firms that emit in India — but carbon-border taxes will surely come about to a point where they will close off the arbitrage opportunity.

The second part of the story will be the international relations complexity for India as a sustained emitter of CO2. The difference between the CO2 trajectory of the advanced economies versus that in India will become increasingly uncomfortable at the level of international relations. Pressure will mount upon India to change course. India needs help from advanced economies (say) in dealing with China. It will become increasingly uncomfortable for India to stay on course in emitting CO2.

ILLUSTRATION: AJAY MOHANTY

To summarise, Indian firms may at first gain tremendously from CO2 pollution arbitrage. With a lag, these arbitrage opportunities will close through a combination of carbon-border taxes and improvements in Indian pollution control. It would be good for Indian non-financial firms and their funders in the financial system to think strategically about this problem. If we merely look at performance as seen in the accounting data over a few quarters, this will justify substantial physical investment and allocations of financial capital. But if we understand the forces at work, we will enjoy this good fortune but know that it's temporary.

When we are execution-oriented, we climb the gradient of our local hill. In the Indian business landscape, there will be many quarters of business triumph which, if acted upon, will result in capital destruction. For non-financial firms and financial analysts, it would be good to start simulating each business in India as if it is operated under Organisation for Economic Co-operation and Development-levels of carbon taxation. Methods like goods and services tax vouchers are required to work out the full upstream carbon intensity of each firm. The sound business models are competitive and generate a good return on equity after paying a shadow price of about $100 per tonne of CO2.

The writer is a researcher at XKDR Forum