Net Zero Readiness Report: Economy

There are several factors that look likely to constrain investments by governments and businesses on decarbonization over the next couple of years.

Many governments worldwide increased spending sharply on healthcare and economic support for individuals and businesses during the COVID-19 pandemic. Following the Russian government’s invasion of Ukraine in February 2022 and subsequent increases in the price of natural gas, many European countries spent heavily to subsidize household energy bills.¹

Such support has led many governments to borrow more, with global public debt increasing from 84 percent of gross domestic product in 2019 to 92 percent in 2022 according to the International Monetary Fund.² Adding to this, rising interest rates have further increased the cost of servicing debts for governments. “It leaves less room for them to spend on meeting net zero targets,” says Yael Selfin, Chief Economist, KPMG in the UK.

In addition, economic growth is relatively weak in many countries, constraining government tax revenues and putting downward pressure on profits for businesses in some sectors, which make them less able to pursue green investments.
Higher interest rates also increase the cost of borrowing by companies to fund such investments. Finally, elections due in several major economies over the next two years add to the policy uncertainty as they could lead to changes in environmental policies, making companies more likely to wait before embarking on large projects.

Carbon border adjustments

Many jurisdictions have set up emissions trading systems (ETS), also known as cap-and-trade systems, that limit or cap the total emissions that certain companies or industries are allowed to emit annually. The amounts are covered by tradeable allowances or permits, which allow the holder to emit a specified volume of greenhouse gas emissions. This sets a price on carbon by requiring companies to buy permits that cover the volume of emissions emitted during a given period or face substantial penalties.

The schemes aim to reduce emissions by having a limited number of permits available that are gradually reduced, increasing the carbon price over time. Such schemes, which typically start by covering just the largest producers of greenhouse gases, provide a long-term financial justification for cutting emissions while allowing companies to choose how they do this. However, due to increased costs from both emissions trading and decarbonization efforts, local companies can potentially be undercut on price by importers from jurisdictions that do not have equivalent carbon pricing systems, a problem typically referred to as ‘carbon leakage’. 

The EU established the world’s first ETS in 2005, which now covers around 15,000 stationary installations producing some 36 percent of the bloc’s greenhouse gas emissions and including non-EU countries Iceland, Liechtenstein and Norway.³ The EU is strengthening EU ETS by extending its scope to additional sectors, phasing out free allowances and accelerating the reduction of the number of allowances in circulation, but all this heightens the risks of carbon leakage. 

To address this risk the EU has introduced the world’s first carbon border adjustment mechanism (CBAM), which will require affected companies importing specified goods into the EU to buy certificates with prices based on the EU ETS weekly auction price adjusted for any recognized mandatory carbon price effectively paid in the country of origin. The intention is that importers will pay the same for the carbon emissions required to produce goods as producers within the EU, creating a level playing field and preventing carbon leakage.

EU CBAM’s transitional phase, starting on 1 October 2023, requires importers to report on emissions embedded in specified goods in a limited number of carbon intensive sectors: cement, iron and steel, aluminum, fertilizers, electricity and hydrogen.⁴ Full implementation of the mechanism, under which importers will have to buy CBAM certificates, is linked to the phasing out of free allowances currently provided under EU ETS and is planned to start on 1 January 2026. Before this the EU will assess the mechanism’s functioning with a view to extend its scope to other carbon-intensive sectors at risk of carbon leakage. The intention is that all goods and sectors covered by EU ETS will also be covered by EU CBAM by 2030.⁵

Other countries are exploring the implementation of their own CBAMs. In March 2023 the UK, which was part of EU ETS until it left the bloc and set up its own similar scheme, said it would consult on proposals for a UK CBAM to be introduced from 2026 at the earliest. KPMG in the UK says the British proposal has similarities with EU CBAM but that businesses could still have to comply with two distinct regimes.⁶

Businesses in other countries with carbon-intensive exports may be faced with significantly increased export costs to markets covered by CBAMs, if importers choose to pass the cost of purchasing certificates on to suppliers. At the COP27 UN climate change conference in November 2022 the governments of Brazil, South Africa, India and China published a joint statement saying that “unilateral measures and discriminatory practices, such as carbon border taxes, that could result in market distortion and aggravate the trust deficit amongst parties, must be avoided”.⁷ In May India indicated that it intends to challenge EU CBAM at the World Trade Organization.⁸ South Africa’s government is considering how to respond, although KPMG in South Africa says some large companies are already working on the issue.⁹

“The introduction of the EU’s CBAM represents a new era of global trade — one where the embedded emissions of products affect competitiveness,” says Nicole de Jager, Senior Tax Manager — Global ESG Tax, KPMG International. “As other countries explore the potential for implementation of their own CBAMs, it is clear that the production of greener products is no longer limited to sustainability departments or public perception management. The carbon content of goods is beginning to feature as a strategic business decision, one that impacts cross-border trade and companies’ future growth and prospects of surviving.”

Climate and sustainability reporting

Companies around the world will soon need to provide more information on how they will be affected by climate change and what they are doing to tackle it. The International Sustainability Standards Board (ISSB) produced what is intended as a global baseline for reporting on sustainability, drawing on the work of the Task Force on Climate-related Financial Disclosures (TCFD), which countries including the UK have indicated they will incorporate into national rules. Other jurisdictions including the EU and the US are introducing their own regimes that build on the ISSB baseline with Japan planning to do likewise.

The ISSB, EU and US all intend to improve disclosures for investors on climate change, with the EU’s draft standards also covering other stakeholders. Both the EU and US plan to phase in such reporting from the 2024 financial year for reports published in 2025. The ISSB standards will be available for 2024 financial year reports although the timing will be a matter for each jurisdiction.¹⁰

Many large companies already publish such material, with research by KPMG in 2022 finding that 96 percent of the G250 group of the world’s 250 biggest companies report on sustainability issues. The survey found  hat TCFD standards were used by 61 percent of the G250, up from 37 percent in the previous survey two years earlier, with nearly threequarters of reports including carbon targets.¹¹

“Effective ESG reporting will not happen overnight and integrating ESG into corporate strategy and operations is a substantial change management exercise,” says Dr Jan-Hendrik Gnändiger, Global ESG Reporting Lead and Partner, KPMG in Germany. “Senior executives should waste no time in hastening their company’s transition to a position where non-financial reporting holds the same importance as financial reporting — and be prepared to obtain assurance.”

ESG assurance

The release of the European Sustainability Reporting Standards in the EU and the first two ISSB standards represents an important milestone, the establishment of globally accepted frameworks that companies can adopt and adhere to while also providing a basis for assurance measures. This offers companies a structured path to follow and a robust system for validation. 

ESG assurance has emerged as a crucial mechanism for offering credible and unbiased verification of a company’s progress towards achieving its net zero objectives. As companies increasingly set ambitious emission reduction targets, the precision and openness of their reported data have taken on significant importance. KPMG’s ESG Assurance Maturity Index, focusing on companies with an average revenue of US$15.6 billion, found that only 23 percent have effectively documented, tested and implemented processes and controls for their environmental data, indicating the ongoing challenges many face in this area.¹²

As reporting standards are phased in over the coming years, ESG assurance will play a vital role in bridging the gap between intention and impact and providing necessary checks and balances that will drive meaningful change and contribute to a more sustainable global economy. “In the journey to net zero, ESG assurance serves to enhance the public trust over ESG related data, and is a strategic driver enhancing transparency, accountability and authenticity, propelling companies toward meaningful and impactful sustainability outcomes,” says Mike Shannon, Global Head of ESG Assurance, KPMG International.