Emissions Reduction Investment Curves (ERICs) overcome many of the issues associated with Marginal Abatement Cost Curves (MACCs) and thereby provide an effective communication tool for expressing technical opportunities in the investment language of corporate finance. Bridging this divide is vital in securing approval for profitable emissions reduction projects which benefit all parties – the environment/community, the company, and shareholders.
The Limitations of MACCs
Marginal Abatement Cost Curves (MACCs) are one of the tools currently used to express the economic attractiveness of emissions reduction opportunities within country or organization. The x-axis shows the size of the saving, and the more negative an opportunity on the y-axis, the better. Beyond this though, explaining a MACC becomes difficult.
Let us examine the specific flaws of the MACC:
1. The MACC is counterintuitive. The more NEGATIVE something is, the better!
2. The y-axis is complex in both the assumptions used and methodology. The height of the bars represents the cost of an action (in $ per tonne of CO2e saved) in 2030. It is calculated (or at least should be calculated) by dividing the net cost of an action over its lifetime by the emissions saved. However the numerator involves a range of difficult assumptions. The net cost of an action is the up-front investment in the technology (assuming some starting time for the action which determines its progression down an assumed experience curve) plus the operating and maintenance costs over the life of the action minus the cost savings over the life of the action. Then these cash flows need to be discounted back to a single point in time (when should that be?) using an assumed discount rate. The discount rate, while it sounds simple has been a longstanding subject of debate, including being one of the key points of contention with the UK’s Stern Review and Australia’s Garnaut report.
If your eyes glazed over while reading the above – then you relate to point three below.
3. MACCs are difficult to explain. Imagine trying to explain all of the above points to a CFO before you even start to talk about the individual opportunities. This is a very big issue because while technical staff may understand the MACC curve in detail, senior executives may not. And while senior executives and CFOs remain uncertain about how the returns on an investment are calculated, projects will not be approved.
The Emissions Reduction Investment Curve (ERIC) addresses these issues.
Here is an example of an ERIC:
1. More positive on the y-axis is good. That is intuitive.
2. The y-axis is Internal Rate of Return (IRR) – the calculation of which is well understood by all executives as it is one of the standard investment metrics used in the business world. It is the language of investment used by senior executives, CFOs, investment committees and broker analysts.
IRR has standard approaches to its calculation globally, with company-specific tweaks widely communicated as standard investment analysis practice within companies. This means there is less suspicion over the numbers so the discussion can concentrate on the potential savings.
3. The ERIC enables both the stand-alone IRRs for individual projects to be shown as well as the CUMULATIVE IRR (the red line on the graph). This is useful as it enables high return projects to cross-subsidise lower return projects and achieve an overall acceptable IRR.
4. By using IRR, no assumption of discount rate is made. This allows executives to choose their preferred risk level (i.e. desired return on investment i.e. IRR), read across the graph to the cumulative curve, and then down the graph to the emissions saving which can be achieved. So even if an executive is extremely risk-averse, they can still be accommodated in the discussion and some projects can be rolled out.
Have a go navigating your way around the ERIC as described above. If you like it, feel free to use it for your emissions reduction analysis and communications.
We would enjoy hearing of your experiences using the ERIC.