Investors: A new world of risk and opportunity

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Mindy Lubber Mindy S Lubber , President of Ceres and Director of INCR, and Russell Read, Chief Investment Officer, California Public Employees’ Retirement System (CalPERS)

Climate change presents enormous risks and opportunities for corporations. Increasingly, as investors make decisions about the value of their investments, they are factoring in how well a company is prepared to manage those risks and act on those opportunities. To do so, they are increasing pressure on companies to make climate change a priority governance issue and using their leverage to encourage companies to analyse and disclose their plans for managing climate risk and their strategies for seizing climate-related opportunities.

CLIMATE CHANGE: A STRATEGIC IMPERATIVE

The debate over whether human behaviour is causing climate change is over. The question is no longer ‘if’, but ‘how’ climate change is changing the world and the scale and urgency needed to reduce greenhouse emissions globally in the near future.

For investors, the question is how well companies will prepare for and adapt to this changing world. Which companies have the management savvy and strategic vision to manage the legal, physical and competitive risks associated with climate change? Which are best positioning themselves to seize what legendary venture capitalist John Doerr has called “the biggest economic opportunity of the 21st century” – renewable energy and clean technologies? Which companies are best prepared to function in a changing regulatory environment? In short, there will be winners and losers as some companies adapt to the new world of risk and opportunity and others do not.

REGULATORY RISKS AND OPPORTUNITIES

There is no doubt that the imperatives of climate change are already bringing about regulations that seek to slow the pace of climate change, especially by limiting greenhouse gas emissions (GHGs). The Kyoto Protocol is now in force, the European Union operates under a carbon cap and trade system and many US states, including California, are imposing limits on GHGs. Such regulatory changes will surely continue, especially as leading corporations and investment firms appeal for clear national policies that will establish the rules under which business must operate in the future. For example, Duke Energy, a leading US utility, has called for “a national, economy-wide greenhouse gas mandatory policy as soon as possible,” and JP Morgan Chase has called for “mandatory carbon constraints.” When industry is willing to be regulated, it is a good bet that policy changes will follow.

How companies, especially those in the energy, auto and energy intensive manufacturing sectors, integrate regulatory changes into capital investment decisions and strategic planning will have a significant impact on their long term financial health. For example, utilities that continue to build coal-fired power plants without taking into account carbon reducing regulations, which will make CO2 emissions more costly, are likely to find their shareholder value under serious pressure. “It is naive to believe that CO2 legislation will fail to pinch profit margins,” wrote Citigroup in a July 2007 research report downgrading coal company stocks. But it’s not only carbon intensive industries that will be affected. No sector of the economy will be immune.

Regulatory changes are creating significant economic opportunities, as well. For example, automakers such as Toyota and Honda that have invested significantly in hybrids and fuel efficient vehicles have already reaped the benefits of their foresight. They are also better positioned to exploit China’s burgeoning demand for cars than US automakers under China’s stringent new auto-emission standards. Similarly, agricultural firms that are producing crops for exploding biofuel markets are well positioned to thrive in a carbon constrained economy.

Indeed, according to a June 2007 report by the United Nations Environment Programme (UNEP) climate change concerns, high oil prices and increasing government support are fueling a dramatic increase in investments in the renewable energy and energy efficiency industries. According to the report, investment capital flowing into renewable energy rose from US$80 billion in 2005 to US$100 billion in 2006, a trend that “shows no sign of abating.” The McKinsey consulting firm is equally bullish about energy efficiency, saying aggressive investments in this area could reduce the global growth rate of energy consumption by more than 50 per cent over the next 15 years.

LITIGATION RISKS

Much as tobacco companies have been held to account for the enormous health care costs their products have imposed on state governments in the United States, legal accountability for climate change is an emerging risk for companies. It is too soon to tell whether major contributors to GHGs will be held liable for damages resulting from climate change, but the risk of litigation alone is a significant bottom line concern for companies.

A number of high profile lawsuits now pending in US courts seek to hold corporations liable for damages resulting from their contribution to global warming. For example, eight states and the City of New York have sued American Electric Power, Southern and several other power providers regarding their carbon emissions. A class action suit on behalf of victims of Hurricane Katrina seeks billions in damages against several oil and gas companies, claiming their GHGs contributed to the storm’s severity.

According to a subcommittee of the American Bar Association, the leading US professional association of attorneys, “The prospect of liability is a serious matter for people who understand climate change and take it seriously.” For investors, the prospect of such liability should also be taken seriously.

PHYSICAL RISKS AND OPPORTUNITIES

Perhaps the easiest of climate risks to understand are severe weather events, drought, floods, forest fires, rising seas, thawing permafrost and temperature extremes, all of which will have profound effects on many companies in the decades ahead. Property insurers are already heading for the hills, so to speak, with many no longer willing to insure coastal and other high-risk property. Single storms such as Hurricane Katrina resulted in US$40 billion in insured losses in 2005 and Lloyd’s of London predicts a US$100 billion hurricane will hit the United States in the coming years. (Whether Katrina’s strength was directly related to climate change is unknowable, but many climate scientists predict an increase in severe hurricanes as the earth warms.)

Oil and gas companies are among those that operate in areas at high risk for climate-related damage – hurricane-prone waters threaten off shore oil rigs and thawing permafrost damages pipelines, for example. Infrastructure damaged by such events can hinder their ability to get products to market. Following hurricanes Katrina and Rita, which caused widespread refinery outages, retail gas prices rose by 50 cents a gallon. Forest product companies face increased risk from drought and warmer temperatures that are making their primary asset more fire and disease prone.

Again, the question for investors is how well prepared are companies in these sectors, and others vulnerable to the physical effects of climate change, to manage their risk? Which among them are creating innovative products and services to meet the needs of customers who may be most impacted by climate change?

COMPETITIVE RISKS AND OPPORTUNITIES

To thoroughly assess a company’s ability to compete in a changing world, investors and analysts must weigh a company’s climate risk preparedness. Which automakers are making the capital investments to be competitive in a carbon constrained economy? Which energy producers are diversifying sufficiently to operate profitably in a world that turns increasingly to alternative fuels? Which major retailers and real estate developers are saving millions on their energy bills by becoming energy savvy in their operations?

Investors stand to benefit from identifying those companies that are anticipating the new economic playing field. Those that are adapting and those that are seizing the abundant competitive opportunities of climate change will undoubtedly fare better than those that are not. It is worth noting that many leading companies are already identifying ways to profit from this transition. For example, General Electric has made a major commitment to development of clean technologies with sales of energy efficient and environmentally advanced technologies. The company’s ‘ecomagination’ programme already has a backlog of green technology orders worth US$50 billion, more than twice the company’s projected revenue of US$20 billion by 2010. DuPont has reduced its GHGs by 70 per cent since 1990, saving US$2 billion in the process, while developing climate-friendly products such as Tyvek insulation that reduces home energy use by
13 per cent. Pacific Gas & Electric (PG&E) has invested billions in energy efficiency programmes that have made California 50 per cent more energy efficient than the rest of the country. The programme also reduced California’s CO2 emissions by 61 million tons and helped the state avoid having to build two-dozen new power plants.

In addition to the bottom line impacts of seizing the competitive edge on climate change, companies that are responding to climate change also reap unquantifiable good will and reputational benefits from leading the movement towards a low carbon future. Such benefits increase competitiveness in many ways: attracting new customers, attracting and motivating a more dynamic work force and cementing a company’s identity as a market leader and innovator in its field. “We’ve found that there are more high quality prospects that are interested in joining the company because of the very positive approach we’ve taken on the environment,” said PG&E CEO Peter Darbee.

CLIMATE RISK DISCLOSURE: TRANSPARENCY IS KEY

A fundamental operating principle for any market system is transparency. To make sound investment decisions, investors must have access to a wide range of information about a company – its operations, management and finances. Securities laws emphasise disclosure of all material facts that are reasonably likely to affect a company’s financial performance.

To enable investors to assess a company’s climate risk, generally accepted standards for disclosure, similar to that which already exists for other types of financial and governance information, are needed. Because climate change is a relatively new issue, however, industry norms for such disclosure have not yet evolved and corporate disclosure in this area has been spotty and inadequate. Indeed, many shareholders, including members of INCR, are introducing shareholder resolutions to try and force such disclosure, sometimes using such resolutions as a tactic to engage management in discussions about climate change preparedness. More than 40 such resolutions were filed with US companies in 2007, many of which received record high voting support.

To address the lack of disclosure standards, INCR, the Carbon Disclosure Project, the United Nations Environment Programme and other investor groups developed the Global Framework for Climate Risk Disclosure. While adherence to this reporting framework is voluntary, there is a basis in existing US securities law to require disclosure of material information related to climate risk. Accordingly, INCR members have urged the US Securities and Exchange Commission to require disclosure of the information specified in the framework.

The framework calls for corporate disclosure in four key areas that would allow analysts and investors to evaluate companies’ climate change preparedness: (1) emissions disclosure, (2) strategic analysis of climate risk, governance, and emissions management, (3) physical risks and (4) regulatory risks.

Emissions disclosure. The framework encourages use of the Greenhouse Gas Protocol’s Corporate Accounting and Reporting Standard, the most widely agreed upon emissions accounting standard, to enable analysts and investors to examine a company’s total GHG output. This data is helpful in approximating a company’s risks from current and future GHG regulations.

Strategic analysis. The framework encourages companies to undertake a thorough analysis of their climate change risks and opportunities to include (a) a statement of the company’s position on climate change, its responsibility to address it, and its engagements with governments and advocacy groups to affect climate change policy, (b) disclosure of steps being taken to reduce the company’s GHGs, including benchmarks and timetables, and (c) how the company is addressing climate change as a matter of corporate governance. For example, have members of the management team been tasked with identifying the company’s climate change risks and opportunities? Has compensation of key officers or managers been linked to meeting climate change goals?

Physical risks. Companies should examine and report on how the physical risks associated with climate change could affect the company’s performance. What physical assets are vulnerable to extreme weather events such as hurricanes or melting of permafrost? Is the company’s supply chain vulnerable to disruptions caused by severe weather? What steps have been taken or are planned to mitigate these risks?
Regulatory Risk. To determine whether companies are prepared for various regulatory futures, analysts and investors need to know whether management has assessed how possible regulatory changes could impact financial condition or operating performance. For example, has the company anticipated (a) possible increased energy or transportation costs, (b) how various national and local GHG emission regulations will impact the bottom line and (c) the future cost of carbon fuels? In short, how does management view the regulatory future and is the company prepared to operate effectively in it?

CONCLUSION

How a corporation manages the risks and takes advantage of new business opportunities presented by climate change will have important consequences on its competitiveness, economic health, and, in some cases, its survival. Companies must improve disclosure of their strategies so their owners can evaluate them. To successfully manage their portfolios for the future, analysts and investors must factor into their decision-making a thorough understanding of how effectively the companies they invest in, or choose not to invest in, are managing climate risk and seizing the opportunities.

Authors

Mindy S Lubber is the President of Ceres, a leading US coalition of investors and environmental leaders working to improve corporate environmental, social and governance practices. She also directs the Investor Network on Climate Risk (INCR), an alliance that coordinates US investor responses to the financial risks and opportunities posed by climate change.

Russell Read is the Chief Investment Officer for the California Public Employees’ Retirement System (CalPERS). He oversees all asset classes in which CalPERS invests and is responsible for the strategic plan for CalPERS’ Investment Office. Mr Read joined CalPERS in 2006 after previously serving as Deputy Chief Investment Officer for Deutsche Asset Management and Scudder Investments. He was responsible for more than US$250 billion of retail and institutional investments in equity, fixed income and commodity-based products. He previously served as Global Head of Quantitative Investing and Research at Zurich Scudder and has held senior investment positions with the OppenhiemerFunds, CNA Insurance, Prudential Insurance and First Chicago.

Organisation

The Investor Network on Climate Risk is a network of institutional investors and financial institutions that promotes better understanding of the financial risks and investment opportunities posed by climate change. Much of INCR’s focus is aimed at improving corporate disclosure and governance practices on climate change. The four-year-old network, coordinated by Ceres, includes more than 60 investor members with collective assets totalling more
than US$4 trillion.

Enquiries

Investor Network on Climate Risk, c/o Ceres, Inc., 99 Chauncy Street, 6th Floor Boston, MA 02111 USA
Tel: +1 617 247 0700 | Fax: +1 617 267 5400
E-mail:

Picture credit: Mario Hornik/iStockphoto

Climate Action - Assisting business towards carbon neutrality