As the turmoil in the financial markets shows, a failure to identify risk in the short term can lead to substantially larger problems in the longer term. A meeting of leading climate change scientists in Copenhagen in early March 2009 concluded that many of the likely physical impacts of climate change had been understated in the IPCC Assessment Report of 2007. As we face widespread warnings of irreversible climate change, it is clear that the risks and opportunities that many corporations face from climate change have the potential to affect their financial condition and it is in every investor’s interest to understand how; not least because it fulfills a fiduciary responsibility to pension fund holders to do so.
Climate change has emerged as an important theme for investors in recent years, evidenced by the growing numbers of shareholder resolutions related to climate change, the significant increase in renewable investment and the huge growth in the value of the carbon markets, now estimated at approximately €40 billion.
Following clear indications from the new US administration and other governments, we can expect to see a marked increase in climate change regulation globally. This will increase the materiality of climate change for investors and drive up costs for companies unable to manage their greenhouse gas inventories. A recent report released by CDP for example reveals how Electric Utilities have a long way to go to de-carbonize, making them vulnerable to rising costs from carbon taxes and cap and trade systems. As regulation expands globally, long term investors such as pension funds will be increasingly compelled to analyze the risks and opportunities from climate change in greater detail. In fact, in research conducted late last year by the Carbon Disclosure Project into how its climate change information is being used by global institutional investors such as pension funds, carbon risk and potential legislation or regulation were cited as primary motivating factors for using climate change data.
And it is not just regulation that is driving a greater move towards investment in low carbon solutions and increased awareness around carbon as an investment issue. Extreme weather events can affect oil operations; changing weather patterns can impact shipping routes; video conferencing companies can see a growth in business as a substitute for business travel; and the 21st century consumer is becoming more inclined to purchase low carbon products such as hybrid cars and low energy light bulbs which can affect company competitiveness and direction. These shifts in business activities, affected by climate change, can of course impact the value and profitability of a company.
According to the CDP research, three-quarters of respondents said they are already including climate change related issues into their investment decisions and asset allocations. Of these, more than 80% consider climate change to be important relative to other issues impacting their portfolio. That the materiality of climate change has been increasing over time and will continue to do so, as regulation increases, means the issue is commanding more attention from investors.
The CDP research highlighted the steps being taken by some committed investors. Some use corporate climate change policies as an indicator of a company’s overall approach to risk management, others feed climate change related data such as strategic initiatives, energy consumption or greenhouse gas emissions, into the assignment of a management quality score with respect to environmental, social and governance (ESG) factors.
But it is not just about risk, there are also considerable opportunities that leading investors in this area are taking into account. The most often cited opportunity is that related to alternative or renewable sources of energy; but others include carbon trading, energy efficiency savings and investment in low carbon products.
CDP data was cited as being used by investors to help inform them on climate change issues for fuelling discussions with company management; this may take the form of comparing companies to assess how far ahead they are on the issue, or to leverage the number of investors backing CDP in order to encourage companies already reporting on climate change to improve their level of disclosure.
Moving forward, some investors are already including climate change data as part of their valuation models and the majority of investors surveyed are working to incorporate climate change data systematically into their financial analysis.
For long-term investors such as pension funds, understanding how changing regulation, disruption from the physical impacts of climate change, changing technologies and potential carbon costs could affect a business is fundamental to the assessment of long-term risk and return.
This is a new and evolving area. Doubtlessly, low carbon investment has a long way to go and investors are refining their approach. What is clear is that the leaders are forging ahead in integrating ESG data into their existing systems, models and processes and actively working to overcome any obstacles so they can make better use of climate change data. The laggards risk being left behind.