Ask the experts: Climate change

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Climate change poses risks and opportunities to which investors and companies must respond, write Douglas Ferrans (above right), chief executive of Insight Investment, and Peter Scales (above left), chair of the Institutional Investors Group on Climate Change, in the Financial Times.

Fifteen institutional investors managing assets worth £850bn ($1.6bn) have signed the Institutional Investors Group on Climate Change’s statement on global warming. Mr Ferrans and Mr Scales argue that the statement is “the strongest call to date from investors for urgent and effective action by policymakers and companies to address the threats posed by rising greenhouse gas emissions.”

“Many investors had been unconvinced that climate change would affect their returns significantly”, they write, “this indifference is passing”.

Will the Institutional Investors Group on Climate Change’s statement put pressure on companies and governments to take action? What more can be done? Douglas Ferrans and Peter Scales will answer your questions below.


How can companies investing in CDM projects to offset emissions manage risk for their investment post 2012, given that it is still unclear what will happen to Kyoto after that date?
Malina Stroumina, Spain

Douglas Ferrans: Addressing long-term policy uncertainty - which clearly affects CDM projects - is a key focus of the Investor Statement on Climate Change. If governments set clear long-term targets supported by appropriate policy instruments, this should help reduce this specific risk.


You call upon governments to set a long-term policy framework to tackle climate change but how can any government implement tougher emissions regulations when the higher costs involved will only see investment and jobs move to some less regulated and less costly country where investment returns will be higher? Do you not see that this is the reason why governments only set targets instead of taking real action and, furthermore, why these targets are continually being missed?
John Bunz , London, UK

Douglas Ferrans: In relation to policy targets, it is probably fair to say that it is only in recent years that the true urgency of climate change has become apparent and, hence, that climate change targets need to be both set and met.

In relation to the question regarding international competitiveness, and focusing on large listed companies, it is pertinent to note that for the majority of companies, energy (including any tariffs or costs associated with climate change) is a relatively small proportion of overall costs. Hence, for these companies, national climate change policy is unlikely to be an important consideration in decisions on where to locate. Clearly, the situation for large energy consumers or major greenhouse gas emitters (in particular in sectors that are exposed to international competition) is somewhat different.

For these companies, we have seen governments actively working to ensure that the impacts of climate change policy on these companies is minimised, i.e. so that competitiveness is not undermined, while at the same time seeking to ensure that overall national greenhouse targets are met.

Peter Scales: Strong governments who tackle these issues may have higher costs but will have more stable economies and these will represent a better investment case. Higher investment returns will mean higher risks and funds may well choose not to take those risks. Without the framework, funds cannot make such effective decisions and governments need to be clear about their policies. Implementation is tough but needs to be addressed.


I would like to know what your own companies are doing to tackle climate change in-house. From what I have heard about them, it seems to me that their energy and transport policies are decidedly lacking, with staff unable to cycle in to work, lack of energy efficiency in offices and staff using taxis instead of public transport fairly regularly.
Amy Hinks, London

Douglas Ferrans: Insight is bound by HBOS’ corporate environmental policies which energy and water reduction targets. One of the measures implemented under this policy was that, in September 2005, HBOS signed a contract with its electricity supplier to provide 100 per cent climate change levy exempt electricity.

Peter Scales: Good point, but as an organisation, LPFA is working to offset its carbon emissions and we know we could do more. The attitudes of employers and transport usage is perhaps more an issue for governments to address and encourage good practice.

As a group, IIGCC is engaging in the property sector as investors to make offices, shops, etc more energy efficient and there is significant for us as landlords to make our investments more efficient and cover some of the issues you raise through the structure and siting of buildings.


What is the Group’s view on investing in research and development to use water power on rivers and places where flows of water were used in the past to generate green power? The objective is to bring to market an innovative world class micro-hydro product, simple to use, quick to install, scalable in size and which is capable of delivering reliable renewable electricity supply to the UK and global market at an economic cost. If positive what is the best way to engage in a conversation with your investors to explore opportunities to invest in the proof of concept work developed so far?
Mike Morrison, Aberdeen, Scotland

Peter Scales: Many of the group already invest in projects for renewables power sources but there needs to be a proper investment case. Pension funds are not entrepreneurs or business angels, but if there is a sound economic case, we will invest to diversify and capture returns.

IIGCC does not promote or recommend specific investments but would consider engaging in such developments which promote sustainability just as we do with companies that create emissions.


Given no universally accepted definition of sustainability (as it pertains to a company’s activities) are your signatories brave enough to pass up investments that others would make for the sake of protecting the planet from climate change? If so can you give examples of this behaviour?
Mark Townsend, UK

Douglas Ferrans: The signatories to the Statement commit to two things: (a) to a better informed analysis of the risks and opportunities presented by climate change, (b) to engagement with the companies in which they are invested to encourage reductions in greenhouse gas emissions.

Peter Scales: Our investment decisions are not aimed at saving the planet but maintaining the value of our investments. To negative screen in this way precludes engagement and narrows the investment choice for the larger funds.

Having said that, disclosure and information properly analysed by sell-side brokers will better inform investment decisions and thereby choices between companies in the same sector, between sectors, and between countries. I am not able to give specific examples of what my managers have done but we have seen a similar outcome in respect of arms manufacturers.


Mr Ferrans and Mr Scales argue that investors are now becoming convinced that climate change might affect returns, yet investors will always want significant returns on their investments. How in the opinion of Mr Ferrans and Mr Scales can such diametric opposites be reconciled?
Susan Drury, Tunbridge Wells, UK

Douglas Ferrans: One way of seeing climate change is as a boundary condition within which we, as investors, seek to deliver the investment returns required by our clients. If governments set targets, then investors will see climate change in a similar manner to other legal requirements (on health and safety for example), as a condition that must be met.

Peter Scales: Institutional investors are not necessarily expecting the highest returns. We need stable returns and income flows that will meet the funds liabilities and we want capital growth to finance the pensions promise without undue burden on contribution rates. The effect of climate change if not managed will impact on the management of pension fund finances. Even if returns are affected we still want companies to take this into account.


Do you believe we might expect the cost of a company’s environmental externalities, incurred in the normal course of business, to be incorporated into its overall financial record, either indirectly in valuing a company or directly in the form of taxes? If so, what role do you believe accountants and research analysts might play, for example, in assigning costs to externalities generated by companies through published financial statements or research reports?
Robert J. Piliero, CFA, Graduate of Middlebury College

Douglas Ferrans: We are already seeing this in Europe where the EU Emissions Trading Scheme means that companies need to internalise at least a proportion of the externality caused by their greenhouse gas emissions. With governments tending to prefer economic instruments over ‘command and control’, it is likely that we will see greater pressures for companies to internalise these costs, although it is not clear whether there will be full internalisation of these costs.

In this context, there is a need for clear rules on how greenhouse gas emissions (and the associated costs) are to be recorded in accounts (cash flow and balance sheet effects). From research analysts (sell-side) it is fair to say that there have been some very good reports on the financial implications of the first phase of the EU Emissions Trading Scheme, with a number of reports on the second phase (2008-2012). However, these reports have tended to focus on a limited number of sectors - primarily electricity, cement and other major greenhouse gas emitters - and have paid little attention to the physical impacts of climate change.

Peter Scales: We take the view that such costs are a crucial measure in assessing the company’s future growth potential. The challenge is to find a suitable set of metrics which are reasonable and comparable. The accountants can have the task of identifying and auditing the metrics, analysts can translate these into effective research for investment decisions. Disclosure is the key followed by interpretation, but we don’t want another IAS 19 event.


Do you think the reluctance of the US, Canadian and Australian federal governments to commit to compulsory reductions of GHG emissions is sustainable, in respect with the growing pressure for actual action? Do you think that voluntary programmes will be effective to engage these economies into the shift of paradigm required by the climate change challenge?
Bertrand Montel, Montreal, Canada

Douglas Ferrans: Uncertainty about the future of climate change policy - will there be a post-Kyoto international regime? Will the EU Emissions Trading Scheme continue beyond 2012? What is the level of national government commitment to greenhouse gas emission reductions? - represents one of the most significant challenges faced by companies.

We (Insight) recently hosted a workshop between institutional investors, policy-makers and companies - where we looked specifically at the implications of climate change policy uncertainty on investment decision-making in the electricity industry. The headline conclusion from the workshop was that uncertainty in climate change policy is a critical barrier to new investment, with companies deferring investment in new plant and keeping existing plant running for longer, with the consequence that greenhouse gas emissions from this sector will remain higher for longer than would otherwise be the case. Note: the workshop report can be found here.

In this context, the attitudes of the US, Canadian and Australian governments are critical. While European governments are willing to push forward with further policy measures directed at reducing greenhouse emissions, they are concerned about the competitiveness implications for European industry if the US, Canada and Australia do not also take action. Our hope is that these countries will start to move forwards as the pressure grows from their state governments (with state-based emissions trading schemes now in place in both Australia and the US) and as US companies see the opportunities presented by emissions trading.

Voluntary measures do have some role to play, in terms of building business and government capacity to respond and in enabling ‘low hanging fruit’ energy saving and emissions reductions opportunities to be grasped. However, the evidence is that voluntary approaches can only go so far and to make the significant reductions that are required - for example, the 60-90 per cent reductions by 2050 - tougher policy measures are likely to be essential.

Peter Scales: Not in the long term. If reluctance is caused by fear of hitting profits, I believe that stance must be reversed once climate change hits profits more heavily. The danger is that delay will worsen response times and increase the ultimate cost. How hard this might impact on global competitiveness is not a question I can answer. Willing volunteers are usually more effective than those pressed ganged by prescription; they also act sooner. In a nutshell, no. Our purpose is to encourage greater voluntary and government action to protect our assets because time is running out.


If climate change continues, will large re-insurance companies go insolvent?
Toshio Matsui, Japan

Peter Scales: I assume the suggestion is that the cost of repairing damage to insured property will become unmanageable. The insurance sector is one where climate risks are already being factored into the re-insurance equation. It is more likely that insurance will not be available and the ultimate cost will be left to governments ~ all the more reason for them to react more swiftly to the issue.


How could addressing climate change help the investment community and corporations mitigate losses? Could it allow them to gain competitive advantages that could be passed on to shareholders? What sort of competitive advantages could be looked forward to by companies addressing these issues? How could the investment community be better positioned to achieve cost-effective risk management solutions that would allow them to adapt to unforeseen future developments?
Arash Nazhad, Canada

Douglas Ferrans: It is clear that governments are intent on encouraging companies to reduce their greenhouse gas emissions and we have seen a raft of policy measures directed to this end; emissions trading, energy efficiency standards, measures to increase the use of biofuels and renewable energies are all examples. These measures, in turn, create both risks and opportunities for companies. Some companies are likely to see increases in their capital and operating costs (if they need to take steps to reduce their greenhouse gas emissions) whereas others may be significant beneficiaries (for example, if climate change policy provides them with a competitive advantage or creates new markets for their products and services).

As investors, our challenge is to ensure that our investment analysis properly accounts for the changing environment faced by companies, to ensure that we can identify the companies that present the best opportunities in a carbon-constrained environment. If we do this well, it should provide improved investment returns for our clients over the medium and longer-term.

Peter Scales: Losses could arise from at least four sources - direct impact of adverse climate, government action to tax carbon culprits, lost competitiveness, and failure to adapt to developing new markets. For the investor, losses damage capital growth and revenue streams, and a lack of knowledge hampers investment decisions. Competitiveness may be a short term concern.

Investors who are exposed to most markets, sectors and stocks want to preserve future value over the long term. Better disclose by companies, focused research by sell-side brokers, greater engagement on key issues, will lead to more effective investment decision taking.


What is the Group’s view on investing in research and development to use water power on rivers and places where flows of water were used in the past to generate green power? The objective is to bring to market an innovative world class micro-hydro product, simple to use, quick to install, scalable in size and which is capable of delivering reliable renewable electricity supply to the UK and global market at an economic cost. If positive what is the best way to engage in a conversation with your investors to explore opportunities to invest in the proof of concept work developed so far?
Mike Morrison, Aberdeen, Scotland

Peter Scales: Many of the group already invest in projects for renewables power sources but there needs to be a proper investment case. Pension funds are not entrepreneurs or business angels, but if there is a sound economic case, we will invest to diversify and capture returns.

IIGCC does not promote or recommend specific investments but would consider engaging in such developments which promote sustainability just as we do with companies that create emissions.


I can’t see wind farms making a significant impact on global warming. How are you going to support active methods of reducing CO2 levels and more importantly, accelerated research into nuclear fusion energy production - the only long-term solution. We need to get this right, for our children, and the emerging economies (and maybe the US) will hopefully follow our lead.
John Watson, UK

Douglas Ferrans: Climate change is not a problem with a “silver bullet” solution. Rather it will require action in a whole series of areas such as renewable energy, clean fuel technologies (both combustion efficiency and carbon capture and storage), energy efficiency in industry and in the commercial and domestic sectors, demand side reductions, etc. Also, it will require action in BOTH the developed and developing countries, although the specific policy measures and solutions will, obviously, need to be considered in the context of specific national circumstances.

Peter Scales: This is a question for the politicians. Pension funds will continue to invest in projects like wind farms which provide good long term returns and impact on global warming, even if they are only part of the solution. More investment is not the answer. Governments need new solutions, possibly nuclear energy, and pension funds will seek to invest in those solutions.


Is climate change used in valuation models and if not should they be?
Robert Klijn, Amsterdam

Douglas Ferrans: At Insight, climate change is explicitly considered in our investment analysis, although, clearly, its financial significance is company and sector-specific.

Peter Scales: Not to my knowledge as a specific actuarial factor, but increasingly, the impact of climate change on global economies and markets will influence the equity risk premium. I would hope to manage that by funds being more active to mitigate the consequences. Conversely, there of course be an impact on longevity which is an issue I would leave for the actuaries.


Background

Douglas Ferrans and Peter Scales: Investors take the lead to help save the planet

John Gapper - Companies see the gains in going green

Ask the experts: Global water shortage

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