Innovest Strategic Value Advisors, Inc.
March 13, 2002
“The greatest challenge facing the world at the beginning of the 21st century is climate change . . .Not only is climate change the world’s most pressing problem, it is also the issue where business could most effectively adopt a leadership role.”
Davos, February 2000
Climate change is rapidly becoming a major issue for U.S. companies and fiduciaries. The increasingly global nature of industrial competition, institutional investment strategies, and legislated disclosure requirements mean that company directors and other fiduciaries in North America should see climate change as a major business risk - and opportunity.
In the private sector, climate change has rapidly developed into a major strategic – and practical – issue for both industrial corporations and their investors. The competitive and financial consequences for individual companies can be huge: Innovest’s own research has indicated that the discounted future costs of meeting even ‘softened’ Kyoto targets correspond to 11.5% of total current market value for the most carbon-intensive U.S. electric utility to 0.2% in the least; and up to 45% of current share value. Increasingly severe climatic events have the potential to stress P&C insurers and reinsurers to the point of impaired profitability and even insolvency; indeed, insurance analysts at one major U.S. investment bank are already known to have lowered their earnings estimates to account for ‘what appears to be a higher-than-normal level of catastrophes’ during early 2001.
By the same token, recent studies give grounds for optimism that the right blend of market based policies, if skillfully introduced, can substantially reduce the direct and indirect costs of mitigation and perhaps even produce a net economic benefit. Indeed, several leading insurance, fund management and industrial companies are already poised with risk management programs and innovative new solutions that promote both GHG emissions reductions and their own bottom lines. Our research shows that, for a variety of reasons, businesses practicing sound environmental management also enjoy enhanced competitive advantage and superior share price performance.
There is therefore an increasingly compelling need for corporate board members, pension fund trustees, and asset managers to take the climate change issue far more seriously than they have to date as a major and legitimate fiduciary responsibility.
A number of major drivers are currently converging to propel climate change to a much more prominent place on the agendas of company directors and executives, as well as those of a growing number of institutional investors:
The most recent report by the IPCC (Intergovernmental Panel on Climate Change) actually strengthened warnings from its earlier work regarding the rate, extent and consequences of climate change. The report accelerated climate change time horizons and identified the possibility that at some unknown threshold, sudden and largely irreversible shifts in global climate pattern may occur. Developing countries are predicted to bear the brunt of future climate turbulence.
A new report by the U.S. National Academy of Scientists released in March 2002 corroborated these findings, adding that exceeding the threshold limits could precipitate sudden and abrupt changes which are far more dramatic than anything that preceded them. Simulation modeling indicates that the cost of a single extreme hurricane could reach as much as $100 billion, on the same scale as the accumulated pollution damage in the USA since industrialization began.
IPCC scientists also believe that North America has already experienced challenges posed by changing climates and changing patterns of regional development and will continue to do so. Varying impacts on ecosystems and human settlements will exacerbate differences across the continent in climate-sensitive resource production and vulnerability to extreme events.
Over the past fifteen years alone, the word has already suffered nearly $1 trillion in economic losses due to “natural” disasters, roughly three-quarters of which were directly weather-related.
Munich Re, one of the world’s largest reinsurers, recently estimated that climate change will impose costs of several billion dollars each year unless urgent measures are taken to reduce greenhouse gas (GHG) emissions. In the year 2000 alone, global damage reached $100 billion, mostly uninsured, and already simulation modelling shows that the cost a single extreme hurricane could reach $100 billion, on the same scale as the accumulated pollution damage in the USA since industrialisation began.
These concerns have now been echoed by other leading mainstream financial institutions including Swiss Re, Credit Suisse and Deutsche Bank. The costs of continued inaction are potentially astronomical, yet there is growing evidence that aggressive mitigation measures need not cause the economic harm and dislocation initially feared by many conservative economic commentators.
“As we are beginning to appreciate within the reinsurance industry, the effects of climate change can be devastating...”
Conventional wisdom suggests that the effects of climate change will be limited to sectors directly associated with the energy value chain (including oil and gas, natural gas, pipelines and electric utilities on the downside, and renewable energy) and those industries consuming large amounts of energy (steel manufacturing, smelting and such like).
Recent research makes it clear, however, that the business ramifications relate not just to energy-intensive industries but also sectors such as telecommunications and high-technology (which influence societal resource consumption and provide enabling technologies); forestry (an integral part of the sustainable energy cycle); automotive (the primary users of petroleum products and leaders in fuel cell development); electronics, electrical industries and other equipment suppliers (where fuel cell technologies are already creating whole new markets); agriculture (where industries ranging from animal farming to winegrowing face major potential impacts), tourism and other sectors.
In addition to the massive aggregate risk exposures noted above, recent evidence on company-level impacts has revealed:
It clearly behooves fiduciaries and investors to know which industry sectors and companies are exposed to the greatest risks and opportunities, and what measures if any are being taken to identify and manage those risks.
Ten years ago, only 3.3% of U.S. pension funds’ equity investments were in non-U.S. company securities. Today, that proportion has more than tripled to over 11%. A similar internationalization of pension fund investing is occurring in virtually every OECD country. What this means for U.S. fiduciaries is simply this: The competitiveness of their investee companies – and therefore their fiduciary responsibilities – will not permit them to ignore or remain isolated from climate change policy and regulatory developments in other parts of the world.
Major international investment houses such as AMP Henderson and Friends Ivory & Sime have developed sophisticated guidelines for assessing companies’ strategic and operational responses to the climate change threat. What is more, they have begun to communicate the importance of the issue to their clients. This initiative by a mainstream investors will go a considerable distance towards “legitimizing” climate change to conservative investors.
A broad coalition of global institutional investors is already forming to press management at the world’s largest companies on shareholder risks associated with climate change via the 'Carbon Disclosure Project’ (CDP). The CDP is a non-aligned Special Project within the Philanthropic Collaborative at the Rockefeller Brothers Foundation with the sole purpose of providing a better understanding of risk and opportunities presented to investment portfolios by actions stemming from the perception of climate change. To date, institutions representing over $2 trillion in assets have already joined the initiative.
In the U.S., climate change-related shareholder resolutions are anticipated against ExxonMobil, Chevron-Texaco, and Occidental Petroleum during the current (2002) proxy season. Major institutional investors including the City of New York and the State of Connecticut are beginning to flex their financial muscles on the climate change issue.
Historically, fiduciary responsibilities have been interpreted rather narrowly in both the U.S. and Europe. Fiduciaries’ principal obligation was the maximization of risk-adjusted financial returns for pension plan beneficiaries, investors, and shareholders. Since environmental performance was widely seen as injurious or at best irrelevant to financial returns, the prevailing ethos held that they were of necessity beyond the legitimate purview of fiduciaries. This ethos has now begun to shift dramatically: A growing body of research is making it clear that companies’ environmental performance may well affect financial returns, and is therefore a wholly legitimate concern for fiduciaries. Legislative reforms of pension legislation in a number of European countries, is codifying this new ethos into law.
Recent independent back-test evidence indicates that a diversified portfolio of more “sustainable” companies can be expected to out-perform one comprised of their less efficient competitors by anywhere from 150 to 240 basis points or more per annum. In particularly high-risk sectors such as chemicals and petroleum, Innovest’s own research has revealed that this “out-performance premium” for top-quintile companies can be as great as 500 basis points or even more.
As the chart below illustrates, depending on how much emphasis was given to environmental performance factors, the out-performance margin ranged from 180-440 basis points (1.8 – 4.4%). None of this out-performance can be explained by traditional securities analysis; it appears to be pure “eco-value”.
“Reputation is something which, unlike a petrochemical feedstock plant, can disappear overnight. We are increasingly getting firms which are conceptual and Enron being a classic case whose value depends on reputation and trust. And if you breach that, that value goes away very rapidly.”
Chairman of the U.S. Federal Reserve Bank
Speaking at the Senate Enron Inquiry on Capitol Hill, Washington D.C.
January 25, 2002
As recently as the mid-1980’s, financial statements captured at least 75% on average of the true market value of major corporations; today the figure is closer to only 15%1. That leaves roughly eighty-five percent of a company’s true market value which CANNOT be explained by traditional financial analysis The yawning disconnect between companies’ book value (“hard assets) and what they are really worth – their market capitalization - is at an all-time historical high.
This leaves institutional investors and fiduciaries with an enormous information deficit, as the recent implosion of Enron vividly demonstrated. Intangible value drivers are now the strongest determinants of companies’ competitiveness and financial performance.
The growing importance of intangibles to company valuations in the U.S. was underscored in a March, 2002 announcement by the U.S. Financial Accounting Standards Board that it will be issuing binding disclosure requirements about companies’ intangible assets within the next 12 months. This will clearly accelerate the integration of intangibles into mainstream financial analysis. Internationally, the growing momentum of other major “transparency initiatives” such as the Global Reporting Initiative (GRI) are certain to add climate change as a significant new source of business and investment risk.
The European Union has already committed itself to a legally binding timetable for Kyoto implementation, including compulsory taxes on GHG emissions above prescribed limits, starting in 2005. Taxes on greenhouse emissions are either proposed or already in effect in Scandinavia, and the Canadian, Australian and Japanese governments are also in the process of establishing national emissions abatement plans. Japan, the U.K. and Canada have both signaled their intent to ratify the Kyoto Protocol within the coming weeks, probably before the forthcoming Earth Summit in South Africa. The imperatives of global competition will clearly impact U.S. companies regardless of any tax or other regulatory measures which may or may not be forthcoming in the United States.
In response to both domestic and international pressure for a robust response to Kyoto, President Bush announced his new climate change policy on February 14, 2002. The administration’s Clear Skies Initiative commits the U.S. to reduce it greenhouse gas intensity by 18% over the next 10 years, and includes substantial financial incentives for renewables and clean technologies. The President’s proposed budget for FY’03 increases spending on climate change mitigation to $4.5 billion per year.
On February 20, 2002, EPA Administrator Christine Whitman launched one of the key components of the Bush Administration’s new climate policy, the Climate Leaders protocol. That initiative encourages companies to report on their emissions of the six major GHG’s, using a reporting framework developed by the World Resources Initiative and the World Business Council for Sustainable Development. In concert with similar initiatives elsewhere, this should make a significant contribution to increasing the level of transparency of carbon risk exposures and, as a result, increase accountability for both corporate directors and investment fiduciaries.
In the United States, there are a number of bipartisan bills, resolutions and legislative proposals currently before the 107th Congress, several of which, among other things, propose significantly increased company disclosure of carbon risks, measurement of emissions, and increased research and development.
The economics of climate change has been a source of considerable uncertainty and controversy. Several high-profile studies have estimated the costs of mitigation to be extraordinarily high, particularly in the U.S. However, these estimates have invariably used worst-case assumptions that necessarily imply high costs, for example, highly limited or none existent emissions trading activity, a need to meet short term targets, or limited use of non-carbon fuels.
Recent studies give grounds for optimism that the right blend of policies, if skillfully introduced, can substantially reduce the direct and indirect costs of mitigation and perhaps even produce a net economic benefit.
Effectively addressing climate change can only be achieved via the adoption of more sustainable development pathways that simultaneously attend to interdependent social, economic and environmental challenges. While the Kyoto Protocol is a crucial first step in managing the problem, focusing entirely on the agreement would encompass too narrow a set of interests and divert attention away from some of the more fundamental social, environmental, technological and economic issues at stake. The broader sustainability context of climate change simply must be appreciated if the issue is to be effectively managed.
Taken separately, few of these trends are sudden or radically new. What is new, however, is their confluence at a single point in time. Taken together, they form a kind of “perfect storm” which has already begun to redefine the responsibilities of fiduciaries in the early 21st century. Together, Innovest believes that they are rapidly moving climate change to a position of growing prominence on both corporate and institutional investor’s agendas.
Providing the right blend of regulatory pressure and market mechanisms to allow institutions to incorporate climate-related factors into future underwriting, lending and asset management activities is a critical step. Directing institutional capital towards supporting organic development of new clean energy technologies in their investees is also crucial. The renewables and clean power technology markets are becoming increasingly compelling in the search for ‘win-win’ outcomes; the nascent GHG, CAT bonds, weather derivatives and microfinance/microinsurance markets also hold substantial promise for strategic finance and insurance companies.
Ultimately, It is Innovest’s belief that unleashing the creative instincts of the private sector is by far the most effective way of dealing with environmental pressures. Our research shows that businesses that practice sound environmental management also enjoy enhanced stakeholder and customer capital, operate with reduced costs and less risk, are faster to innovate and generally foster a higher level of management quality. More importantly, our research also shows that these benefits translate into sustainable competitive advantage and superior share price performance. This linkage between environmental and financial performance therefore creates a virtuous circle, in which proactive firms are rewarded by investors and encouraged to continue in their endeavors. Less proactive firms are also provided with a powerful incentive to adopt more positive responses. In the ensuing battle for best-in-sector leadership, the only surefire winner is the American public, who benefit from a more competitive private sector whose interests are better aligned with the broader tenets of sustainable development, with all the quality-of-life benefits this brings.
INNOVEST STRATEGIC VALUE ADVISORS, INC.
Innovest Strategic Value Advisors is an internationally-recognized investment research firm specializing in environmental finance and investment opportunities. Founded in 1995 with the mission of delivering superior investment appreciation by unlocking hidden shareholder value, the firm currently has over US$1-billion under direct sub-advisement and provides custom research and portfolio analysis to leading institutional investors and fund managers throughout the world. Innovest’s current and alumni principals include senior executives from several of the world’s foremost financial institutions, as well as a former G7 finance minister. The company’s flagship product is the EcoValue 21 platform, which was developed in conjunction with strategic partners including PricewaterhouseCoopers and Morgan Stanley Asset Management. Innovest is headquartered in New York, with offices in London and Toronto.
Dr. Whittaker is a Managing Director with Innovest Strategic Value Advisors, Inc., specializing in the energy and resource sectors. His research serves as critical input into the equities research, product development and consulting activities of Innovest. He also spearheads Innovest’s work in climate change matters, designed to assist the financial community understand the investment risks and opportunities surrounding climate change. Martin is a former consultant with Golder Associates and has worked in the oil and gas industry with Elf Aquitaine, the French multinational. He contributes regular analysis and commentary on finance and sustainable development in the media and has also lectured on subject at several Canadian business schools. He holds a Ph.D. in environmental risk management from the University of Edinburgh, as well as Bachelor's and Master of Science degrees from, respectively, the University of St. Andrew’s and McGill University, Montreal.
 U.S. National Academy of Sciences, Abrupt Climate Change: Inevitable Surprises, March, 2002.
 U.S. Department of Energy, U.S. Insurance Industry Perspectives on Global Climate Change, February 2001.
 See, for example, the IPCC Third Assessment Report 2001
 See, for example, Innovest Strategic Value Advisors, Electric Utilities Industry Sector Report, 2002
 Innovest sector research; Pew Center on Global Climate Change, Corporate GHG Reduction Targets, 2001
 R.A.G. Monks, The New Global Investor, John Wiley, 2001
 See, for example, Baker & McKenzie (Virginia L. Gibson, Bonnie K. Levitt, and Karine H. Cargo), “Overview of Social Investments and Fiduciary Responsibility of County Employee Retirement System Board Members in California,” Chicago, 2000
1 Baruch Lev, Intangibles: Management, Measurement and Reporting. Washington, D.C. Brookings Institution, 2001
For example, ‘Scenarios for a Clean Energy Future’, Oak Ridge; Argonne; Pacific North West; Lawrence Berkeley; National Renewable Energy Labs, for U.S. Department of Energy, 2001