The price of climate change

CLIMATE change is gaining traction as a global policy initiative, a key risk factor and an emerging investment theme. This report gives our views on the likely impact on investors and investment outcomes.

We are not going to debate the science of climate change, but note the following key points are driving the debate:

Global average surface temperatures (land and ocean) have risen 0.88 degree Celsius since records began in 1880, according to the US National Oceanic and Atmospheric Administration.

Seventeen of the past 18 years have been the hottest on record globally.

Possible causes are many, including an increase in carbon and other heat-trapping greenhouse gas emissions.

Rising temperatures help explain melting ice caps, rising sea levels, shifting precipitation patterns, droughts and floods.

A warming of two degrees Celsius or more (from the 1880 starting point) is seen by many scientists as an initial threshold for irreversible damage and severe weather effects.

Even if you are sceptical of global warming and its causes, we think it is prudent to appreciate the regulatory momentum behind it.

Governments are moving to curb and eventually reduce greenhouse gas emissions.

Policy changes

Policymakers are targeting fossil-fuel producers and energy intensive industries with tough and costly new rules. They are supporting technologies and companies that boost efficiency and/or harness renewable energy sources.

The Financial Stability Board, which monitors risks to the global financial system, is looking into stress testing of portfolios (starting with insurers) for carbon and eventually water risks. This will likely have implications for pension plans (which own many of the assets) and governments (which generate tax revenues from the resource industry).

Rules can have a material impact. Look no further than the European car-industry selloff after Volkswagen admitted it had cheated on emissions tests.

Or to the underperformance of European utilities after the 2011 tsunami in Japan led to a raft of new safety regulations and a phasing out of nuclear power generation in Germany.

We expect regulators to pay closer attention to standards and enforcement. This is likely to drive up the cost of doing business - much like it did for financial services companies after the global financial crisis.

It took more than a century and trillions of dollars to build the current carbon-intensive economy. It will likely take decades to transition to a lower-carbon world.

Changes will not be smooth, linear or cheap. They will likely involve tradeoffs with economic growth that may not be palatable.

Carbon markets are a case in point. They were introduced to establish a price for the right to emit above a government-set level.

Yet, governments historically have been overly generous with the allotments for polluting companies, in part for fear of hurting national competitiveness.

Emissions also have been lower than anticipated in recent years. Reasons include tepid global economic growth and increased use of cleaner burning natural gas (oversupplied and inexpensive thanks to the US shale energy boom). The result: Carbon prices currently are too low to mitigate emissions.

It is far easier to pay the price of eight euros (S$12) a tonne than invest a multiple of that in a project with funding and operational risks. This shows the inherent conflicts policymakers face.

Carbon markets may have more teeth in the future. Auctioning permits instead of awarding them, tougher caps on emissions and extending the remit to sectors that are mostly exempt currently (transport) would likely help carbon markets flourish.

Why care now?

Global business and policy leaders take climate change seriously.

Extreme weather, natural catastrophes and failure of climate change adaptation ranked among the top 10 global risks in terms of likelihood in 2015, a 2014 World Economic Forum survey of 900 members shows.

Most of these events also were seen as risks likely to have the most impact in 2015.

This high risk perception has put climate change on the global policy agenda.

Climate change creates uncertainty. Temperature rises make weather harder to predict (despite increased data) and raise the margin of error in modelling knock-on effects such as changes in sea levels, agricultural and weather patterns.

There are also economic reasons for climate change mitigation.

China, for example, knows its credit-fuelled and resource-intensive development will become unsustainable, and is shifting to a services-dominated economy. Its citizens are clamouring for cleaner air and water as part of a social pact with the ruling Communist Party. This means Beijing is bent on cutting emissions.

The efforts to curb carbon emissions have evolved in fits and starts. The 1997 Kyoto Protocol required developed countries to cut emissions by 5.2 per cent below 1990 levels by 2008-2012.

The problem? Neither the US nor China, which together produce one-third of global greenhouse gases, were party to the Kyoto agreement.

Onwards to Paris

It soon became clear governments were unable (or unwilling) to meet their Kyoto targets.

The 2011 Durban climate meetings revived the effort, laying the groundwork for new emissions-reduction commitments from 2020.

The United Nations Climate Change Conference in Paris in December 2015 (also known as COP 21) will aim to ratify a new emissions-reduction framework based on the current patchwork of country-specific, post-2020 pledges.

What to expect from the gathering of thousands of delegates beyond intensive use of Paris's bicycle-sharing programme? We anticipate more country-specific commitments. Each country is required to submit intended nationally determined contributions (INDCs). These will be key signposts for progress - especially if the bottom-up approach can evolve over time into a legally enforceable global treaty. The pledges may also offer glimpses of future regulatory regimes.

An international deal to cut emissions has many obstacles: conflicting incentives, a poor economic backdrop and different development stages.

Plus, the Intergovernmental Panel on Climate Change 2014 report says the world needs to halve emissions between 2010 and 2050 to limit the increase in global temperatures to two degrees Celsius from the 1880 level.

If temperatures were to rise by more than two degrees, the risk of climate disturbances would increase and adaptation would become costlier. Recent pledges, especially those from the US and China, have given treaty supporters some cause for optimism, however.

Promises of emissions cuts are thick in the air. Most countries will likely lowball their initial targets. This is not necessarily a bad thing. Some proponents of emissions cuts would say it is better to pick something achievable and ratchet up the target once you have proven it is possible to cut emissions without hurting growth.

China's target is a case in point. Most analysts expect its emissions to peak by the mid-2020s. Yet, the country's official targets factor in a peak in 2030. This should allow China to give the appearance of overachieving (a diplomatic gift that keeps on giving).

It is also key to understand how emissions reductions are achieved. Europe's emissions, for example, are down by some measures - in part because growth has faltered.

This is not a good model to export to the rest of the world.

A signpost of whether COP 21 will have teeth is whether the delegates can agree on regular reviews (say, every five years) that include gradual ratcheting up of targets.

Another signpost would be the adoption of accounting guidelines that help price climate risks across the financial system.

International financial regulators appear to be moving towards eventually incorporating an assessment of climate risk into accounting standards. Will COP 21 actually mitigate climate change? We do not know, and doubt anybody does.

Yet, we keep at least three points in mind:

Politicians often take significant action only when they have their backs against a wall. This sense of urgency has been lacking - and it may not change soon.

Energy efficiency can reduce emissions significantly. The use of fuel-efficient vehicles and energy-saving appliances and lighting will save more than 700 million tonnes of oil equivalent annually by 2040, according to the International Energy Agency (IEA).

This roughly equals the combined annual oil consumption of Germany, France and the UK today. Solutions will range from low-technology (insulation) to high-tech ("smart grids" that use technology to efficiently match electricity demand and supply).

This is already happening. Regulations on emissions and efficiency standards will likely accelerate the change.

Other technology advances and shifting consumer preferences also have the potential to uproot the carbon status quo. Wind power has become cost competitive with traditional sources of electricity generation, according to the IEA. Solar panel prices halved between 2010 and the end of 2014.

No climate change risk for stocks?

Many equity investors ignore climate risk, and credit investors and ratings agencies do not routinely assess it. Property markets often ignore extreme weather risk, even in highly exposed coastal areas.

Most asset owners do not measure their exposure to potentially stranded assets such as high-cost fossil fuel reserves that may have to be written off if their use is impaired by climate change regulation.

Who can blame them? There is little evidence that assets more susceptible to climate change and related regulatory risks trade at a discount to the market.

A simple analysis of monthly returns in the MSCI World Index shows low carbon-intensive equities (those with the lowest carbon emissions by revenues as at 2014) have outperformed those with the highest carbon intensity over the past 20 years. Yet, this outperformance vanishes after stripping out the impact of common return factors such as size and geography, we found. In other words, we found there has been no climate change risk premium for equities. Yet, this does not mean there will be no premium in the future. In fact, we think there likely will be one. Many countries are set to adopt carbon taxes or cap-and-trade (emissions trading) programmes to help meet their INDC targets.

Greater transparency on climate risks and exposures will likely lead to a gradual discounting of companies and assets exposed to climate risk - and increase the value of those most resilient to these risks. Some asset owners are already divesting from carbon intensive equities, while others are "hedging" their carbon exposure by investing in renewables, energy efficiency and clean tech.

It can be costly to underestimate environmental risks. Just ask BP's equity and debt holders. Rising risks increase the importance of having accurate data to monitor and help prevent climate change casualties in portfolios. We encourage corporate management teams to improve disclosure and support index provider MSCI's methodology for tracking ESG (environmental, social and governance) risks in around 5,500 companies.

Scoring is still relatively crude, but it is quantitative and scalable. This helps investors recognise and monitor ESG risks in their portfolios. We are building the ESG data set into our Aladdin risk management system. We are also taking advantage of emerging sets of carbon data to measure the carbon footprint of portfolios or to generate alpha.

Sustainable investing

Many asset owners do not only want to identify climate risks in their portfolios; they increasingly want to make sure their assets reflect their values and deliver a long-term positive impact on the world.

Institutional investors managing US$24 trillion in total assets signed the Global Investor Statement on Climate Change in 2014.

The pact commits signatories (which include BlackRock) to manage climate change risk as part of their fiduciary duty to clients.

This involves working on initiatives to deploy capital towards a low-carbon economy; identifying low-carbon investment opportunities; and encouraging company disclosure of climate change risks.

Asset owners focused on sustainable investing can have impact in three ways:

Prevent: Screen out securities that do not align with their values, such as fossil fuels, tobacco or arms makers. Norway's parliament, for example, has voted to divest coal assets from its sovereign wealth fund.

Promote: Focus on companies with strong ESG track records and integrate ESG factors into the investment process. Sustainable investment portfolios are an example.

Advance: Target outcomes that have a measurable impact on the environment. Examples include direct investments in renewable or energy-efficient projects and green bonds.

Sustainable investing is not a passing fad.

This is not just about doing or feeling good. ESG factors cannot be divorced from financial analysis. We view a strong ESG record as a mark of operational and management excellence. Companies that score high on ESG measures tend to quickly adapt to changing environmental and social trends, use resources efficiently, have engaged employees, and face lower risks of regulatory fines or reputational damage.

Some carbon-intensive companies have invested heavily in alternative energy. And the biggest polluters have the greatest scope to reduce future emissions. Many of them will be part of the solution.

Winners and losers

Which countries are best prepared for a less carbon-intensive world? Sweden and France look ahead of the curve thanks to their low emissions and high energy-efficiency, according to our simple scoring system.

The world's two largest emitters - China and the US - score poorly, as do energy-exporting countries such as Saudi Arabia.

Australia is in a tough spot. Its largest export is coal, which also accounts for two-thirds of its electric power generation, according to the Australian Bureau of Resources and Energy Economics. Australia is still investing in coal mines and infrastructure. Some of these assets are at risk of becoming obsolete if demand for coal dries up and prices keep falling.

We see two caveats: Tumbling coal prices actually increase the cost advantage of coal-fuelled power over renewables. And the need to cut carbon emissions has to be balanced against growing demand for energy (particularly from emerging Asia). New "ultra-supercritical" coal-fired plants are 35 per cent cleaner than traditional plants and part of the solution, proponents say.

Countries that import fossil fuels could be winners, provided they have the political will and capital needed to invest in renewables.

China consumes half the world's coal and generates 26 per cent of global carbon-emissions, according to the IEA. Its five-year economic plan emphasises sustainable growth, increases regulations on air pollution and expands carbon trading. The falling cost of renewables could lead to a shift away from traditional energy sources.

Another potential winner is India - if it invests to improve power distribution and clean up worsening air pollution. The country has 15 of the 30 most polluted cities in the world by air quality, according to the World Health Organisation.

There are savings to be made. India's electricity transmission and distribution is inefficient. It loses 17 per cent of electricity generated, compared with 6 per cent in the US and China, World Bank data shows.

Lower fossil-fuel consumption would ease the fiscal burden of fuel subsidies amounting to 0.5 per cent of India's economy in 2014-2015, according to the World Bank.

Meanwhile, investing in a high-growth sector such as renewables is not for the faint of heart. When too much capital chases limited opportunities, bubbles are created. Prices often fall as adoption rises and competition intensifies. Today's margin of scarcity is tomorrow's competitive opportunity for a disruptor.

This is why we like to invest in renewable infrastructure projects. An influx of capital into the sector is pressuring returns on operational assets, but construction-stage projects often offer better value, we believe. These are long-term investments with limited liquidity. Patience and a stomach for volatility are key.

This article was first published on December 7, 2015.
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