As global markets digest the implications of the latest move from the Obama Administration, we argue that investors must adapt to the evolving reality of climate change with transparency, engagement and pragmatism.  In this note, John Wilson, Cornerstone’s Head of Corporate Governance, Engagement & Research, articulates our firm’s position on this pivotal issue.

Introduction

Although it is broadly understood that climate change has potential far reaching economic implications, the effect on investment analysis has been limited by a lack of certainty about long-term climate policy.

The Obama administration’s regulatory agenda, including the recently introduced proposed regulations on existing power plants, begins to clarify expectations for industry for greenhouse gas reductions. While substantial uncertainty remains, investors can expect that increasingly broad-based and stringent restrictions on greenhouse gas emissions will impact valuations across sectors, particularly the energy sector.

Especially in light of a divestment campaign targeted at the fossil fuel industry that has gained widespread attention, investors are challenged to respond to the rapidly changing dynamics of this issue. However, the necessary data and analytical tools have not yet fully emerged.

This statement identifies the perspective of Cornerstone Capital about how investment managers should adapt to this evolving reality. It emphasizes the impact on the energy industry, which is the sector most directly affected by the shifting market dynamics, but is applicable to all sectors.

Background

Cornerstone Capital Group trusts the scientific consensus, affirmed by the 5th Assessment Report (AR5) of the United Nations Intergovernmental Panel on Climate Change (IPCC), that human activities, especially the burning of fossil fuels, are having a profound effect on the world’s ecosystems. The warming of the atmosphere and the acidification of the oceans resulting from the increased concentration of greenhouse gases in the atmosphere are causing rising sea levels, mass extinctions, increased extreme weather events and many other disruptions. Going forward, climate change threatens to disrupt social-political systems and reduce economic growth, especially in developing countries.

Uncertainties about these outcomes gradually will increase financial market volatility and erode the ability of investors to produce reliable economic forecasts. For example, the world’s food system, which is dependent on energy- and water- intensive systems of agriculture (and itself a driver of climate change), is especially at risk from disruptions to atmospheric and hydrological systems. Predicted decline in agricultural yields could increase global food prices, hampering economic growth in developing countries and increasing risk of civil conflict. The resulting macroeconomic impacts could be dramatic but hard to predict.

The AR5 confirms that it will not be possible to completely avoid the effects of climate change, and physical impacts have already been observed. Conversely, the World Bank and others have argued that it may not be possible for the economy to adapt to severe climate change predicted under some “business-as-usual” scenarios. Preserving long-term economic and social resilience will require a combination of mitigation and adaptation strategies.

Insufficient political will currently exists to adopt policies to fully reverse a global trend of rising emissions, driven primarily by economic growth in developing countries. However, as the cumulative physical and social impacts of climate change become increasingly apparent, a “tipping point” in favor of more aggressive policies grows more likely over time. Without such policies, the physical and social effects of climate may begin to drive macroeconomic trends in the coming decades.

Investment Implications

The International Energy Agency has observed that existing fossil fuel reserves held by the energy industry are far greater than the amount that can be combusted sustainably. Some non-governmental organizations (NGOs) and financial analysts claim that once climate policies are implemented, existing fossil fuel assets will become stranded, leading to a devaluation of the shares of fossil fuel companies. Indeed, many U.S. coal companies, facing stringent environmental legislation, currently trade at a discount to the book value of their assets. On the other hand, some recent oil and gas industry analyses dismiss the possibility of aggressive climate policy that would demand a change of business strategy.

Some NGOs have called upon institutional investors to divest their holdings of these companies and redirect the proceeds towards renewable energy and other climate-friendly investments. Divestment supporters argue that not owning fossil fuel companies will improve investment results, but their primary objective is to build political momentum for strong climate mitigation policies.

The divestment campaign has proven to be an effective strategy for mobilizing people, particularly young people, to take action.  However, the campaign is less likely to be effective as an investment strategy, since a minimal proportion of all invested assets participates in divestment campaigns. Moreover, because energy production and consumption drive the level of greenhouse gas emissions, energy policy must encourage a transformation of market demand in addition to a diversification of fuel sources.

We agree that climate risk is not fully captured by financial market prices, in part because of the difficulty modeling climate-related uncertainties and in part because of the perception that the problem takes place on a time scale beyond the horizon of most investment analyses. Although many asset managers await clearer regulatory signals before factoring environmental issues into valuations, over time economic models that do not integrate the full potential impacts of climate change may become increasingly unrealistic.

Nevertheless, the assertion that all fossil fuel companies are overvalued because of “stranded assets” is too simplistic. Climate change is both an industry-wide and a competitive issue, and numerous uncertain factors will determine the risk and valuations to particular companies, for example:

  • The relative greenhouse gas intensity of different fuel sources
  • Uncertainties around reserves levels, expected timing of resource development, and capital development costs
  • The timing and nature of restrictions on carbon emissions, especially as they impact market demand
  • The cost of substitutes, including energy efficiency improvements and low carbon sources of energy
  • The political economy of resource producing states
  • The long-term economic and social effects of climate change itself

Unless companies disclose information about how they may be affected by these and other relevant factors, investors will be unable to fully understand the implications of this issue for company valuations.

Recommendations

Cornerstone Capital believes that the financial markets’ primary contribution to a resilient economy should be to properly value the economics of the environment and more efficiently allocate financial resources to sustainable uses. We recommend that investment managers take a proactive approach to enhancing their own capabilities in this area.

  • Investors should engage with portfolio companies in the energy sector, asking for better information about how companies are positioned to manage climate change. Some companies may claim that they will be unaffected by future climate policy, but investors cannot evaluate these claims without a clear analysis of all relevant scenarios.
  • Investment managers should develop their capabilities to model the economics of climate change, including both industry wide and competitive implications of diverse climate scenarios. This will require increasing investors’ ability to model uncertainty, as opposed to risk as traditionally defined.
  • In any interactions with policymakers, researchers, and industry associations, investors should contribute to and learn from broad-based efforts to improve existing tools to anticipate and value the potential implications of climate change.