Climate change a risk, not an uncertainty

Climate change is emerging as a major systemic issue facing investors. Economic damage from extreme weather and shifting climatic belts is expected to get worse, and governments are unlikely to sit on the sidelines.

Investors should no longer categorize the climate change issue as uncertainty, that is, an issue whose impacts can't be quantified. Rather it should be categorized as a risk, in which impacts, particularly of government intervention, can be estimated. This move would facilitate development of a coherent, flexible investment strategy.

Investors need to act now, developing a coherent, flexible strategy to manage the risk of intervention.

The “unburnable carbon” issue — that burning a significant fraction of fossil fuel reserves would trigger unsustainable atmospheric warming and so it must stay in the ground — has become polarized. Those advocating full divestment are seen by many as extreme, particularly as divestment entails the willful avoidance of dividend streams and a risk of underperformance if energy prices rise. However, recent statements from fossil fuel exploration and production companies challenging the analysis behind so-called stranded asset risk have been less than persuasive.

Asset owners increasingly are frustrated, particularly if faced with rising stakeholder pressure to reduce exposure to fossil fuels. Although there have been a few high-profile announcements of wholesale divestment, for the vast majority, the default response is to do nothing and wait for further developments.

Investors struggle to deal with uncertainty, in which the magnitude and timing of a potential impact cannot be readily estimated, but are typically comfortable with incorporating risk information into their decisions, particularly the level of allocation to different types of assets.

For many years, the mainstream investor reaction to climate change has been that the science and likely policy response have been too uncertain to justify action. However, the U.N. Intergovernmental Panel on Climate Change report of September 2013 conveyed a strong scientific consensus over the causes of climate change and the likely consequences for the planet of the current trajectory of greenhouse gas emissions. Subsequent announcements from both the U.S. and China of specific plans to limit emissions of carbon dioxide have raised materially the probability of policy intervention. Investors can now legitimately consider scenarios in which major economic blocs pass legislation to restrict CO2 emissions within the next decade, for example through a “carbon price” which will affect the economics of both energy producers and consumers. Armed with this information, investors can use their traditional management tools, adjusting their asset allocation to reflect a new perspective on risk.

Investors generally have combinations of three types of response to higher levels of risk: seek lower exposure to the assets concerned, reduce the risk or hedge the risk.

Faced with a material probability of a carbon price — charges levied on carbon dioxide emissions — within the next decade, that is, a timescale that matters for decisions taken today, it is rational for investors to reduce their exposure to assets that could be affected. On the one hand, it is likely that the effect on today's valuations of these lower wholesale prices is “drowned out” by myriad other drivers of prices, for example political risk. On the other hand, a carbon price also might render those assets with a higher marginal cost of production stranded, or potentially worthless. It is these assets that should be targeted for selective divestment.

To mitigate risk, investors should challenge the companies whose fortunes could be improved by a change of strategy, for example major oil companies that could cut back on capital expenditure into high marginal cost assets, possibly with a commensurate increase in dividend levels.

Although the wholesale energy price would be depressed by a carbon price, the retail energy price can be expected to rise. By reinvesting the proceeds of selective divestment of fossil fuel assets into energy efficiency-related business opportunities, investors can maintain exposure to the energy sector while avoiding the negative impacts of potential carbon pricing.

Taking a risk-analysis approach to the impact of future climate change policy, investors might decide to reduce their exposure to fossil fuel assets rather than full divestment. A plan of action should include several components. First, examine individual assets to determine their marginal cost of production and thereby their potential exposure to carbon pricing. Second, develop scenarios for the level of carbon prices and the probability and timing of their introduction; a simple model can be developed further as circumstances change. Third, divest in line with the probability-weighted loss per asset; that is, multiply the loss per asset in the scenario by the probability of the scenario occurring. This will be far from an exact science, so it makes sense to start with conservative assumptions, i.e. a relatively low level of divestment. Fourth, consider reinvesting the divestment proceeds into the energy efficiency sector.

Alongside their divestment plans, investors should request additional information from the companies they hold on exposure to carbon pricing risk and consider supporting wider initiatives to persuade stock exchanges and financial market regulators to oblige companies to provide further public disclosure.

Policy to reduce greenhouse gas emissions isn't developed in a vacuum. We won't wake up one morning and discover a material carbon price has been imposed overnight. Nevertheless, governments have a nasty habit of ratcheting up their intervention to solve important policy problems, so investors who can anticipate government action and take pre-emptive measures to protect themselves are likely to outperform.

Ian Simm is CEO of Impax Asset Management Ltd., London.