From a fiduciary perspective, it is not necessary to accept the full version of climate change to begin to manage climate risk exposure.
The transition to a low-carbon economy will have a material impact on financial markets. Both the high-carbon exposure risks run by certain traditional companies and the low-carbon opportunities created by many innovators are exceptionally high. It is essential for fiduciaries to actively consider developments of this magnitude. Inaction due to well-informed active decision-making is justifiable; inaction due to inattention is simply not defensible.
Looking at the response to the underlying science and economics may prove sufficient for fiduciaries to make the case to incorporate climate management in their long-term investment strategy. Two new political developments in August illustrate this theme clearly.
First, the Chicago-based 7th U.S. Court of Appeals for the 7th Circuit in Zero Zone Inc. et al. vs. U.S. Department of Energy et al. ruled that the Energy Department acted appropriately when it issued rules promoting energy efficiency in refrigerators. Even though the federal government does not currently price carbon dioxide emissions, the ruling means that federal agencies in their cost-benefit analysis may apply a social cost of carbon in policymaking, meaning pricing based on market price plus the cost of social externalities.
There are two regional carbon dioxide cap-and-trade schemes that already price carbon dioxide in the U.S. and are mandatory for a specified set of large emitters. The Regional Greenhouse Gas Initiative composed of nine East Coast states and California's Greenhouse Gas Cap-and-Trade Program price carbon dioxide emissions at $5 and $13, respectively, in metric tons.
Second, the White House Council on Environmental Quality issued guidance to assist federal agencies when considering the potential environmental impact of proposed federal actions. Specifically, the council recommends that federal agencies propose updates to include greenhouse gas emissions and climate change.
These are major developments because carbon pricing is the public sector's simplest and most transparent lever for addressing global warming. The Obama administration estimates that a socially efficient carbon price would be $36 a ton, significantly higher than the two cap-and-trade prices. How big would such a tax be in practice? A $36 a ton tax on carbon translates to 36 cents per gallon at the gasoline pump. This tax would constitute a substantial but not an outsized increase in gasoline prices given fluctuations in energy prices over the last decade. Policymakers have indicated such a tax could be deployed for a variety of purposes, including possible progressive rebates and supporting more carbon-efficient technologies.
Corporate profits could be substantially hurt by such a carbon tax. Indeed, if direct emissions of all companies in standard global equity indexes were taxed at $36 a ton and none of the tax was passed on to consumers, corporate profits would fall by 10%. Furthermore, just 10% of companies (and the same proportion by market capitalization) are responsible for 75% of emissions. For this 10% of companies, profits could fall by three-quarters.
As a result, it should not be surprising that organizations like the New York State Common Retirement Fund, the California State Teachers' Retirement System and other asset owners are pursing low-carbon investment strategies that reduce equity portfolio exposures to companies with high levels of carbon emissions and fossil fuel reserves.
Yet low-carbon investing should not focus solely on avoiding high-carbon risks by eschewing carbon-intensive companies. Low-carbon investing should also involve accessing positive opportunities by investing in companies that will benefit from and contribute to the transition to a low-carbon economy.
Indeed, investors have reached out for opportunities in upstream power generation such as solar and wind. The pace of technological change in this segment of the economy has been so rapid that wind and solar costs — which have fallen by 60% to 80% over the last six years, according to Lazard Freres & Co.'s Levelized Cost of Energy Analysis, Version 9.0 — are now competitive in significant parts of the U.S. market.
The opportunity set, however, is much broader. Opportunities exist along the full energy value chain from production, transportation and distribution to generation, transmission and usage. Utilities will need to access and manage alternative energy sources; industrial, equipment and service companies will be able to create emissions saving technologies; and energy-intensive companies stand to benefit most from reducing their direct carbon footprint.
Some companies are already seeing and realizing these attractive downstream opportunities, Oracle Corp. agreed to purchase Opower Inc. in May for its utilities-focused energy efficiency cloud services. Last year, Honeywell Inc. acquired the Elster division of Melrose Industries Inc., focusing on electricity metering.
Progress toward reducing carbon emissions will come through the actions of the private sector, as the main driver of innovation and investment, and also via the public sector, as both actor and enabler. The dynamics of technological progress and advancing regulation will provide some of the catalysts for distinct winners and losers, which could have significant impact on investment portfolios sooner than many anticipate.
Last year featured a wealth of global warming headlines: the December Paris Agreement on climate change; Pope Francis' encyclical on climate and the economy; the collapse of oil prices; the Obama administration's clean power plan to reduce carbon pollution; France's mandatory carbon reporting; and New York state Attorney General Eric T. Schneiderman's subpoena of Exxon Mobil Corp. on climate research conflicts. It was also the warmest year on record.
Global warming headlines in 2016 have been slimmer but the threat of global warming has not diminished. The National Aeronautics and Space Administration reported that each month from January to June set new temperature records, with the average temperature nearly 1.3 degrees Celsius above preindustrial levels. Estimates from the Intergovernmental Panel on Climate Change, a worldwide group set up to provide assessments for policymakers, imply that the atmosphere can only absorb 20 more years of carbon dioxide emissions at current levels if we wish to preserve a two-thirds chance of keeping global warming below 2 degrees Celsius, a level above which risks exposing communities to increasingly dangerous climate impacts.
Investors looking for a guide to these opportunities would be wise to follow two adages: sell picks to miners and find the pinch point in the value chain. Low-carbon investing aligns with the missions and stakeholder interests of many institutional investors and thus deserves consideration for a range of non-financial reasons as well as financial reasons. n
Jess Gaspar is managing director, head of asset allocation and research of Commonfund, and William F. Jarvis is executive director of Commonfund Institute, the education and research activities arm of Commonfund. Both are based in Wilton, Conn.
