Climate change – setting the record straight for investors
Investors and analysts who bought into the idea that climate change would have a major impact on their investment strategies over the next 30 years could be wondering if they, and the climate scientists, got their forecasts entirely wrong. In the wake of recent events the climate skeptics suddenly appear to be in the ascendancy. At Inflection Point Capital, however, we take a decidedly contrary view: all of our empirical stock market research tells us that, even with grossly imperfect public policy and regulatory regimes in place, there is already a “carbon beta premium” available to companies with more robust climate risk/opportunity management — and for their investors.
The trick, of course, is to assess companies’ risk and opportunity exposures with a robust, multi-factorial model, rather than relying on the criteria and information sources which seem so prevalent today: companies’ “carbon footprints”, and self-reported, unverified company “disclosures”. We have written about this in much greater detail elsewhere; the point of this article is simply to examine whether arguments which seemed compelling six months ago still hold water.
Which brings us back to the currently ascendant skeptics. There are five recent developments that the skeptics might point to in order to back their long held view that concerns about climate change are based on bad science and misguided political agendas. These five areas of contention, which may now be unsettling the large numbers of investors who backed initiatives such as the Carbon Disclosure Project (CDP) can be summarised as follows:
i. During the winter of 2010 much of Europe, North America and parts of Asia experienced very heavy and sustained snowfall, accompanied by freezing temperatures, even snow and ice in usually balmy Florida, physical evidence it would appear that the planet is not hotting up (the image, opposite, of a ‘whiteout’ Britain made front page news);
ii. The Hadley Centre, part of Britain’s Meteorological Office, estimated that the warmest year since records began was 1998. A period of twelve years without another new record would represent a significant lull in what was forecast to be a rising trend;
iii. Question marks have been raised over the science of climate change and the integrity and impartiality of the IPCC and leading academics. An email from Dr Kevin Trenberth of America’s National Centre for Atmospheric Research found its way into the public domain. In it he wrote that “The fact is that we can’t account for the lack of warming at the moment and it is a travesty that we can’t.” This was one of thousands of leaked e-mails from the Climatic Research Unit of the University of East Anglia in the “climategate” furore of November 2009. To make matters worse, the Intergovernmental Panel on Climate Change — meant to be the gold standard and subject to rigorous peer review and based on hard scientific data — has made a series of blunders. The IPCC assertion that there is a very high likelihood glaciers in the Himalayas will disappear by 2035 is unsubstantiated by science. The IPCC has now admitted it was "a lapse in standards". But this follows a number of other assertions about the impact of natural disasters and the future of the Amazonian rainforest that now turn out to be controversial.
iv. The failure of Copenhagen, which had been billed as ‘Hopenhagen’ by many in the climate camp, had several negative ramifications for investors. Carbon prices in Europe dropped to a six-month low after agreements made at the Copenhagen climate summit to cut emissions disappointed traders. The European Union said it was not willing to raise its carbon cutting target to 30% by 2020. In early market trading after COP15, EU allowances for December 2010 delivery, dropped 8.7% to just €12.40 a tonne. A deeper cut in emissions targets would have increased demand for these allowances, pushing up prices. The 193-nation UN conference ended with delegates simply "taking note" of a US-led climate deal. Climate convention head Yvo de Boer has just stood down from his post.
v. Claims by leading industrial nations such as Britain about the importance of green elements of fiscal stimulus packages seem to be rather hollow ones. In January 2010 Prime Minister Gordon Brown announced that a strong industrial strategy would turn Britain into the world’s leader in low carbon industry. Yet to factories and businesses not much seems to be happening. When analysts at HSBC studied last year’s fiscal stimulus plan, they concluded that only 7% would go to the environment. The day after the Prime Minister’s statement it emerged that due to a lack of British suppliers most of the funds earmarked to build the world’s largest offshore wind farm in the Thames estuary would be going to foreign firms. Last summer Britain’s only wind turbine factory on the Isle of Wight was shut down.
So the evidence would now seem quite compelling, that climate change is actually an illusion dreamt up by bureaucrats, and investors have been hoodwinked. Or at best there may be some cautious investors who still see the potentially negative impacts of climate change on returns, but who feel that direction is now lacking.
At IPCM we take a much less pessimistic view of the developments outlined above, and can point to strong counter-arguments in each case. Let us deal with them one by one.
While it may appear unlikely at the moment, as many of us continue to shiver in the snow, 2010 may well turn out to be the hottest year on record. It would be a mistake to confuse the weather with the climate. Weather refers to short term, localised and unpredictable meteorological patterns, climate refers to longer term trends at the global level. The fact that no record high occurred in the past decade does not mean that there was no warming over that period. Trends at scales coarser than the annual continued to point upwards and several authorities suggest there have been record years during the period.
Nor was the length of time without an annual record unusual. Models simulating centuries of warming normally have the occasional decade in which no rise in surface temperatures is observed. This is because heat can be stored in other parts of the system such as the oceans and for a while be hidden from view. One reason for the assertion that the coming year will be warmer than any other is that the Pacific Ocean is currently releasing heat. This phenomenon, by which heat that has been stored up in the sea over the previous few years is released into the atmosphere, is known as El Niño. A strong Niño contributed to the record temperatures in 1998. In 2007 and 2008 the opposite phenomenon, a cooling La Niña, was observed, but this is now weakening. That goes some way to explaining why those years were cooler in comparison with those of the 2000s.
The sun’s brightness also has an impact. It fluctuates over an 11-year cycle and whilst the fluctuation is not dramatic, it is sufficient to make a difference from peak to trough in the warming charts. In 2009 the sun was at the bottom of its cycle and is likely to brighten over the next 12 months.
Where ‘Climategate’ is concerned, Dr Trenberth’s emails appear to have been taken out of context; he was not suggesting that the relatively stable temperatures of the 2000s were particularly out kilter. Instead, he was postulating that the array of satellites and measurement networks being installed to monitor the climate should now make it possible to identify the places and processes that hide energy from the climatologists. These additional data sets would make it possible to determine what has actually happened to the energy trapped by increasing levels of greenhouse gases. It has also been recently revealed that a police unit set up to support forces dealing with extremism in the UK is helping investigate the leaking of climate change data in Norfolk. In November 2009 the computer server at the Climate Change Unit at the University of East Anglia had been hacked and the e-mails leaked.
So far as the IPCC is concerned, the vice-chairman of the UN's climate science panel has admitted it made a mistake in asserting that Himalayan glaciers could disappear by 2035. But he said it did not change the broad picture of man-made climate change, quoted as saying: “I don't see how one mistake in a 3,000-page report can damage the credibility of the overall report….Some people will attempt to use it to damage the credibility of the IPCC; but if we can uncover it, and explain it and change it, it should strengthen the IPCC's credibility, showing that we are ready to learn from our mistakes.” He suggested that some of the IPCC's working practices should be revised by the time work begins on its next landmark report, due in 2013. But its overall conclusion that global warming is “unequivocal” remains beyond reproach.
And in March 2010 a review published by the UK Met Office found that human activities are causing climate change. It claimed the evidence is stronger than when the Intergovernmental Panel on Climate Change carried out its last assessment in 2007. The analysis, published in the Wiley Interdisciplinary Reviews Climate Change Journal, has assessed 110 research papers on the subject and reports that the Earth is changing rapidly, probably because of greenhouse gases. Since publication of the IPCC study the evidence that human activities are responsible for a rise in temperatures has increased, according to this new assessment by Dr Peter Stott and colleagues at the UK Met Office.
The lack of a tangible deal at COP15 is admittedly one area where a weak message was sent to investors. The biggest step Copenhagen could have taken to stimulate the green economy would have been to send a strong signal that the financial penalties for carbon dioxide pollution will increase. But the deal that emerged included no national carbon dioxide caps. While it did lay down a goal to maintain global temperature rise to within 2ºC of pre-industrial levels, it left emission reduction declarations to the end of January 2010 — and even these are not legally binding. It does mean investors are unsure about the likely future price of carbon. Airlines and utilities companies, for example, could argue they are unsure about whether upgrading to cleaner technology will be economically worthwhile.
However, this does not change the fact that the Copenhagen conference was a unique moment in history, with 110 world leaders present and a single issue on the agenda. The countries that brokered the text, the US, China, India, South Africa, Brazil and the EU, also reflect a 21st century world in which the balance of power has shifted significantly and inexorably, with emerging market countries now firmly on investor horizons.
The conference redefined the debate between countries in terms of awareness of climate science and support for action. Climate change now figures in the political thinking of virtually every country on the planet. In addition, public awareness has also increased greatly. Campaigns run around the world prior to Copenhagen by governments, NGOs and business, together with the extensive media coverage of the issue and the summit, made the need to address climate change widely understood amongst consumers.
Another achievement was the idea that green growth is fast becoming the prevailing economic model of the 21st Century. The view that addressing climate change is bad for business was dealt a mortal blow at Copenhagen. Countries from both developed and developing worlds have announced low-carbon economic plans and are moving forward, with funds being made available for that. Furthermore, while an aggregate global emissions cut may not have been agreed upon (a 50% cut by 2050 had been mooted in pre-summit texts) individual nations and economic blocks such as the EU are still setting ambitious targets for emissions reductions that will have a major impact on government policy in areas such as energy, transport and real estate, such that a business as usual scenario no longer exists.
Finally, to turn to apparent low levels of investment in the green economy by governments such as the UK, real commitments are in fact being made. Countries such as Denmark, Germany and Japan are forging ahead and building low carbon industries, fiscal stimulus plans show spend on the environment at 81% in South Korea, 34% in China and 12% in America. And in the UK successful bids for nine new offshore wind farm zone licences within UK waters have just been announced. A consortium including Npower and Norway's Statkraft won the licence for the biggest zone, in Dogger Bank, which could produce nine gigawatts of energy. Turbines in the nine zones could generate up to 32 gigawatts of power, a quarter of the UK's electricity needs.
Where the climate change debate is concerned, some would argue it’s now become a two horse race. The protestations of the climate sceptics have, until recently been drowned out by the overwhelming concensus of opinion suggesting that climate change matters a great deal to investors. The skeptics would now argue that they have enough evidence to support their cause as we enter the final furlong in this debate. Our view, however, remains unchanged, and that it would be backing the wrong horse to allow recent doubts about the veracity of climate change arguments to dent investor conviction that this issue will have to be incorporated into investment strategies in order to minimize future portfolio risks and identify corporate out-performers.
The secular direction for this phenomenon has now been set, and atmospheric physics alone suggest that it will not be reversed. The only real questions remaining are the timing and full magnitude of its impacts, as well as its geographic, sectoral, and company-specific effects, which will vary widely. Our own research suggests that same-sector climate risk exposures — properly defined — can vary by thirty times or more. Savvy investors will want to know which companies are which.
See, for example, Matthew Kiernan (2010) “SRI or NOT SRI” in A. Calvello (ed) Environmental Alpha:Institutional Investors and Climate Change. New York: John Wiley & Sons)