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Climate Change November 2013 Natural Capital Identifying implications for economies This report explains the concepts of natural capital, the future drivers of change and the mechanisms to factor natural capital into macroeconomics. Changes to the availability and functionality of natural capital will become increasingly material for economies, political agendas and corporates, ultimately impacting investment decision making. Natural capital factors – air, land, water and habitats – underpin the ability of economies, corporates and consumers to operate. As the quantity and quality of natural capital components change, productivity is impacted. We think climate change vulnerability, expressed through water and carbon risk, is the most important focal point for investors. By Zoe Knight, Nick Robins and Wai-Shin Chan Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it Natural capital and the economy Lakes Rainfall Water Natural Capital Nature Hydro electricity Transportation Industrial processes Drinking water Sanitation Purification Human health and welfare Economic activity Conservation Industrial effluent Reduced quantity Pollution Scarcity Damage Natural capital management This report has been produced in conjunction with Professor Paul Ekins of the Institute of Sustainable Resources at University College London Source: HSBC Climate Change Global November 2013 abc Summary Natural capital provides the environmental basis for economic activity, but is not routinely captured in forecasting. We think that natural capital factors are becoming a bigger driver of overall economic productivity and that, increasingly, policymakers will act to manage change. Ultimately, this will impact the potential return profile of assets. Our climate analysis shows that water and carbon risk management are the most pressing issues to be incorporated into macroeconomic thinking. Natural capital and economic activity inherently linked The economic system does not exist independently from natural capital – it exists within it, with air, water, land and habitat all providing a variety of environmental functions and life-support mechanisms that enable growth and development. The contribution of these natural capital components to economic activity and to society more broadly have been difficult to isolate and analyse because of limited data and insufficient methodology. This is changing. Natural capital imbalances at a local level (water availability) and on a global basis (carbon) driven by population, economic activity and technology have increased in prominence. Disruption has become clearer and governments are starting to manage the risks by implementing policy. Now, investors are driving demand for natural capital metrics and methodology to take potential risks and opportunities into account at the macroeconomic level. How does natural capital fit into the macro economy? We believe that natural capital intersects with the macro-economy – notably output and prices – in three main ways: first, natural capital contributes to economic value; second, economic activity can depreciate natural capital; and third, response measures to restore natural capital can have macro-economic effects. Natural capital contributes to economic value Natural capital stocks provide a direct contribution to economic output (eg, water in hydro power) as well as indirectly by providing services for human welfare (eg, clean drinking water). Natures’ replenishment system also acts as a regulating mechanism (eg, the water cycle can dissipate effluent). But these benefits are often taken for granted as positive externalities, and so are often over-used and abused. Changes to the availability and quality of natural capital resource stocks and the flow of services they provide will impact economic productivity. For instance, a lack of water availability for cooling power facilities could result in electricity outages, resulting in suboptimal industrial production, or low water levels in a canal could delay freight traffic. Aside from these factors, surprise events relating to a natural 1 abc Climate Change Global November 2013 capital resource such as too much water in the form of flooding can result in lower-than-expected growth or inflationary pressures. Economic activity can depreciate natural capital Economic activity can result in natural capital depreciation. In the words of economist, Partha Dasgupta, “ecosystems are capital assets. Like reproducible capital assets… ecosystems depreciate if they are misused.” The cost of this can now be accounted for. In India, for example, the World Bank estimates that natural capital degradation costs USD36-124bn annually, equivalent to 2.6-8.8% of 2009 GDP. For China, the World Bank estimated costs were USD76bn (2.2% of GDP) in 2007. These costs impair human health, reduce long-run trend growth and undermine overall ecosystem quality. Responding to natural capital depletion has macroeconomic implications Investment is required to maintain natural capital stocks and the ecosystem services that flow from them. Public funding for natural capital is relatively small compared with other sectors. For instance, the EU15 spends just 0.9% of GDP on the environment, compared with 7.5% on health, 5.3% for education and 1.5% on defence. Private investment from households and business is also mobilised by government policy, whether through direct regulation, economic instruments or education that shifts social behaviour. The UNEP Green Economy assessment concluded that 2% of GDP invested in the environment would enable a superior growth profile. Importantly, countries can also respond to insufficient natural capital domestically through trade. We believe that well-designed policy measures to sustain natural capital are positive for long-run economic prospects, helping to drive resource productivity, a key competitive factor. For example, HSBC’s co- head of Asian Economics, Fred Neumann, notes that for China a carbon tax would encourage gains in overall efficiency by spurring the adoption of more advanced technology, boosting productivity and sustaining China’s growth. Chart 1: Summary of how natural capital factors permeate into the macro economy Quantity and quality of natural capital is a driver of economic activity Economic productivity can be enhanced or disrupted because of natural capital factors Managing natural capital can lead to regulatory, fiscal or monetary responses Growth boost / drag Source: HSBC 2 Price pressures Climate Change Global November 2013 abc Prioritising the macroeconomic drivers We believe that the assessment and management of natural capital is becoming more important, particularly for countries with large and growing populations with relatively scarce natural capital at a domestic level, such as China and India. Anticipating the prospect of constraints and/or policy responses to restore natural capital will enable superior investment decision making. In addition to the natural capital implications for trend growth, we also highlight the way in which investor expectations have been challenged by natural shocks, such as extreme weather events (e.g. floods and storms). With climate change, historical patterns of extreme events do not provide a clear guide to future impacts. Ignoring the natural capital factor could result in nasty surprises in the difference between expected and realised growth rates and values. Looking across the G-20 group of economies, (see table 1) we have highlighted a selection of priority countries for investor attention. National water risk: Saudi Arabia and South Africa are already water scarce (<1,000m3/capita), and Saudi is deteriorating fast; India, South Korea and Germany are water stressed (<1,700m3/capita) and India is deteriorating fast. Sub-national water risk: National averages, however, can hide significant regional water risk, and we highlight China and India as particularly exposed (see ‘Scoring climate change risk’, 24 September 2013). We have also conducted a case study of Australia (pages 30 to 33), which has high national per-capita water availability, but exposure to local droughts prompting the use of conservation controls, water tariffs and compensation packages. National carbon risk: China and the USA have the highest emissions, but Australia, Canada, Saudi Arabia, South Korea and the USA have the highest per-capita emissions. Russia, Germany and the USA show the best improvement in carbon intensity (CO2/GDP) (Chart 4). We identify the USA as the economy within the G-8 with greatest distance to target in terms of carbon improvement, and China as the country with the greatest alignment of factors – air pollution, water, technology and carbon – pushing on carbon risk. In short, there are three questions for investors to ask in relation to natural capital and the macro economy. (1) What are the critical economic exposures to natural capital? (2) Is this natural capital exposure well-managed? (3) What are the future risks and resulting economic consequences? Without an understanding of these relationships, investment expectations could be disappointed. 3 abc Climate Change Global November 2013 Table 1: Water and carbon factors are the most important issues to assess from a natural capital perspective G20 Countries Argentina* Australia Brazil Canada China France Germany India Indonesia Italy Japan Mexico Russia Saudi Arabia South Africa South Korea Turkey UK US World 2020 target emissions 2011 water Water 2012 CO2 2012 CO2 % change 2012 CO2 % change % of world Water availability† resource, resource % emissions per capita CO2 / cap intensity of real GDP CO2 (Optimum is very high GDP intensity of availability and rising change 2012 m3/per capita MtCO2 2003-2012 2002-2011 fast) GDP 20032012 0.8% 1.6% 2.1% 2.3% 8.4% 4.2% 5.7% 2.5% 0.8% 3.2% 8.8% 1.9% 1.8% 0.9% 0.6% 2.0% 1.2% 4.5% 25.2% 6,771 21,764 27,551 82,969 2,041 3,168 1,302 1,165 8,332 3,002 3,399 3,563 30,195 85 888 1,340 3,083 2,314 9,001 -7.6% -13.3% -8.8% -8.9% -4.5% -5.3% 0.3% -12.3% -9.6% -5.4% -0.4% -10.6% 1.9% -23.6% -8.8% -4.1% -11.1% -4.9% -7.9% 190 392 500 620 9,208 383 815 1,823 495 406 1,409 496 1,704 615 446 764 318 530 5,786 4.6 17.3 2.5 17.8 6.8 5.8 10.0 1.5 2.0 6.7 11.0 4.1 11.9 21.7 8.7 15.3 4.3 8.4 18.4 33% -5% 31% -11% 102% -16% -10% 55% 27% -21% 2% 11% 7% 32% 1% 26% 29% -16% -16% 0.45 0.46 0.44 0.49 2.04 0.17 0.27 1.33 1.16 0.24 0.30 0.50 1.74 1.24 1.45 0.71 0.51 0.22 0.43 -48% -17% 2% -16% -14% -19% -21% -9% -14% -16% -5% -2% -27% -8% -18% -5% -6% -19% -21% 34,466 31,693 4.9 4.1* 14% 0.64 0% High, falling Very high, falling fast Very high, falling Very high, falling Medium, falling Medium, falling Low, rising Low, falling fast High, falling Medium, falling Medium, falling Medium, falling fast Very high, rising Very low, falling fast Very low, falling fast Low, falling Medium, falling fast Medium, falling High, falling Carbon per capita‡ (Optimum is low per capita and falling fast) Low, rising fast Very high, falling Low, rising fast Very high, falling fast Medium, rising very fast Medium, falling fast High, falling Very low, rising very fast Low, rising fast Medium, falling fast High, rising Low, rising fast High, rising Very high, rising fast Medium, rising High, rising fast Low, rising fast Medium, falling fast High, falling fast Source: HSBC, BP Statistical Review. Note: Argentine latest GDP is for 2010. *2020 targets based on IEA World Energy Outlook 2013 reference scenario CO2 from energy, calculated using UN population forecasts Water Risk† Resource availability: Very low = <1,000m3/cap (water scarce), low = 1,000-1,700m3/cap (water stress), medium = 1,700-5,000m3/cap, high = 5,000-10,000m3/cap, very high = 10,000+m3/cap. Water availability per capita change: Falling fast = -10%-50%, falling = -10% -0%, rising = 0-10%, rising fast = 10%-50%, rising very fast = 50%+ Carbon per capita‡ Per capita levels: low = under 5 tCO2/ cap; medium = 5-10 tCO2/ cap; high = 10-15 tCO2/ cap; very high = 15+ tCO2/ cap. Per capita change: Falling fast = -10%-50%, falling = -10% -0%, rising = 0-10%, rising fast = 10%-50%, rising very fast = 50%+ 4 abc Climate Change Global November 2013 Chart 3: Water resource change 2000 4000 1600 3000 1200 2000 800 1000 400 0 Canada Russia Brazil Australia US Indonesia Argentina Mexico Japan France Turkey Italy UK China S Korea Germany India S Africa S Arabia m3 /year/ cap 5000 0 % 5% 0% -5% -10% -15% -20% -25% Saudi Arabia Australia India Turkey Mexico Indonesia Canada Brazil South Africa US Argentina Italy France UK China South Korea Japan Germany Russia Chart 2: Water availability and use per capita Water resource per capita (LHS) Total water withdrawal per capita (RHS) Source: Aquastat. Black line denotes absolute scarcity, grey line denotes water stress Source: Aquastat Chart 4: % change in CO2 intensity of GDP 2003-2012 Chart 5: Absolute CO2 and CO2 per capita tCO2/ cap 25 MtCO2 10000 5% 0% 8000 20 -10% 6000 15 4000 10 2000 5 0 0 -15% -20% -30% Russia Germany US UK France South Africa Australia Canada Italy China Indonesia India Saudi Arabia Turkey South Korea Japan Mexico Brazil -25% Source: World Bank, Thomas Reuters Datastream, BP. Note: Argentina is excluded since its latest available real GDP data is of 2010. China US India Russia Japan Germany S Korea Canada S Arabia UK Brazil Mexico Indonesia S Africa Italy Australia France Turkey Argentina -5% CO2 emissions (LHS) CO2 emission per capita (RHS) Source: HSBC, IEA, BP 5 abc Climate Change Global November 2013 Contents What is natural capital? Natural capital concepts Natural capital components 7 7 8 Stocks and flows 11 Conclusions 12 Why is it important? 13 Potential trend growth destabilisation 13 Surprise events bring macro volatility 14 Natural capital losses are significant 15 Increased demand for analysis 16 Conclusions 17 How does it fit into the macroeconomy? 18 Natural capital contribution 18 Cost of depletion 20 Investment to maintain the capital stock 22 Increasing policy drivers will become the norm 24 Conclusions 25 What should investors do? 26 Incorporating natural capital 26 1) Identify the natural capital contribution 28 2) Evaluate natural capital management 28 3) Assess future risks and economic consequences 29 Conclusions 31 6 Appendix 1: Data, indices, accounting, modelling 32 Data monitoring has improved 32 Indices – further development 33 Adjusted net income indices aid natural capital accounting 34 Economic modelling 36 References 38 Disclosure appendix 43 Disclaimer 44 abc Climate Change Global November 2013 What is natural capital? Natural capital is water, air, land and habitat Natural capital comprises the ‘stock’ of natural resources together with the ‘flow’ of environmental services they provide As stocks depreciate, the ability of natural capital to provide flow service provision is diminished Natural capital concepts The concept of natural capital relates to the resources (stocks, eg, freshwater) and environmental functions (flows, eg, water provision for plant growth) that provide essential functions to society. For a variety of reasons, these are often not fully factored into policy decisions, economic growth projections and corporate accounting. Natural capital is resources, together with the environmental functions they provide and the ecosystems that support them and are defined as four categories, water (fresh and marine), air, land (including minerals and landscape) and habitats (the summation of water, land and air, including the ecosystems and plants and species habitats support). Previously, when the population was smaller and industrialisation was lower, nature’s replenishment cycle was more than adequate so that natural capital was perceived as unlimited. Now, more people, increasing economic activity and extractive technologies are creating imbalances in natural capital on a regional (water) and global (air) basis, which creates disruption. We argue that natural capital degradation and depletion will become increasingly material for economies, political agendas and corporates, ultimately impacting investment decisions and the value of assets. Haven’t we been here before? The concept of resource scarcity in economic thinking is not new. In 1798, Malthus thought that the provision of food would eventually be constrained in the future when the growth rate of the population outstripped the ability to produce food given the limited capacity of the earth. "The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race.” David Ricardo (1817) and John-Stuart Mill (1862) expanded upon the idea that the economy would stop expanding, whilst Jevons (1865) warned about the potential effect that exhausting coal reserves could have on British competitiveness. Jevons noted that even with technological improvements (increased efficiency of the steam engine) the consumption of coal had increased, leading to the so-called ‘Jevons Paradox’, whereby an improvement in resource efficiency 7 abc Climate Change Global November 2013 "It is wholly a confusion of ideas to suppose that the economical use of fuel is equivalent to a diminished consumption. The very contrary is the truth.. ..[E]very. . .improvement of the engine, when effected, does but accelerate anew the consumption of coal." More recently, in 1972 Meadows et al used a System Dynamics model to simulate the effects of changes in industrialisation, population, food production, non-renewable resources and environmental degradation based upon past trends. The results found that under most scenarios the planet’s growth limitation would be reached within the next century, even with optimistic efficiency and technology assumptions. At the time, the ‘Limits to Growth’ concept gained substantial interest as it coincided with rising energy prices. A 2008 study ‘A comparison of the limits to growth with 30 years of reality’ found that the 1972 publication gave reasonably accurate projections on climate change. The study noted that forecasts for an increase in global CO2 concentrations were for 380 ppm in 2000 (from 320ppm in 1970); in reality the concentration in 2000 was 369 ppm. Today levels are 395ppm. Technology can break the link In reality, technological capabilities and trade have opened up new channels of economic activity. Going forward, we expect technological shifts to continue to have a significant impact upon production capabilities in a number of sectors that are naturally capital intensive, such as energy, industry and transport (please see ‘Disruptive Technologies’, 7 October 2013). Local shortages create imbalances Technology, trade and pricing mechanisms will provide substitutes and solutions for some industries in some regions. The point here is that 8 natural capital is all pervasive, so that significant localised disruption to a natural capital factor means change to economic productivity. In some cases, the financial consequences may be negligible, but in others the natural capital factor will result in significant changes to the way value is created. Natural capital components The core natural capital elements, air, water and land together comprise habitats, but each are made up of sub-components. Air: Quality control Air comprises the stocks of different gases in the atmosphere. Atmospheric and climatological processes can affect ecosystems through air quality, temperature, rainfall and wind. Of the various air functions, quality has a significant direct bearing on the economy through pollution control measures, but air temperature also is a contributor towards changes in the water cycle as warmer weather results in increased evaporation. Chart 6 shows the differences in air quality between G20 countries, as recorded by annual mean PM 10 concentrations. The World Health Organisation recommends that the annual mean should be below 20 micrograms per cubic metre. Half the G20 exceed that level. Chart 6: Air quality varies between countries PM 10, ug/ cu.m 100 80 60 40 Threshold lev el 20 0 S Arabia Indonesi China Argentin India Turkey S Korea Mexico Japan Italy Brazil S Africa US German Canada Russia Australia UK France leads to an increase in consumption of the resource over the long run. Source: World Bank abc Climate Change Global November 2013 Generally air quality is managed through regulation such as emissions caps on energy and industrial facilities and product manufacturers, with fines payable for breaching them. In addition, product standards, such as for vehicle emissions, have been a clear driver of innovation in the industry. Currently, European auto manufacturers are subject to the tightest targets. Chart 7: Target CO2 emission standards for passenger vehicles gCO2/km 170 162 155 150 130 130 110 oceanic). Water availability depends on the level of water in reservoirs, interactions with the atmosphere (rainfall, glacial melt), runoff and river discharge, and tides and ocean currents. Water provides environmental services that directly benefit human welfare and also the environment more generally. Water can provide a direct input into economic production (hydropower, wheat crops) and human welfare (drinking water) as well as providing a habitat for life (fish stocks), transport and tourism (canals, rivers and lakes). Water also provides regulating functions such as the natural filtering of water through the dispersion and dilution of emissions. Regional shortages already exist China USA EU Source: World Resources Institute, China Environmental Standards Organisation, Environmental Protection Agency, EU. Emission standards to be achieved by 2015 in China and EU, 2016 in the USA In 2013, increasing air pollution has captured the headlines, particularly in China. Most recently, the seriousness of the problem has escalated with a study from the World Health Organisation demonstrating the link between pollution and cancer (please see ‘Air pollution causes cancer’ 25 October 2013). The policy mechanism to tackle air pollution is relatively straightforward – legislation, with fines for breaching standards. Some 85 countries (representing 83% of global emissions) have targets in place for reducing greenhouse gas emissions in response to the global consensus of keeping temperature rises to below 2°C. We expect the enforcement of targets to tighten, which means tighter legislation on emission standards and pollution control. Water: Availability and quality Water comprises both the freshwater resources within a nation (surface and underground aquifers) and also marine waters (coastal and Already, pockets of water scarcity are an increasing problem. The water cycle is changing in response to climate change, while increasing demand for water-intensive activities continues unabated. The water cycle is intensifying at about twice the rate predicted by global climate models. Higher temperatures increase evaporation, so that 8% more moisture is absorbed for every 1°C of warming. Essentially, dry regions are already getting drier and wet areas are getting wetter (see ‘Water stress: Analysing the global challenges’, 19 September 2012. The most water-intensive sectors are agriculture, energy, mining and utilities. Any disruption to water supply or quality for these industries means that production costs will likely increase. This is already playing out on a case-by-case basis in the mining industry. For instance, in Chile, which contributes 34% to global copper production, more than 90% of copper production came from water-stressed to water-scarce regions in 2010. So far, desalination technology is propping up the mining industry there, but that translates into higher costs than for other regions. 9 abc Climate Change Global November 2013 Chart 8: Water costs are more where it is scarce 5 0 1.4 1.8 1.4 1.5 1.6 Australia Peru Chile Chilean fresh water Transportation, operating cost Transportation, capital cost Desalination, operating cost and capital cost Source: Wood Mackenzie, CRU Group, Mining Council Chart 8 shows that the cost of transporting water to a copper mine in Chile makes projects 3.6 times more expensive than projects in Australia. While clean, unpolluted water is obviously an important factor for human health and the environment, water quality is not always relevant or imperative for every economic sector. Pollution clearly affects drinking water but is less detrimental as a power industry coolant. We think that water is the most tangible natural capital element to look at for modelling productivity in the context of economic activity, and corporates more generally. For countries that have already been exposed to drought, such as Australia, and where managing water is already a priority, detailed regional and usage statistics are available (albeit buried in the national statistics offices, or meteorological offices). We have previously assessed water challenges from an industry perspective in ‘No water, no power: Is there enough water to fuel China’s power expansion’, 19 September 2012, and ‘China Coal and Power: The water-related challenges of China’s coal and power industries’, 18 June 2013. Land: Agriculture and carbon risk Land, importantly, includes fossil fuels and minerals, which are used as inputs to energy and 10 While small in an economic context, contributing just 3.14% of world GDP in 2010, agricultural production is clearly significant from a humanitarian perspective and employs 30% of the global workforce. In 2011, 4.9bn hectares of land were in use for agricultural purposes globally. This is 37% of the total area of all countries and is 5x the size of the USA. Agricultural yields are the best expression of how combinations of natural capital components work together. Yields are directly impacted by temperatures during the growing season, water availability and soil nutrition. Chart 9 shows that yields have plateaued, while land area harvested is still growing. Clearly, disruption to natural capital factors has a knock-on effect for agricultural productivity, which can result in inflationary pressures (see ‘Less bread for your dough’ 20 August 2012) if supply is less than expected. We looked at the impact of climate change factors in ‘Agriculture: Double Trouble’ 12 December 2011. Chart 9: Agricultural land has increased, yields have plateaued Area Harvested (LHS) Ha 180 ton/ Ha Yield (RHS) 6 160 5 140 4 120 3 100 80 Source: FAO Stat 2012 1 1.8 2002 2 Agriculture: small in value, big in importance 1992 3 1.8 1982 1 1972 4 1962 6 industrial production, soil, which allows agricultural production, as well as geologies and landscapes more broadly. USD/m3 2 abc Climate Change Global November 2013 Chart 10: The carbon budget (GtC) 1600 1400 1200 1000 800 600 400 200 0 1,560 349 1,210 309 1,000 269 >33% >50% Non-CO2 forcings Remaining budget Remaining budget of 269GtC for >66% chance of below 2°C >66% Emitted by 2011 779 Carbon embedded in fossil fuel reserves Source: HSBC, Intergovernmental Panel on Climate Change Habitats: catch-all category Habitats vary considerably depending upon natural conditions involving climate, soil, water and other locational characteristics. It includes woodlands, grasslands, wetlands, freshwater (lakes, rivers, streams, etc), coastal areas (cliffs, sand dunes, etc) and marine habitats. From a climate perspective, forest habitat is the issue to focus on because of its climate regulation properties for CO2. 4150 4100 4050 2010 2008 2006 2004 2002 2000 1998 World 1996 3950 1994 4000 1992 A theme that has increased in prominence in the debate of climate change risk, and which falls under the ‘land’ category of natural capital, is asset stranding of fossil fuels. The current thinking is that to have a 50% chance of limiting the rise in global temperatures to 2°C, only a third of fossil fuel reserves can be burned before 2050. Legislation is already in place to reduce CO2, but there is a wide variation in the scope of tackling a carbon budget with existing initiatives (see ‘Investing within a carbon budget’, 30 September 2013). While the carbon budget is a driver of action, in the larger short-term incentive, in our view, is the by-product of fossil fuel combustion and particularly coal, air pollution. Chart 11: World Forest area on a steadily declining trend (million ha) 4200 1990 Fossil Fuels: plenty of reserves but carbon risk Source: FAOSTAT Natural capital data is improving While current data sources to quantify these systems are by no means comprehensive, they provide information that is a considerable improvement on what was available even a few years ago. Generally, there is more internationally available and consistent data for issues that are further up the policy agenda, such as air emissions and water. We expect metrics to consider natural capital components to become more widely available as quantification increasingly becomes the norm. Stocks and flows Stocks are the underlying resources Together, air, water, land and habitats provide a stock of basic resources that can be used for economic activity. ‘Goods’ (eg, timber, that are inputs into production or consumption) are usually provided by the components (plants, minerals, etc). Flows are natures’ services The ‘services’ (eg, waste recycling) are usually provided by the processes (eg, biogeochemical cycling). Service providing processes can be classified into the following categories. Source functions are those that contribute directly to the economy. A resource stock can provide more than one source function at once; for 11 abc Climate Change Global November 2013 instance, a river can be used for drinking water, and as a method of transportation. Sink functions are the capacity of natural capital to deal with the wastes from human activity, eg, the dilution of emissions in water, or carbon sequestration by forests. The source and sink functions can be in competition with each other, which might create conflict. For instance, as well as drinking water, the river might provide food in the form of fish, and be an outlet for industrial effluent. The river ecosystem can process some waste, but there will be a threshold beyond which the river ceases to be able to provide the drinking water and habitat functions. Where there are conflicts, governments have to decide how to best manage the competing pressures through policy. Unfortunately economic activity too often produces negative externalities into the natural capital stock (greenhouse gases, air and water pollution), which can undermine the natural capital ability to provide the necessary regulating services. This can result in a vicious cycle of environmental degeneration. Table 2 shows examples of the source and sink functions of natural capital components. Table 2: Natural capital components and source & sink functions Air: Properties Water: Ocean Land: Soil Land: Soil Habitat: Forest Source Sink Oxygen Transportation Food production Plant nutrients Oxygen Greenhouse gas Dilutes shipping waste Animal waste Carbon sequestration Carbon Dioxide Source: HSBC Natural capital stocks and flows are of strategic relevance for several industries and can make them more or less productive and profitable. For instance, very energy-intensive industries are often located near stable and low-cost energy sources (eg, hydropower), while the construction of wind turbine blades often takes place in factories located near ports for ease of transport. 12 Conclusions We believe the priority natural capital components to assess are water and carbon risk, which manifests through CO2 emissions. More specifically, this means incorporating analysis of how temperature rises translate into changes in the water cycle in a given region, and how the management of CO2 emissions in relation to reduction goals translates into policy change. Changes in natural capital stocks will, in our view, affect macro indicators such as GDP and unemployment, as well as corporate profits. It is important to keep track of both quantity and quality of resources and attempt to comprehend the feedback effects that changes in these would have on the physical economy. This is especially important in situations where there is an element of critical natural capital (for example, agricultural production, when it is a significant contributor to exports), falling below a level that would fundamentally affect or preclude certain kinds of economic activity. abc Climate Change Global November 2013 Why is it important? Trend growth potential may be destabilised in response to natural capital changes Natural-capital-related event disruption impacts economic output in the short run Regulatory changes are being implemented to tackle the issues, these have longer-term consequences Potential trend growth destabilisation Natures’ cycle of replenishment and evolution alters the stock of natural capital over time. Now, the effects of climate change (global average land temperatures are 0.8°C higher than they were in 1880) in conjunction with population growth and economic activity, are speeding up imbalances between the natural capital stock and its ability to perform environmental functions. Climate change is the archetypal boiling frog. The slow, shifting bias of seasonal temperatures (please see ‘Tackling global warming’, 1 August 2013) is contributing to changes in the water cycle. The physical effects of climate change manifest through water availability, so that past hydrological trends are no longer indicative of future availability as climate change alters rainfall trends and destabilises glacial melt. This can lead to changes to regular events such as the monsoon, and sudden disruptive ones like floods. Variation of the Indian monsoon impacts productivity India is heavily dependent on the monsoon season, and among the G20 consumes the largest volume of water at around 600bn m3/annum, with 90% used for agriculture. In 2011, agriculture contributed 14% to the Indian economy and livelihood to over 70% of the population. Poor irrigation infrastructure in India means that 60% of agricultural land area is dependent on monsoon rainfall. The volume of water during the monsoon season can be measured on a regular basis so that changing trends can be identified. Chart 12: Variation in the monsoon correlates with agricultural activity Monsoon anomaly Agriculture (RHS) % 20 15 10 5 0 -5 -10 -15 -20 -25 GDP (RHS) % y/y 16 12 8 4 0 -4 1980 1985 1990 1995 2000 2005 2010 -8 Source: Indian planning commission Rainfall shortfalls during the monsoon season correlate with agricultural output falls, as shown in Chart 12. In June 2013, the World Bank explored what increasing temperatures would mean for the 13 abc Climate Change Global November 2013 Indian monsoon. It found that global mean warming approaching 4°C would result in a 10% increase in annual mean monsoon intensity and a 15% increase in year-to-year variability of Indian summer monsoon rainfall compared with normal levels during the first half of the 20th century. This would clearly impact agricultural activity. Surprise events bring macro volatility Chart 14: Thai quarterly GDP progression (flood H2 2011) 20% Chart 13: Australian quarterly GDP progression 6% 5% 4% Flood Dec 2010 -> 3% 2% GDP growth YoY (%) Source: Thomson Reuters Datastream Flooding in Thailand In the monsoon season in H2 2011, Thailand witnessed floods that inundated 66 of the country’s 75 provinces. In the immediate Q1-13 Q1-12 Q1-11 Q1-10 Q1-09 Q1-08 Q1-07 Q1-06 Q1-05 Q1-04 1% Q1-03 5% 0% Q1-13 Q1-12 Q1-11 Q1-08 Q1-07 Q1-06 Q1-05 Q1-04 Q1-03 -10% Q1-10 Flood H2 2011 -> Q1-02 In December 2010, Queensland in Australia received 2.5x the normal volume of rainfall resulting in disruption to the coal mining industry. Queensland usually produces 40% of global coking coal exports, but in Q1 2011 export volumes were down 27% year on year. GDP fell -0.5% q/q from Q4 2010 to Q1 over the period (see ‘Australian GDP washed out’, 1 June 2011). In addition, the coal price, though not reaching pre-crisis levels, hit a high of USD138.5/t in January 2011. Q1-02 10% -5% Flooding in Australia 14 15% Q1-09 Recent events in the Philippines provide a stark reminder of the destruction of which nature is capable. Previously, Australia and Thailand have been subject to extreme floods. 0% aftermath of the disaster, HSBC revised 2011 GDP forecasts down from 4.9% to 3.9% (Floods in Thailand, 10 October 2011) and the Thai finance ministry cut its 2011 growth forecast from 4.0% to 3.7%. In addition, the Bank of Thailand cut policy rates by 25bp to 3.25% “to support the economy’s recovery from devastating floods”. GDP growth YoY (%) Source: IMF, Thomson Reuters Datastream The World Bank estimated the damage cost USD45.7bn, while economic growth fell 11% q/q in Q4 2011, resulting an 8.8% fall from Q4 2010. According to the Office of Insurance Commission (OIC), insured losses by the end of the year were only USD10.8bn, implying that the majority of the damage was uninsured. The biggest damage was in the manufacturing sector with a total loss of USD32bn (around 9% of GDP) (see Asian Economics Q2 2012: When you least expect it, 29 March 2012, Frederic Neumann). Flooding seriously affected industrial manufacturing and transport infrastructure resulting in far-reaching impacts on the global supply chain of automotive and electronic components. Thailand is a major exporter of auto/electronic components – electronic components constituted over 16% of its total export in 2010; auto parts accounted for 35% of total exports in 2011. abc Climate Change Global November 2013 In terms of biodiversity, the rate of species extinction in recent decades is estimated to be between 100 and 1,000 times faster than the ‘natural’ rate. Two thirds of the ecosystem services examined in the Millennium Assessment have been degraded or used unsustainably over the past 50 years, including freshwater, fisheries, air and water purification. The TEEB (The Economics of Ecosystems and Biodiversity) initiative is a global effort to draw attention to the economic benefits of biodiversity, including the growing cost of biodiversity loss and ecosystem degradation. The idea behind TEEB is to acknowledge the plurality of values (including monetary, nonmonetary, ethical and aesthetic), which people hold for nature. TEEB’s aim is to mainstream ecosystem services into policy making. 100% 80% 60% 40% Natural capital Produced capital UK Japan US France Brazil Germany India China 0% S.Africa 20% Canada The Millennium Ecosystem Assessment offered a preliminary account of the extent of natural capital degradation and loss, particularly regarding biodiversity, ecosystems and the services they provide. Chart 15: Composition of the capital base in selected G20 countries (2008) Australia Increasing incidences of unsustainable practices has led to recognition among policymakers that maintaining natural capital has economic value. In 2011, in the ‘Towards a Green Economy’ report, economist Partha Dasgupta noted “ecosystems are capital assets. Like reproducible capital assets…ecosystems depreciate if they are misused.” Both the Millennium Ecosystem Assessment (MEA 2005) and UNEP’s Green Economy Report (UNEP, 2011) show that the economic growth of recent decades, while being underpinned by the contribution of nature, did not allow natural capital to regenerate and brought about substantial negative environmental impacts. S.Arabia Independent assessments The Inclusive Wealth Report, produced by UNEP and the UN University’s International Human Dimensions programme on global environmental change, highlighted the varying balance of natural, produced and human capital in the country-level asset mix, as shown in Chart 15. The report showed that in many countries natural capital has been declining in the past two decades. In some cases, such as for the UK and Saudi Arabia, this is due to the depletion of fossil fuels. Russia Natural capital losses are significant Human capital Source: UNEP and UNU-IHDP: Inclusive Wealth Report 2012 More work on metrics In tandem, work is underway to create the metrics to monitor changing levels of natural capital by country. In addition, a variety of organisations have also launched composite indices and accounting. These give an overview of country-tocountry environmental differences and provide a high level starting point for understanding the most critical issues across geographies. Here it is worth reiterating that data gathering and methodologies are still in their infancy, and a number of issues can affect the outcome of the indices, including weighting, aggregation and data availability between different resources across countries. It is therefore necessary to be aware of the limitations of each index so as not to misinterpret or over-rely on their results. 15 abc Climate Change Global November 2013 Nevertheless, we think the composite indices are a good starting point for assessing the relative strengths of country natural capital positioning. One of the most influential indices has been Yale University’s Environmental Performance Index, which is composed of 22 performance indicators representing ecosystem vitality and environmental health, and covers 132 countries. The breakdown of components is given in Appendix 1. In our view, the value of composite indices will become much greater over time as trends in natural capital factors will emerge. We believe that country climate vulnerability and, in particular, water and carbon risks are the most important factors to look at when determining natural capital risks. Increased demand for analysis UK Natural Capital Committee Some governments are increasing commitments to identifying how to account for and value natural capital. For instance, the UK Government set up the Natural Capital Committee in 2012 as an independent body to advise on the effects of natural environment on the performance of the economy and individual well-being. The NCC work programme includes: 1 Producing an annual report on the State of Natural Capital; 2 Developing experimental natural capital national accounts and exploring the links with corporate natural capital accounting; 3 Working with land owners, businesses and accounting bodies to encourage the take-up of corporate natural capital accounting; and 4 Working with academics and research councils to identify research priorities. The aim is for natural capital metrics to be included in economic accounting by 2020. 16 Europe is aiming to enhance natural capital The European Commission recently published a paper on ‘Green Infrastructure – Enhancing Europe’s natural capital’, building on its commitment to resource efficiency. The paper provides guidance on how to integrate green infrastructure into the implementation of key policy areas (eg, transport and energy, climate change mitigation and adaptation among others). The plan is to set up a financing facility to support green infrastructure projects by 2014, complete a study on the ways to implement green infrastructure across an EU-wide network by the end of 2015 and publish further recommendations by 2017. Natural capital declaration Investors are also recognising the importance of natural capital, which was one of the key themes at the Rio +20 summit last year. Then, governments agreed on the need ‘for broader measures of progress to complement GDP’, and alongside this over 50 countries and nearly 90 companies agreed on specific initiatives to factor in the value of natural assets into decision-making. During the summit, financial institutions including banks, investors and insurance firms committed to the Natural Capital Declaration, an initiative for signatories to change their business models to reflect the materiality of natural capital for the financial sector. More than 40 CEOs of banks, investors and insurers worldwide signed the declaration. The four commitments in the Natural Capital Declaration are: Understanding impacts and dependencies on natural capital; Embed natural capital considerations in loans, equities, bonds and insurance products; Embed natural capital in financial accounts; and Disclose and report on natural capital. abc Climate Change Global November 2013 Investors know that natural capital risks are increasing Investors are increasingly recognising that in a bear-case scenario regulation targeting greenhouse gases and/or the physical effects of climate change may result in ‘asset stranding’, ie, that the expected value of an asset may not be realised. When an element of natural capital breaches a critical threshold and can no longer be utilised, the underlying asset is stranded. This discussion has mostly focused on the fossil fuel industry in relation to CO2-reduction goals, but a driver to stranding could also be an absolute resource shortage (such as water). Regulatory drivers to manage natural capital (such as limiting greenhouse gases) are likely to change the demand for a particular good so that the ‘stranding’ effect is likely to impact an industry more broadly. Realised asset value would fall to zero with complete asset stranding. and Germany. However, all countries are impacted by natural capital factors. So far, the analysis of weather-related natural capital disruption has naturally been retrospective because the ability to predict the scale and timing of extreme weather events is challenging. Climate scientists and meteorological organisations are focusing on assessing the probability of an increased likelihood of extremes however, and up-to-date analysis on adapting to climate change will be published in the ‘Impacts, Adaptation and Vulnerability’ report from the Intergovernmental Panel on Climate Change (IPCC) to be released in April 2014. This is most relevant for economies and companies exposed to fossil fuels, such as oil and mining. We have looked at the concept of stranded assets in relation to regulating greenhouse gas emissions to mitigate global warming in ‘Coal and carbon’, 21 June 2012, and ‘Oil & carbon revisited: Value at risk from ‘unburnable’ reserves’ 25 January 2013. Conclusions Clearly, identifying the timing of an extreme disruptive weather event that will impact natural capital is difficult. However, we identified which countries are the most vulnerable to climate change factors in ‘Scoring climate change risk’, 24 September 2013. This is a good framework to prioritise country analysis. Our analysis shows that India, China, Indonesia, South Africa and Brazil are most vulnerable to extreme events relating to climate. The least vulnerable G20 countries are Canada, South Korea, USA, Japan 17 abc Climate Change Global November 2013 How does it fit into the macro-economy? Economic growth relies on labour, capital and natural capital Economic activity uses up natural capital stocks; to maintain quality and quantity of stocks spend is necessary No easy plug in methodology, but macroeconomic tools to manage natural capital include taxes, subsidies and regulation Natural capital contribution At the heart of the natural capital concept lies the stock of resources used to create goods and services, and the flow of environmental services these resources provide. While a number of the resources, such as coal, oil and timber, are well quantified in markets, there are many others that are not, which can lead to stocks and flows being significantly undervalued or ignored altogether. However, it is often not straightforward to apply common economic valuation techniques to these. It is important to relate the natural capital variables to demographic and economic factors in order to incorporate them into any analysis, which is more difficult. Natural capital flows affect people and the economy, which in turn affects the natural capital stock. Increasing human population sizes and urban concentrations will affect many of the characteristics of air, water, land and habitats. Substantial development of analytical models and techniques has taken place to try to give greater weight to, and generate more reliable insights into, natural capital issues in economic analyses. But substantial further development of these 18 models and techniques is required before the economic issues relating to natural capital can be fully taken into account. Theoretical approach: natural capital in the production function The theory of capital as a factor of production and driver of economic growth is long established in economics literature. In the traditional production function, output is a function of manufactured capital, which includes all the machinery and tools used in production as well as the value of the buildings in which formal economic activity is carried out, and labour, which represents the total number of workers. Labour is needed to execute work, either directly or through the use of capital, and contributes to the creation of value. Natural capital and environmental services are missing in this simple but quite standard representation of the factors driving economic growth. Total Factor Productivity (TFP) captures efficiency Over time, output is simply a function of how much capital and labour an economy employs, abc Climate Change Global November 2013 and importantly, the efficiency with which it combines these for full effect. The latter is total factor productivity. Since TFP cannot be directly observed, it is calculated as a residual: after we account for the amount of capital and labour that was added to an economy in a given year, the part of growth not directly explained by the addition of these inputs must have been achieved through gains in productivity. Testing the hypothesis that natural capital TFP is routinely used to track technological progress and efficiency improvement. Indeed, in ‘An Inconvenient Truth’, 1 August 2013, Co-Head of Asian economics Fred Neumann shows that the slowdown in economic growth in Asia is in part down to a decline in TFP growth. In reality, elements of natural capital change are probably included by the TFP residual, but data availability and understanding of the relationship between natural capital and economic growth has hindered isolation of the natural capital variable. We think this is changing because of increased measurement of resource stocks. It is therefore difficult to demonstrate the true relationship between a change in an element of the natural capital stock (eg, less clean air) with its impact on people (worse health) and the resulting implications for contribution to growth (lower labour productivity). At this point, however, it is worth remembering that analysis of the contribution of natural capital to the macro-economy is so far in its infancy, partly because a common assumption in economics has been that substitution between manufactured and natural capital is unconstrained, an assumption that now seems increasingly questionable. The balance between capital stocks has shifted dramatically, such that in many contexts it is natural capital that is now the scarce factor. Why is it so difficult to include natural capital in GDP growth forecasting? In a more realistic production function, natural capital would combine with manufactured and human capital as an input to production. This is much easier said than done for several reasons. contributes to growth is difficult because isolating the relationships is complex Natural processes are complex, even before assessing how they relate to growth. Many of the most fundamental environmental functions, such as climate regulation, operate globally and involve many natural systems in sometimes little understood ways. But isn’t the labour relationship with growth also complicated? Measuring the contribution of labour to growth is relatively straight forward by comparison. At any moment in time, there is a fixed stock of workers who are of working age (which clearly changes over time because of demographics and net migration). Of these, some will gain higher education, and there are techniques to quantify and aggregate these gains, such that the contribution to growth from an increase in the number of workers that achieve a given level of education can be modelled. So why can’t we measure natural capital productivity? For natural capital, it is difficult to determine how productive the fixed stock is. Often the stock component is quantifiable (litres of water, barrels of oil, hectares of land), as is the flow (X litres of water to produce Y KWh of hydro-electricity, A barrels of oil to drive B km), but the overall contribution of the resource to economic activity is dependent on other variables. 19 abc Climate Change Global November 2013 Example: water and coal for electricity Electricity can be produced using clean or polluting sources. In the production of electricity with the ‘clean’ source, hydro, the value of the end electricity output is known by the price that is paid for it, but the value of water in producing it is effectively a residual: the price of electricity (in part set by another source of power generation) less the cost of all the labour and capital inputs to generate the power. If the quantity of water declines, so will the power output from the dam, and the value of that can be calculated and accounted for as the value of the water reduction, but the effect on the macroeconomy will depend on the availability of other power supplies (such as coal) to supplement the reduction in hydro-electric power, and the cost of these substitute resources. The macroeconomic contribution of the water crucially depends not only on itself but on the availability of other variables as well. Furthermore, the electricity end user can produce the same number of goods because of the substitutability between the ‘good’ and the ‘bad’. It gets more complicated Economic activity, for instance agriculture, can also be dependent on two interdependent natural capital components. Example: land, its sub components and contribution to agricultural productivity In the case of assessing the contribution of soil to agricultural productivity the main stock of the resource – land – has sub categories such as soil and interdependencies with other natural capital factors such as water and air (productivity depends on the right air temperatures during the growing season). Soil allows food to be grown with varying productivity depending on other inputs, but it also acts as a sink for storing carbon, permits the 20 seepage of water to recharge groundwater and supports biodiversity. Of these examples, only food has a clearly marketable output to give a direct sense of the value of the contribution of soil to the economy. The contribution of the other inputs to food production (machinery, fertiliser, labour) is relatively easy to identify because they are mostly purchased. However, the separation of the contribution of soil to food production from that of water (especially rain) is effectively impossible. Either too much or too little water can damage agricultural productivity, but by how much will also depend on the type of soil, the crop and timing of the water deficit or surplus. Separating out these different economic contributions even at a farm level is very hard indeed. At the level of the macro-economy, it is only possible with the most sweeping general assumptions that abstract almost completely from the detail of the actual processes involved. These interdependencies provide insight into why assessing, and by extension forecasting, the contribution to economic growth from the natural capital factor is so difficult. Cost of depletion Mainly quantifying individual cases On a more positive note, it is much easier to assess the impact of economic activity on natural capital, e.g., the polluting effect of industrial activity and the resulting costs of the health impact. In many instances, the costs arising from the depreciation of natural capital, including ecosystems, are externalised onto society. This is due in part to market signals that account imperfectly for the economic value of natural capital goods and services, and for the costs of related degradation and loss, but also due to the lack of appropriate measurement and valuation methodologies. abc Climate Change Global November 2013 Costs are usually calculated as environmental degradation and expressed in terms of GDP. It is easier to quantify negative externalities than positive ones because there is a ‘forced’ cost to ‘fix’ the problem when activity depletes resources to critical levels, such as purifying drinking water, increasing health treatment for pollution, or infrastructure rebuild after natural capital disasters. Example: The many costs of forest depletion The presence of forests is crucial for timber production, such that depletion will impact the profitability of firms. In addition, excessive deforestation can also lead to higher river sedimentation, reducing the use of waterways for the transport of goods and people. The creation of roads is then seen as a solution to the problem, but it is in fact a cost required to replace a (free) function previously offered by nature, as is the cost of dredging, an action implemented to restore an environmental function, and a cost that could have been avoided by maintaining the forest. Interestingly, the cost of replacement of these functions very often will show up in GDP as an increase in economic output, when in fact such costs are only replacing goods and services that were previously provided for free. GDP in such cases systematically overstates the actual net gain from such economic replacement activities. Vicious cycle of increasing costs as stocks are diminished below sustainable thresholds Initially, small costs can escalate into significant ones as more is required to achieve the same productivity. For example, if fish stocks are depleted, more capital investment (eg, in expanding the fleet and more nets, and more employment to operate them) will be required to maintain the catch, the cost and price of which will increase. Further economic growth will add to the demand for fish and raise the price further. Technology can provide initial solutions, but also comes at a cost Initially, if a natural capital element becomes scarcer because of increased use, solutions can be found through technology, but this too is likely to result in higher costs – the need for desalination technology in the mining industry is a good example. In some cases this may lead to a situation where the state subsidises unsustainable practices, such as water for agricultural irrigation, leading to even greater inefficiency and depleting the natural capital factor further. In other cases, corporates may face the cost increase. The costs of degradation vary widely (depending on the assumptions used) In India, the country we consider most vulnerable to water and climate risk, the World Bank calculates that natural capital degradation costs between USD36bn and USD124bn annually, equivalent to 2.6-8.8% of 2009 GDP. Chart 16 shows the midpoint estimate of the damage costs for each category assessed. Chart 16: Annual cost of environmental damage in India USD bn 50 40 30 20 10 0 Env ironmental demage Share of total cost Annual cost of environmental degradation: USD80bn 60% 50% 40% 30% 20% 10% 0% Air pollution Crop lands Water Pastures Forest degradation degradation degradation Note: Air pollution is summation of both outdoor and indoor air pollution and Water comprises supply, sanitation and hygiene. Source: World Bank, 2013 The report considers the damage costs of urban air pollution, including particulate matter and lead, inadequate water supply, poor sanitation and hygiene and agricultural damage – from soil salinity, water logging and soil erosion, rangeland degradation and deforestation. 21 abc Climate Change Global November 2013 The calculation does not include damage from natural disasters, but separately the World Bank notes that India incurred damages equivalent to INR150bn (USD2.3bn) per year from 1953 to 2009 from natural disasters. In a separate report on China, the World Bank estimates that the costs of environmental degradation and resource depletion would approach 10% of GDP by 2030. Of this, air pollution would account for 6.5%, water pollution 2.1% and soil degradation 1.1%. Based on 2008 data, more than half of China’s water is polluted, over 300m people use contaminated water supplies and about a fifth of China’s farmland has been contaminated with heavy metals. In 2007, the World Bank estimated that the annual environmental damage costs the country USD76bn from air pollution, water pollution and scarcity, crop loss, fishery loss and material damages (Chart 17). Chart 17: China’s environmental burden USD bn Env ironmental damage Share of total cost 50 40 Annual environmental 30 burden : USD76 bilion 20 10 0 Air pollution Water Crop loss Fishery loss 70% 60% 50% 40% 30% 20% 10% 0% Material damage Source: Note: Water costs are for water pollution mortality, and scarcity. Crop loss is from waste water irrigation and acid rain. Source: World Bank, 2007 not included in the analysis would suggest to us that the forecasts are conservative. Table 3: Annual environmental costs for the global economy Greenhouse gas (GHG) emissions Water abstraction Pollution* General waste* 2008 USD bn 2008 % of GDP 2050 2050 USD bn % of GDP 4,530 7.5 20,809 12.9 1,226 546 197 2.0 0.9 0.3 4,702 1,926 635 2.9 1.2 0.4 54 42 6,596 0.1 0.1 11% 287 256 28,615 0.2 0.2 17.8 Natural resources Fish Timber Total Source: Trucost Note pollution includes Sox, Nox, PM, VOCs, mercury With increasing regulatory constraints, mounting civil society pressure and growing risks of disruption to supply chains, the materiality to investors of natural capital loss and degradation is becoming more obvious, as is the need for this materiality to be better integrated into assessment and decision-making processes. Investment to maintain the capital stock Managing the capital stock can be achieved through direct regulation (such as implementing water use caps or emission standards), or by investing in the stocks and flows that are critical for nature’s functions. There is increasing recognition by investors and policymakers of the risks of not managing natural capital resources and ecosystems; however, currently it is at the bottom of the priority list. Government investment is low In 2011, Trucost estimated the annual environmental costs caused by human activity at USD6.6trn for 2008 (11% of global GDP). It projected an increase to USD28.6trn by 2050 under a ‘business as usual’ scenario. Clearly, there are uncertainties with long-term forecasts, not least discussion around the underlying assumptions. However, the fact that several natural resources and other ecosystem services are 22 Government expenditure on natural capital and environmental protection is considerably smaller than for other types of capital. For instance, there is usually considerable spend on human capital for education or health, as shown in Table 4. abc Climate Change Global November 2013 Table 4: Public spend as a % of GDP for selected countries % of GDP Defence Education Health Environment EU-15 Germany 1.5% 5.3% 7.5% 0.9% 1.1% 4.2% 7.0% 0.7% Norway US China 1.6% 5.6% 7.3% 0.7% 4.1% 0.5% 5.1% 0.3% 1.2% 4.1% 1.4% 0.6% Source: OECD, BEA, US Treasury, China National Bureau of Statistics Country environmental spend varies but is mostly less than 1% of government expenditure. In the UNEP Green Economy report, UNEP showed that an investment of 2% of global GDP into natural capital helps to decouple growth from resource use. We think that spend as a percentage of GDP for environmental purposes will increase as the accounting linkages between growth and natural capital are developed. In 2011, in the ‘Towards a Green Economy’ report, economist Partha Dasgupata noted “ecosystems are capital assets. Like reproducible capital assets… ecosystems depreciate if they are misused.” But natural capital is profoundly different from capital stocks as traditionally understood by economists and investors. Firstly, its depreciation can be irreversible; secondly, it is difficult, if not impossible, to replace a depleted natural asset with another; and finally, ecosystems can collapse abruptly as we demonstrated previously. Future proofing the natural capital stock by investing will be cheaper than reacting to natural capital disruption, but governments still need a framework to account for natural capital to assess the spend required. The SEEA (System of Environmental-Economic accounting) attempts to harmonise accounting principles and data. So far, 14 countries are implementing the SEEA framework, as shown in the Table 5. Table 5: Countries implementing the System of Environmental Economic accounting framework Australia Brazil Egypt India Indonesia Jamaica Mexico Morocco Philippines Russia Samoa Tanzania Uganda Vietnam Source: UN Statistical Database, UN Department of Economic and Social Affairs In addition, the World Bank’s Wealth Accounting and the Valuation of Ecosystems Services (WAVES) initiative is aimed at consistency of natural capital accounting for economic planning purposes. A stock of natural capital may provide many different functions at the same time and over time as part of the replenishment and evolution process, to arrive at a full valuation of the natural capital in this context it is necessary to capture the benefits of social (eg, human health and nutrition benefits) and ecological (eg, climate regulation) factors and compute a value in terms of their net present value. For the most part, these are externalities and difficult to ascribe monetary values to. In ‘The cost of policy inaction’, in 2008 Braat & ten Brink calculated the environmental damage resulting from the absence of additional policy or policy revision, using, among other reports, the conceptual framework set out in the Millennium Ecosystem Assessment. It estimated the welfare losses from the loss of ecosystem services at EUR545bn in 2010 (just under 1% of world GDP). In our view, it is appropriate for investors to devote time to identifying the contribution of natural capital to economic activity and the impact on expected growth and asset values arising from natural capital degradation and the policy changes adopted in response. 23 abc Climate Change Global November 2013 Increasing policy drivers will become the norm It is difficult to value and account for natural capital functions and their contribution to economic productivity. Nonetheless, depreciating natural capital stocks can create a drag on economic activity, and sudden natural capital shocks create output volatility. However, policy tools can increase resilience to such shocks. Policy drivers can be kneejerk responses to surprise events or longer-term attempts to create behavioural change. For instance, the kneejerk response to the Thai floods was a monetary one, with the Thai Central Bank reducing interest rates from 3.50% to 3.25% immediately to stimulate activity in relation to the anticipated activity slowdown. An alternative approach to change behaviour towards a natural capital factor over the long term could be fiscal, by way of a pollution tax. Either way, standard economic tools can be utilised in response to managing natural capital issues. The choice of response boils down to scale and speed of disruption compared with economic activity management, ie, an interest rate response is usually quicker to implement than a fiscal one. These economic management responses to the natural capital issue are standard policy tools and can be analysed in relation to growth and inflation expectations in the usual way. Environmental taxes Policymakers are facing up to the risks around the depreciation of natural capital. Some are being kicked into shape by a desire to reduce pollution (China), while others are using the notion to change behaviour (energy consumption in Korea). In both cases, carbon taxes have been mooted as a solution. Taxes encourage gains in overall efficiency by spurring the adoption of more advanced technology, which would likely boost productivity in countries – but taxes can also be a welcome revenue boost. For China, we think a carbon tax would be among the most consequential reforms officials could adopt. The Ministry of Finance has already proposed its introduction, but it now needs the explicit backing of the leadership. A tax would Chart 18: Summary of how natural capital factors permeate into the macro economy Quantity and quality of natural capital is a driver of economic activity Economic productivity can be enhanced or disrupted because of natural capital factors Managing natural capital can lead to regulatory, fiscal or monetary responses Growth boost / drag Source: HSBC 24 Price pressures abc Climate Change Global November 2013 include a fixed charge per ton of carbon emitted by industrial polluters (for China this would be an initiative in addition to cap and trade). In China’s case, we think a carbon tax would be a positive measure (see ‘For China, benefits of carbon tax far outweigh the costs’ 12 November 2013) On the negative side, carbon taxes may have an inflationary impact. Ronald Man, HSBC’s economist for Korea, estimates that the implementation of a carbon tax in Korea may trigger and upward bias to inflation – he estimates that a 1% increase in energy prices raises headline CPI by around 0.2% (please see ‘A taxing prevention to blackouts’ 16 July 2013). On balance, we think taxes can and should be used advantageously to drive behaviour towards low carbon growth. Cap-and-trade schemes While the European emissions trading scheme (ETS) is long established, new carbon cap-andtrade schemes have sprung up, notably in China and the USA (the carbon giants). The EU scheme has only had limited success in terms of generating a high enough carbon price to trigger long-term investment flows into low-carbon technologies, but it has achieved some success in helping to reduce emissions. Several studies have attempted to quantify the effect the EU ETS has had on emission reduction in Europe. In general, the literature estimates the savings attributable to the scheme at 40-80 MtCO2/year (around 2-4% of the phase 2 cap), but New Carbon Finance found that 40% of the 3% fall in 2008 emissions was due to the ETS. Product standards and legislation Regulatory drivers can be successful at changing behaviour. Most performance standards have been aimed at improving the environmental efficiency of products or industrial facilities, such as by mandating pollution control standards or guidelines around resource efficiency Conclusions Metrics and methodology to analyse natural capital factors have developed significantly in recent years, driven by government and investor appetite to understand further and manage natural capital risks. On the whole, however, analysis is still in its infancy, but we do not think this should be used as an excuse to ignore natural capital. Countries are increasingly building frameworks to account for the depletion of natural capital as a result of economic activity. For now, there is a disconnect between the proportion of government spend on the environment compared with government spend on other issues, such as health and education, but we expect this gap to narrow in the future as recognition of the benefits of pre-emptive investment over retroactive cost become clearer. The current status of economic thinking suggests that for the time being natural-capital-related analysis will mainly be reactionary rather than preemptive. However, we think this means there is greater justification for investors to identify which countries are more susceptible to natural capital risk factors, which we have done in ‘Scoring climate change risk’, 24 September 2013. More importantly, in our view, survey results reveal that the ETS has been effective in terms of raising climate change awareness in company boardrooms, helping to pave the way for future policies aimed at promoting low-carbon investment decisions. 25 abc Climate Change Global November 2013 What should investors do? Identify the contribution of natural capital to country economic activity. Water- and carbon-related factors are the most important Evaluate whether natural capital is well managed and above sustainability thresholds Assess the future risks and potential economic consequences Incorporating natural capital Natural capital, the environmental functions it performs and the ecosystem goods and services it provides, has always played a fundamental role in sustaining human economies, health and welfare. Over time, we think that developments in metrics and methodology will overcome the current uncertainty on how the various natural capital components interact to underpin economic growth. For now, we think water and carbon risk (in relation to climate change) are the most important issues to assess. Currently, there is no ‘one stop shop’ approach for investors to translate natural capital analytical techniques across countries, simply because countries have different natural capital resources and are at different stages of development. However, there is a consistent assessment framework (contribution, management, risk, impact) that is relevant across economies and can be applied on a case-by-case basis. Table 6 provides a starting point for investors to compare water and carbon risks between countries. The key points to note are: National water risk: Saudi Arabia and South Africa are already water scarce 26 (<1,000m3/capita), and Saudi is deteriorating fast; India, South Korea and Germany are water stressed (<1,700m3/capita) and India is deteriorating fast. Sub-national water risk: National averages, however, can hide significant regional water risk, and we highlight China and India as particularly exposed (see ‘Scoring climate change risk’, 24 September 2013). National carbon risk: China and the USA are the highest emitters of CO2 in absolute terms, but Australia, Canada, Saudi Arabia, South Korea and the USA have the highest per-capita emissions. Russia, Germany and the USA show the best improvement in carbon intensity (CO2/GDP). We identify the USA as the economy within the G-8 with greatest distance to target in terms of carbon improvement, and China as the country with the greatest alignment of factors – air pollution, water, technology and carbon – pushing on carbon risk. In the following framework, we take Australia as an example. This is because, on paper, Australia has plenty of water, as shown below, but at a regional level the country has suffered long term drought. abc Climate Change Global November 2013 Table 1: Water and carbon factors are the most important issues to assess from a natural capital perspective G20 Countries Argentina* Australia Brazil Canada China France Germany India Indonesia Italy Japan Mexico Russia Saudi Arabia South Africa South Korea Turkey UK US World 2020 target emissions Water 2012 CO2 2012 CO2 % change 2012 CO2 % change Water availability† % of world 2011 water real GDP resource, resource % emissions per capita CO2 / cap intensity of CO2 (Optimum is very high change 2012 m3/per capita MtCO2 2003-2012 GDP intensity of availability and rising 2002-2011 fast) GDP 20032012 0.8% 1.6% 2.1% 2.3% 8.4% 4.2% 5.7% 2.5% 0.8% 3.2% 8.8% 1.9% 1.8% 0.9% 0.6% 2.0% 1.2% 4.5% 25.2% 6,771 21,764 27,551 82,969 2,041 3,168 1,302 1,165 8,332 3,002 3,399 3,563 30,195 85 888 1,340 3,083 2,314 9,001 -7.6% -13.3% -8.8% -8.9% -4.5% -5.3% 0.3% -12.3% -9.6% -5.4% -0.4% -10.6% 1.9% -23.6% -8.8% -4.1% -11.1% -4.9% -7.9% 190 392 500 620 9,208 383 815 1,823 495 406 1,409 496 1,704 615 446 764 318 530 5,786 4.6 17.3 2.5 17.8 6.8 5.8 10.0 1.5 2.0 6.7 11.0 4.1 11.9 21.7 8.7 15.3 4.3 8.4 18.4 33% -5% 31% -11% 102% -16% -10% 55% 27% -21% 2% 11% 7% 32% 1% 26% 29% -16% -16% 0.45 0.46 0.44 0.49 2.04 0.17 0.27 1.33 1.16 0.24 0.30 0.50 1.74 1.24 1.45 0.71 0.51 0.22 0.43 -48% -17% 2% -16% -14% -19% -21% -9% -14% -16% -5% -2% -27% -8% -18% -5% -6% -19% -21% 34,466 31,693 4.9 4.1* 14% 0.64 0% High, falling Very high, falling fast Very high, falling Very high, falling Medium, falling Medium, falling Low, rising Low, falling fast High, falling Medium, falling Medium, falling Medium, falling fast Very high, rising Very low, falling fast Very low, falling fast Low, falling Medium, falling fast Medium, falling High, falling Carbon per capita‡ (Optimum is low per capita and falling fast) Low, rising fast Very high, falling Low, rising fast Very high, falling fast Medium, rising very fast Medium, falling fast High, falling Very low, rising very fast Low, rising fast Medium, falling fast High, rising Low, rising fast High, rising Very high, rising fast Medium, rising High, rising fast Low, rising fast Medium, falling fast High, falling fast Source: HSBC, BP Statistical Review. Note: Argentine latest GDP is for 2010. *2020 targets based on IEA World Energy Outlook 2013 reference scenario CO2 from energy, calculated using UN population forecasts Water Risk† Resource availability: Very low = <1,000m3/cap (water scarce), low = 1,000-1,700m3/cap (water stress), medium = 1,700-5,000m3/cap, high = 5,000-10,000m3/cap, very high = 10,000+m3/cap. Water availability per capita change: Falling fast = -10%-50%, falling = -10% -0%, rising = 0-10%, rising fast = 10%-50%, rising very fast = 50%+ Carbon per capita‡ Per capita levels: low = under 5 tCO2/ cap; medium = 5-10 tCO2/ cap; high = 10-15 tCO2/ cap; very high = 15+ tCO2/ cap. Per capita change: Falling fast = -10%-50%, falling = -10% -0%, rising = 0-10%, rising fast = 10%-50%, rising very fast = 50%+ 27 abc Climate Change Global November 2013 1) Identify the natural capital contribution Identifying the contribution of natural capital to economic activity enables an assessment of whether a country would be able to meet growth expectations against a natural capital disruption or constraint. For instance, if an economy is reliant on water-intensive activities, shortages in supply could mean that output would suffer. This could come from two factors – interrupted power supply because of lack of water for electricity, and/or lack of water for operational processes. A first assessment in relation to water, therefore, should be of the contribution of water-intensive sectors – agriculture, utilities, mining and energy – to the economy. Australia: Relatively water dependent 1 economy Australian mining contributes around 10% to gross value added (GVA) and is also relatively water intensive. Mining activities are split 50:50 between fossil fuels, and iron ore and copper. Other industries contribute 77% to economic output but only consume 11% of water. However, these industries would be at risk of disruption if the electricity supply is disrupted because of water issues. Electricity generation is a relatively waterintensive sector, consuming 16% of the total, with 85% of Australia’s electricity generated from coal (also presenting a carbon risk) and the remainder mostly hydropower, both water-intensive sources. Agriculture, though contributing only around 3% of total gross value added (GVA), consumes the most water. 1 The information on Australia is drawn from a longer case study by Dr Matthew Winning, UCL Institute for Sustainable Resources 28 Chart 19: Gross value added per industry and water productivity (2010-11) Agriculture Manufacturing Other industries Mining Electricity , w atse & w ater 100% 80% 77% 60% 40% 20% 0% 3% 8% 10% 6% 5% 11% 16% 63% 2% Gross v alue added (%) Water consumption (%) Source: Australia Bureau of Economics, Note: Agriculture includes forestry and fishing; mining includes oil & gas extraction; manufacturing includes food & beverages, textile, petroleum, wood & paper, metallic and non-metallic products, machineries In 2012, exports accounted for over 21% of GDP, some USD313bn, with the top three the relatively water-intense iron ore, coal and gold. We think there is a risk to Australian industry from disruption to electricity supply that could come from water constraints. 2) Evaluate natural capital management A high dependency on a natural capital component does not always present a risk if it is managed appropriately. For many regions, natural capital management is crucial to at least maintaining, if not increasing, output. Australia has long experience of drought management Australia, despite having the highest per-capita surface water storage capacity in the world, is also the driest inhabited continent on the planet, with variable rainfall and aridity. As of July 2013, water storage in Australia was at 69.5% capacity, but by year and territory the volume levels can vary significantly. The most recent drought in Australia lasted 10 years from 2002 to 2012. Severely low levels of rainfall meant that a number of rivers, dams and lakes operated substantially below capacity, impacting agricultural production. Major abc Climate Change Global November 2013 reservoirs in the Murray Darling Basin (MDB) fell from c75% capacity in 2001 to 17% capacity in 2007. During the drought periods, the Australian authorities used water pricing and use restrictions and subsidies as policy tools. Water pricing Water prices vary between territories, but between 2008 and 2011 prices increased from AUD/L 0.74 to AUD/L 1.03 on average. Varying tariff structures were introduced and mandated water use restrictions were implemented, backed up by fines. Farmer compensation Price rises had a significant effect on farmers. In 2007, the cost of a million litres of water had risen from AUD50 to AUD950, making it impossible for many to afford to continue farming. The Australian Government paid compensation and provided interest rate subsidies to farmers whose product yields were affected by drought. In 2010, around AUD4.4bn was paid out from exceptional circumstance funds, with approximately 70% of agricultural land in Australia receiving support during this period. 3) Assess future risks and economic consequences Identifying the future risks for natural capital means analysing potential changes to the availability of the resource, in this case water, and the disruption potential because of other factors. For water, this includes assessing future changes to the water cycle driven by temperature rises. More droughts a risk For Australia, droughts remain a concern, in our view. The Commonwealth Scientific and Industrial Research Organisation (CSIRO) and the Bureau of Meteorology (BOM) estimate that 50% of the rainfall decrease in south-western Australia since the late 1960s is due to climate change, as is the rainfall decline in south-eastern Australia since the late 1950s. Chart 20: Temperature anomalies in Australia 1.5 1 0.5 0 -0.5 -1 Regional subsidies In order to attempt to save the MDB both federal and state governments have committed AUD1bn since 1998 into programmes seeking to restore the flow of water. In addition, AUD1.4bn has been spent on the National Action Plan for Salinity and Water Quality comprising 1,700 projects in 21 priority areas in Australia over a seven-year period from 2000. Public policy response Australia has used a public policy response to change behaviour in relation to monitoring water and in respect of pricing and subsidy payments. In our view, the management of water is well understood and managed but is and will continue to be a drain on public finances. -1.5 1910 1921 1932 1943 1954 1965 1976 1987 1998 2009 Australia annual mean temperature anomaly (°C) Source: Australian Bureau of Meteorology CSIRO provide climate forecasts. It estimates that by 2030 temperatures will increase by another 1oC on average in Australia. These forecasts are based on the current stock of emissions already in the atmosphere2. Water use and sustainability thresholds Water use and sustainability thresholds must be examined on a case-by-case basis. For instance, increasing water use and declining water 2 Projections are given relative to the period 1980-1999 29 abc Climate Change Global November 2013 availability in Canada may not matter much (provided it is significantly above sustainability thresholds) for the country’s ability to deliver growth, but is likely to be critical for India. The Water Exploitation Index (WEI) is a good indicator of breaching sustainability thresholds. It is calculated as the mean of the annual abstraction of freshwater divided by the mean annual freshwater resources. A warning threshold would be around 20% with medium water stress up to 40% and severe water stress above this level. In Australia for 2011, we calculate the WEI as 14.6%, an increase from 4.5% in 2000 as measured by Aquastat, demonstrating a significant increase in water stress over the last decade with a decline in resources and an increase in water-intensive industries. It is currently not possible to calculate the WEI at a territorial level because extraction and consumption data rates are inconsistent. In a bear case, Australia’s water will become extremely scarce. Some water storage facilities were operating at a fifth of their capacity during the droughts of the 2000s. Temperatures of several degrees higher and rainfall reductions of 20% would reduce resources to levels never before witnessed. Previously, the economic effect of drought played out through consumer price inflation. Charts 21 and 22 show headline inflation and inflation rates for selected food groups. Chart 21: Headline CPI 8.0% 6.0% 4.0% From a natural capital perspective, we think Australia is managing its most vulnerable natural capital component – water, well. Over the longer term, it will likely have to continue allocating public funding to providing continuity of supply, and subsidies to farmers may be higher if significant drought prevails. In the short term, we think there is limited risk of significant variation to growth forecasts directly attributable to water. Carbon risk For carbon risk, a starting point is to identify country emission levels, the country policy on emission reduction, the energy intensity of growth, the carbon intensity of energy and the carbon intensity of GDP. Australia has the third highest CO2 level per capita in the G20 at 17.8 tonnes (behind Saudi Arabia and the USA), but the new government recently retracted most of its carbon commitments (see ‘Australia’s uncertain climate future’, 9 September 2013). We expect the carbon risk in Australia to manifest through global carbon pressures, namely the reduction in demand for CO2-intensive fossil fuels, which will change the demand profile for one of Australia’s most important exports – coal. HSBC mining analysts looked at potential risk factors from the long-term curbing of coal demand in ‘Coal and carbon’, 21 June 2012. Chart 22: Inflation for selected food groups – shading represents drought periods 60% 30% 40% 20% 20% 10% 0% 0% Source: Australian Bureau of Statistics, Thomson Reuters Datastream 30 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013 Q1 2013 Q1 2012 Q1 2011 Headline CPI YoY Q1 2010 Q1 2009 Q1 2008 Q1 2007 Q1 2006 Q1 2005 -20% Q1 2004 -40% Q1 2003 0.0% Q1 2002 -10% Q1 2001 -20% Q1 2000 2.0% CPI Fruit & Veg YoY CPI Lamb YoY Source: Australian Bureau of Statistics, Thomson Reuters Datastream Climate Change Global November 2013 abc Forecasting the future impact of a natural capital issue (such as continued risk of drought in Australia) means, at this stage, an assessment of whether country growth expectation is more or less likely to be achieved, or whether a policy may be implemented to tackle the natural capital issue, which will result in another economic issue, such as inflationary pressures. Conclusions There is no silver bullet template for capturing and analysing natural capital factors, which can be rolled out across countries and industries. However, there is a consistent methodology to assess and analyse the issues that can be applied across countries, namely – identify the contribution, assess how well the natural capital factor is managed, identify future risk and assess the potential economic impact. This could come from changes to trend growth, inflationary pressures or policy responses. Our previous analysis on climate change issues leads us to believe that water and carbon risks are the most critical natural capital issues for investors to take into account at present. Ultimately, analysis will evolve to include new data, metrics and methodology to incorporate air, land, water and habitats, along all elements of the value chain of assessing natural capital. This is an evolving issue that is not straightforward but complexity is not a reason to ignore natural capital. 31 abc Climate Change Global November 2013 Appendix 1: Data, indices, accounting, modelling Quantity, quality and frequency of observations are improving, while indices provide country snapshots using aggregated data Standardised accounting methodologies are under development Economic models are in use for central planning purposes Data monitoring has improved There is now a substantial quantity of internationally comparable data on environmental and resource issues, which is available from a range of global economic and scientific institutions. In our view, the most robust data is from the organisations summarised in Table A1. Table A1: Organisations providing time series on data Category Organisation Water Land Air Air, Land, Water Aquastat Food and Agricultural Organisation NASA Earth Data NASA Socio-Economic Data Analysis Centre OECD statistics UN Environment Programme's Environmental Data Explorer UN Statistics Division World Bank World Meteorological Organisation Air, land, water Air, land water Air, land, water Air, land, water Temperature, rainfall Water World Resources Institute Source: HSBC, Y/ZenGroup 32 Acronym AS FAO NASA SEDAC OECD UNEP EDE UNSD WB WMO WRI abc Climate Change Global November 2013 Indices – further development The data series noted above have been used in the construction of a number of composite indices for cross-country comparison. In our view, these are a necessary starting point for identifying analytical and investment priorities for policymakers. The indices provide different functions. Some are a tool to assist in capital allocation for policymakers, whereas others are designed to monitor the utilisation of natural capital resources across countries. Chart A1 shows the components. The time series is useful for monitoring how much progress countries are making in certain categories. The indices provide a snapshot of country-level vulnerabilities and strengths, and compare them with other countries. We think these indices are a useful starting point for further analysis. To identify the true impact of natural capital changes on the economy, investors must make a judgement on the contribution of natural capitalintensive sectors to the economy. In our view, the most comprehensive index is the Yale Environmental Performance Index, which provides a breakdown of 22 performance indicators across 10 policy categories. Table A2: Comparison of composite indices Index Source Countries Period Frequency WB 246 1980 to 2012 Annual SEDAC 132 2000 to 2010 Environmental Sustainability Index SEDAC 146 2000, 2001, 2002, 2005 Environmental Vulnerability Index SEDAC 235 2004 Natural Resource Management Index SEDAC 174 2004 to 2011 Benefits Index for Climate Change GEF 160 Jul-08 Benefits Index for Biodiversity GEF 160 July 2008 Adjusted Net National Income Environmental Performance Index (Yale performance index from 2012) Comment Methodology Time series data Net National Income adjusted for depletion of natural resources All static data except 22 performance indicators in 10 policy categories for the 2012 2012 environmental burden of disease, water (effects on human publication contains health), air pollution (effects on human health), air pollution revisions to (ecosystem effects), water resources (ecosystem effects), methodologies biodiversity and habitat, forestry, fisheries, agriculture and climate change. Four publications 2006 (1994-2006 data), 2008 (19942007 data), 2010 (1994-2009 data), 2012 (2000-2010 data). Static data. Total four Methodological publications. 2000 changes between (1979-1999 data), publications 2001 (1980-2000 data), 2002 (19802000 data) 2005 (1980-2000 data) Static data Single publication released in 2004, using data from 1973-2003 Total two Time series data. Some methodological publications. 2010 (2004-2011 data) changes between the two publications and 2011 (20062011 data) Single publication Static data released in 2008 Single publication released in 2008 The index provides a composite profile of national environmental stewardship based on a compilation of 21 indicators derived from 76 underlying data sets. This index contains 111 variables and is designed to be used with economic and social vulnerability indices to provide insights into the processes that can negatively influence the sustainable development of countries. Composite index derived from the average of four proximity-to-target indicators for eco-region protection (weighted average percentage of biomes under protected status), access to improved sanitation, access to improved water and child mortality Seeks to measure the potential global benefits that can be realized from climate change mitigation activities in a country. The approach reflects the objectives of the GEF climate change operational programs to address long-term priorities to mitigate climate change. Static data Seeks to measure the potential global benefits that can be realized from biodiversity related activities in a country. It reflects the complex, highly uneven distribution of species and threats to them across the ecosystems of the world, both within and across countries. Source: HSBC, World Bank, Y/Zen Group, UCL 33 abc Climate Change Global November 2013 Chart A1: Components of Yale environment composite indicator EPI Objectives Policy Categories Environmental Health 15% Environmental Health (30%) Air (Effects on Human Health) 7.5% Air (Effects on Human Health) 7.5% Air (Ecosystem Effects) 8.75% 2012 Environmental Performance Index Water Resources (Ecosystem Effects) 8.75% Biodiversity & Habitat 17.5% Ecosystem Vitality (70%) Agriculture 5.83% Forests 5.83% Fisheries 5.83% Climate Change & Energy 17.5% Indicators Environmental Health 15% Particulate Matter 3.75% Indoor Air Pollution 3.75% Access to Sanitation 3.75% Access to Drinking Water 3.75% SO2 per Capita 4.38% SO2 per $ GDP 4.38% Change in Water Quantity 8.75% Critical Habitat Protection 4.38% Biome protection 8.75% Marine Protected Area 4.38% Agricultural subsidies 3.89% Pesticide Regulations 1.94% Forest Growing Stock 1.94% Change in Forest Cover 1.94% Forest Loss 1.94% Coastal Shelf Fishing Pressure 2.92% Fish Stocks Overexploited 2.92% CO2 per Capita 6.13% CO2 per $ GDP 6.13% CO2 per KWH 2.63% Renewable Electricity 2.63% Source: Yale Adjusted net income indices aid natural capital accounting Sub-systems of the SEEA accounts are split between individual resources on energy, water and land, and ecosystem services. Linked to the UN SEEA procedure is the World Bank’ WAVES project (Wealth Accounting and Valuation of Ecosystem Services). This project aims to help individual countries implement and use the SEEA data on environmental accounting. It includes the UN Environment Programme, UN Development Programme and UN Statistical Commission, as well as a number of countries and private sector organisations. Adjusted net savings In practice, perhaps the most ambitious attempt to date to implement environmental and resource valuation in a systematic way at a global scale, and particularly to estimate the annual change in the value of natural capital as affected by depletion and natural regeneration, has been carried out through the ‘genuine savings’ methodology and indicators of the World Bank. 34 The adjusted net savings (ANS) estimates how much gross national savings would change if natural capital considerations were taken into account, expressed as a percentage of gross national income. The methodology is as follows. Start with net national savings, Add investments in human capital (education expenditure), Deduct depletions of natural resources (energy, mineral and net forest depletion), and Deduct pollution damages (CO2 and PM10). The values of energy, mineral and net forest depletion are calculated as the present value of resource rents to exhaustion time of the resource. A carbon price of USD20 per tonne is used for the CO2 damage cost, and PM damages are calculated on a willingness to pay basis, in the context of willingness to pay for avoided mortality and morbidity attributable to particulate emissions. This varies for different countries. abc Climate Change Global November 2013 Table A3 compares adjusted net savings methodology for 2008 and 2012 for the UK, USA, China and India. The ANS result is dependent on investments in education being adequate substitutes for the depletion of natural capital that has taken place. In environmental terms, these four countries (like many others) are depleting their natural capital, but all the countries are sustainable in the sense that they all have positive adjusted net savings levels. The same is true for all OECD countries. However, it is unlikely that this situation can continue globally on an indefinite basis, no matter how much countries are investing in education. The estimation of genuine savings is important in that it permits the comparison of the economic value created through production with the change (perhaps a reduction) in the value of the natural resources used as inputs for that production. However, a shortcoming with this methodology is that there is no explicit consideration of water and soil. There is a consideration of the source and some of the human welfare functions of natural capital, but not the sink or the majority of the lifesupport functions. Also, there is an assumption that manufactured and human capital can substitute for natural resources, which is not always the case. Table A3: Comparison of adjusted net savings (values expressed as a percentage of gross national income) % of gross national income ___ United Kingdom ___ 2008 2010 Gross national saving Consumption of fixed capital Net national saving Education expenditure Energy depletion Mineral depletion Net forest depletion CO2 damage PM10 damage (2002 and 2004 WHO data) Adjusted net saving (including PM10 damage) Adjusted net saving (excluding PM10 damage) 15.6 -10.3 5.3 5.1 -2.1 0.0 0.0 -0.1 0.0 8.1 3.91 12.3 -11.1 1.2 5.1 -1.3 0.0 0.0 -0.2 0.0 4.8 4.8 ____ United States _____ 2008 2010 12.7 -12.3 -0.8 4.8 -1.8 -0.1 0.0 -0.3 -0.1 2.8 2.9 11.5 -12.3 -0.8 4.8 -0.8 -0.1 0.0 -0.3 -0.1 2.8 2.8 _______ China _________ ________ India _________ 2008 2010 2008 2010 52.9 -10.8 42.0 1.8 -6.0 -1.7 0.0 -1.1 1.2 33.6 35.0 52.6 -10.8 41.8 1.8 -3.7 -1.8 0.0 -1.1 -1.3 35.7 37.0 34.1 -10.1 23.9 3.1 -4.5 -1.5 -0.8 -1.0 -0.6 18.6 19.3 35.0 -9.8 25.2 3.1 -2.6 -1.2 -0.6 -0.9 -0.6 22.5 23.0 Source: World Bank, Note: 2010 is the most recent year of data for all countries 35 abc Climate Change Global November 2013 Economic modelling Incorporating natural capital into the production function In their analysis of the drivers of economic growth, economic models have tended to ignore the role of natural capital. So far, natural capital and environmental services are missing in the simple but quite standard representation that manufactured capital and labour are the main factors driving economic activity. It is becoming increasingly apparent that natural capital plays a very important role in supporting economic activity, as well as contributing directly to health and welfare. However, the dominance in the modern economy of the industrial and service sectors (for example, natural capital-intensive agriculture only contributes 3.14% to global GDP) obscures the reliance of sectors on natural capital, and fails to indicate the importance of the quantity and quality of either the natural capital stocks or the functions that it performs. One of the reasons for this is that natural capital has been perceived to be effectively infinite as far as the scale of the human economy was concerned. In addition, at the time the models were developed, there was insufficient understanding of, and data about, the complexities and functions of natural capital and the contribution However, while it is relatively simple to incorporate natural capital into an illustrative diagram of the economy (see Chart A2) adding a Chart A2: The contribution of natural capital and its environmental functions to national economic production 3 Environmental functions Human welfare (Income, Societal benefits) 2 Stocks of capital Natural capital Intermediate production 1 Investment Labour Manufactured capital Production process/National economy Capital feedback effects Source: Ekins, P 36 Goods Bads Consumption Waste pollution Depreciation, depletion abc Climate Change Global November 2013 natural capital parameter to the production function in economic models is not straightforward. A more realistic production function would need to capture the facts that: 1 Natural capital combines with manufactured and human capital as inputs to production. From the natural capital perspective, resources – such as fossil fuels to provide energy for industrial processes – or raw materials – such as wood and minerals – are the inputs. These may be transformed into finished products. 2 Some environmental functions and services are sustained by the natural capital stock (the functions ‘of’ the environment, eg, sources or sinks), and the replenishment and evolution part of the cycle. 3 Some environmental functions contribute directly to human welfare (environmental functions ‘for’ humans’, eg, clean drinking water). 4 Natural (and other) capital stocks may experience depreciation through depletion and pollution. There have been a number of recent modelling exercises to seek to represent these relationships, as shown in Table A4. These efforts are still in their infancy, and substantial research and development is still required to produce models that can adequately represent environmenteconomy relationships. Table A4: Economic modelling for planning purposes Model Example Methodology Used by Spatially disaggregated model Tallis et al.(2012), Integrated Valuation of Ecosystem Services and Trade-offs Lenzen et al.(2012), MRIO model Considers land-use mapping with GIS to draw economic projections on the availability of natural capital and environmental services Uses extended I-O model to track the passage of resources, and associated environmental impacts, through economic sectors Van Paddenburg et al. (2012), to study the natural capital in Borneo forest along the border of Indonesia, Malaysia and Brunei Wiedmann et al. (2010), to calculate greenhouse gas emissions associated with a country's consumption rather than production Chateau et al. (2011), Environmental linkage model Considers economic drivers to study the impact of natural capital depletion on economy Chateau et al. (2011), to study impact of natural capital depletion in OECD economies Bassi et al. (2010), T21- World model Considers natural capital as a factor of production and fully couples biophysical variables with economic ones, across social, economic and environmental sectors, also accounting for feedbacks, delays and nonlinearity. Econometrics Bassi et al. (2010), to study natural capital for UNEP's Green Economy Report Econometrics Barker et al. (2008) to analyse the economic implications of large scale carbon reduction Multi Regional InputOutput (MRIO) Macro-economic model Computable General Equilibrium models (CGEs) System dynamics model Macro-econometric model GINFORS E3ME, E3MG Lutz et al. (2010), to analyse environmental economy at both the European and global levels. 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UNEP Finance Initiative, CEO Briefing (2010), Demystifying Materiality: Hardwiring Biodiversity and Ecosystem Services into Finance, United Nations, http://data.un.org/Explorer.aspx?d=CLINO United Nations Environment Programme, http://geodata.grid.unep.ch/ Universal Ownership: Why Environmental Externalities Matter to Institutional Investors, Trucost (2011) World Health Organisation, Water Scarcity Fact File World Bank (2013), China 2030: Building a Modern, Harmonious, and Creative Society, Development Research Center of the State Council, the People’s Republic of China World Bank, http://data.worldbank.org/ World Energy Outlook 2010, International Energy Agency IEA, Paris World Resource Institute, http://www.wri.org/publications/data-sets Bohringer and Jechem (2007), Measuring the immeasurable - A survey of sustainability indices, Ecological Economics, 63, pp.1-8 HSBC Reports: After the flood: Thailand’s central bank to cut rates, Frederic Neumann, November 2011 Aussie Economic Comment: A Levy to Break the Floods, Paul Bloxham, January 2011 Australian exports fall: Queensland floods to blame, Paul Bloxham, May 2011 Australian GDP preview: GDP to fall 1.3% q-o-q in Q1 due to Queensland floods, Paul Bloxham, May 2011 Australian GDP washed out: Floods hit coal exports but domestic demand strong, Paul Bloxham, Jun 2011 China Inside Out: Drought, wages, oil and inflation…DON’T PANIC, Qu Hongbin, February 2011 Climate Investment Update: China’s drought; symptomatic of rising water stress?, Zoe Knight, February 2011 Climate Investment Update: More flooding; Thailand this time, Zoe Knight, October 2011 39 Climate Change Global November 2013 Climate Investment Update: Extreme climate; expect more droughts and floods, Zoe Knight, November 2011 European Chemicals Weekly: Drought is good news for agrochemicals in 2013,Dr Geoff Haire, September 2012 Floods in Thailand: A first look at the economic implications, Frederic Neumann, October 2011 Floods to boost inflation: Still expect next rate hike in Q2 2011, Paul Bloxham, January 2011 Sri Lanka: Flood factor; Bad weather push up February CPI inflation, Leif Eskesen, March 2011 Sri Lanka: Tempered by floods: Q1 GDP growth eased slightly, Leif Eskesen, July 2011 The Fertile Crescent: US drought dominates, Yonah Weisz, September 2012 The Philippines: Supply shocks from floods to keep rates steady, Trinh Nguyen, August 2012 This one's old news: Thai exports to drop after floods, Frederic Neumann, October 2011 40 abc Climate Change Global November 2013 abc Notes 41 Climate Change Global November 2013 Notes 42 abc Climate Change Global November 2013 abc Disclosure appendix Analyst Certification The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Zoe Knight, Nick Robins and Wai-shin Chan Important Disclosures This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means. 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No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Bank plc. MICA (P) 118/04/2013, MICA (P) 068/04/2013 and MICA (P) 110/01/2013 [395039] 44 Zoe Knight* Director, Climate Change Strategy HSBC Bank plc +44 20 7991 6715 [email protected] Zoe Knight joined HSBC in 2010 as a senior analyst. She has been an investment analyst at global financial institutions since 1997, initially focusing on Pan European small-cap strategy and subsequently moving into socially responsible investing, covering climate change issues. Throughout her career she has been ranked in Extel and II. She holds a BSc (Hons) Economics from the University of Bath. Wai-Shin Chan*, CFA Director, Climate Change Strategy – Asia-Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2822 4870 [email protected] Wai-Shin joined HSBC in 2011 as the Director for Climate Change Strategy in Asia Pacific. Previously, he worked as a fund manager and was centrally involved in the integration of Environmental Social Governance (ESG). Wai-Shin is a former Executive Director of ASrIA (Association for Sustainable and Responsible Investment in Asia) and was previously an ESG equity analyst for Asia. He holds a degree in Mathematics and Physics from Durham University (first class honours) and is a CFA charterholder. Nick Robins* Head of HSBC Climate Change Centre HSBC Bank plc +44 20 7991 6778 [email protected] Nick Robins, head of the HSBC Climate Change Centre, joined the bank in 2007. He has extensive experience in the policy, business and investment dimensions of climate change and sustainable development. *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.