Download Climate change: now risk not uncertainty

Climate change:
now risk not uncertainty
For professional investors only – June 2015
1
Executive summary
2
Assessing the risk
3
Towards an investment
response
4
Divestment in practice
5
Positioning for
outperformance
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1 ‒ Climate change: now risk not uncertainty ‒ June 2015
Climate change: now risk not uncertainty
By Ian Simm
Chief Executive, Impax Asset Management
Ian Simm is the Founder and Chief Executive of Impax Asset Management Group plc. Ian has
been responsible for building the company since its launch in 1998, and continues to head the
listed equities and real assets investment committees.
Prior to Impax, Ian was an engagement manager at McKinsey & Company advising clients on
resource efficiency issues. In 2013 he was appointed by the Secretary of State (Senior Minister)
for Business, Innovation and Skills as a member of the Natural Environment Research Council
(NERC), the UK’s leading funding agency for environmental science. He has a first class honours
degree in physics from Cambridge University and a Master's in Public Administration from
Harvard University.
1. EXECUTIVE SUMMARY
As we learned from the recent financial crisis, systemic issues can wreck portfolios and undermine
investor confidence for years. For many, climate change is emerging as a major systemic issue facing
investors: economic damage from extreme weather and shifting climatic belts is likely to get worse, and
governments are unlikely to sit on the side-lines. Investors need to act now, developing a coherent,
flexible strategy to manage the risk of intervention.
The “unburnable carbon” issue has become polarised. Those advocating full divestment are seen by
many as extreme, particularly as divestment entails the wilful avoidance of dividend streams and a risk
of underperformance if energy prices rise. However, recent statements from fossil fuel E&P companies
to challenge the analysis behind stranded asset risk and/or downplay its significance have been less
than persuasive.
Asset owners are increasingly frustrated, particularly if faced with rising stakeholder pressure to reduce
exposure to fossil fuels. Although there have been a few high profile announcements of wholesale
divestment, for the vast majority, the default response is to do nothing and wait for further
developments.
Polarised responses are irrational for two reasons. First, recent developments in science and policy
have had a major impact on the climate change issue, recasting it as a risk rather than an uncertainty,
thereby facilitating the use of traditional investment management tools, particularly asset allocation.
And second, developments in energy efficiency markets have created options for investors to mitigate
some of the risks implied by divestment.
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Climate change: now risk not uncertainty
2. ASSESSING THE RISK
3. TOWARDS AN INVESTMENT RESPONSE
Investors struggle to deal with uncertainty, where the magnitude and
timing of a potential impact cannot be readily estimated, but are
typically comfortable with incorporating risk information into their
decisions, particularly the level of allocation to different types of asset.
Investors generally have three types of response to higher levels of
risk: lower exposure to the assets concerned, reduce the risk and/or
hedge it.
For many years, the mainstream investor reaction to climate change
has been that the science and likely policy response have been too
uncertain to justify action. However, the UN Intergovernmental Panel
on Climate Change report of September 2013 reported a strong
scientific consensus over the causes of climate change and the likely
consequences for the planet of the current trajectory of greenhouse
gas emissions. Subsequent announcements from both the United
States and China of specific plans to limit emissions of carbon dioxide
have materially raised the chances of policy intervention. Investors
can now legitimately consider scenarios in which major economic blocs
pass legislation to restrict CO2 emissions within the next decade, for
example through a significant “Carbon Price” which will affect the
economics of both energy producers and consumers.
Faced with a material probability of a Carbon Price within a decade, a
timescale that matters for decisions taken today, it is rational for
investors to lower their exposure to assets that could be affected. On
the one hand, it is likely that the effect on today’s valuations of these
lower wholesale prices is “drowned out” by myriad other drivers of
prices, for example political risk. On the other hand, a Carbon Price
may render those assets with a higher marginal cost of production
“stranded,” or potentially worthless (Figure 1). It is these assets that
should be targeted for selective divestment.
To mitigate risk, investors should challenge the companies whose
fortunes could be improved by a change of strategy, for example oil
majors that could cut back on capital expenditure into high marginal
cost assets, possibly with a commensurate increase in dividend levels.
Figure 1: Illustrative oil (or coal) market and lower wholesale
price (P1)
Lower wholesale price (P1)
Price
($/tonne)
Illustrative oil (or coal)
Price
($/tonne)
Supply 1
Supply 2
Supply 1
“Price on
carbon”
Carbon Price
introduced
“Stranded
Demand
Cumulative Market
Volume (tonnes)
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Assets”
Demand
Cumulative Market
Volume (tonnes)
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3 ‒ Climate change: now risk not uncertainty ‒ June 2015
Climate change: now risk not uncertainty
Although the wholesale energy price is depressed by a Carbon Price,
the retail energy price can be expected to rise (Figure 2).
By reinvesting the proceeds of selective divestment of fossil fuel
assets into energy efficiency related business opportunities, investors
not only hedge the risk that they miss out on future energy price rises,
but also create exposure to energy prices that should increase in line
with government intervention to limit greenhouse gas emissions.
At the heart of this issue is the scarcity of useful data, particularly
around marginal production costs. Alongside their divestment plans,
investors should request additional information from the companies
they hold and consider supporting wider initiatives to persuade stock
exchanges and financial market regulators to oblige companies to
provide further public disclosure.
5. POSITIONING FOR OUTPERFORMANCE
Figure 2: higher retail price (P2)
Supply 2
Supply 1
Price
($/tonne)
Policy to reduce greenhouse gas emissions isn’t developed in a
vacuum. We won’t wake up one morning and discover a material
Carbon Price has been imposed overnight. Nevertheless, governments
have a nasty habit of ratcheting up their intervention to solve
important policy problems, so investors who can anticipate
government action and take pre-emptive measures to protect
themselves are likely to outperform.
“Price on
carbon”
“Stranded
Assets”
Demand
Cumulative Market
Volume (tonnes)
4. DIVESTMENT IN PRACTICE
Taking a risk-analysis approach to the impact of future climate change
policy, investors may rationally decide to reduce their exposure to
fossil fuel assets rather than full divestment. We recommend that a
plan of action includes four components. First, examine individual
assets to determine their marginal cost of production (and thereby
their potential exposure to Carbon Pricing); this is likely to be difficult
except for discrete assets or for companies with high levels of
disclosure. Second, develop scenarios for the level of Carbon Prices
and the probability and timing of their introduction; we recommend a
simple model to start with which can be developed further as
circumstances change. Third, divest in line with the probabilityweighted loss per asset, i.e. multiply the loss per asset in the scenario
by the probability of the scenario occurring; this will be far from an
exact science, so it makes sense to start with conservative
assumptions, i.e. a relatively low level of divestment. Fourth, consider
reinvesting the divestment proceeds into the energy efficiency sector;
this may introduce additional risks, for example exposure to the
industrial capital expenditure cycle.
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4 ‒ Climate change: now risk not uncertainty ‒ June 2015
Climate change: now risk not uncertainty
CONTACT INFORMATION
Ian Simm
Chief Executive
+44 (0) 20 7434 1122
[email protected]
[email protected]
+44 (0) 20 7434 1122
www.impaxam.com
Disclaimer
This document has been prepared by Impax Asset Management Limited (Impax, authorised and regulated by the Financial Conduct Authority). The information and any opinions contained in
this document have been compiled in good faith, but no representation or warranty, express or implied, is made to their accuracy, completeness or correctness. Impax, its officers, employees,
representatives and agents expressly advise that they shall not be liable in any respect whatsoever for any loss or damage, whether direct, indirect, consequential or otherwise however arising
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advised to ensure that they obtain appropriate independent professional advice before making any investment. This document is not an advertisement and is not intended for public use or
distribution.
Impax is a wholly owned subsidiary of Impax Asset Management Group plc, whose shares are listed on the Alternative Market of the London Stock Exchange. Authorised and regulated by the
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This document is for Professional Investors only.
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