Global warming will create significant risks as well as opportunities for investors that cannot be ignored.
Introduction
When I was at university in the late 1970s/early 1980s there was speculation that carbon emissions would lead to a “greenhouse effect” whereby heat from the sun would be trapped in the atmosphere causing an increase in the world’s temperature. The greenhouse effect and resultant climate change are now generally accepted by most scientists. The debate has moved from whether it’s happening to the magnitude of its impact. Global warming and climate change has major implications for all of us, not just in terms of our lifestyle but also for our investments.
The science of climate change
The scientific consensus is that global warming, driven by greenhouse gas emissions (eg, carbon dioxide, methane, and fluorinated hydrocarbons), is now a reality. Records from ice core samples suggest carbon dioxide in the atmosphere was stable at around 280 parts per million up until the industrial revolution, but it’s now around 380 ppm.
Source: Intergovernmental Panel on Climate Change, AMP Capital investors
On current trends, if left unchecked it’s likely to rise to around 800 ppm by the year 2100. Naturally there are various scenarios around this, many of which are worse. The general consensus amongst scientists is that carbon needs to be stabilised somewhere around or below 550 ppm if major calamities are to be avoided. The balance of evidence suggests rising greenhouse gas concentrations in the atmosphere are contributing to a gradual increase in average global temperatures (0.6 degrees C over the last 100 years). This in turn is showing up in rising sea levels – arctic sea ice is melting at 9% a decade – and as climate change in the form of more extreme weather events. For example, 2005 saw the worst hurricane season on record in the Gulf of Mexico, it was also the world’s hottest year and Australia is experiencing its worst drought on record.
Long-term impact
Without urgent measures to reduce carbon emissions, the impact of climate change will accelerate:
· Average temperatures are predicted to rise 2-3 degrees C this century, but with a range of up to 6 degrees C;
· Sea levels are projected to rise by up to a metre by 2100 – enough to flood 17% of Bangladesh and create serious problems for cities like New York and Sydney;
· With this will come even more extreme weather events;
· A 2.5% rise in average world temperatures has been estimated to reduce world GDP by around 3%. Very cold countries would benefit, but already hot countries would be hit the hardest. However, the GDP impact dramatically understates the cost of global warming as it ignores the huge potential loss of property and the impact on the quality of life. On the basis of GDP alone, Hurricane Katrina was good news for the US economy – but New Orlean’s residents may not see it that way!;
· Australia is predicted to be 2 degrees C hotter by 2030, with the south hardest hit by reduced rainfall.
It’s not all hopeless
Much of the debate about global warming makes it sound hopeless. Some see it as unstoppable, some think it’s impossible to turn around corporate and individual behaviour and others fret that action to redress the problem will lead to economic ruin. Most scientists would say it’s not too late and the history of environmental change suggests it’s not hopeless.
Problems of air pollution have been dealt with before. In the mid 1970s there was talk of global cooling (Newsweek actually ran a cover story on “The Cooling World”) due to sulphur pollution in the atmosphere reflecting sunlight, but this was dealt with by efforts to control that sort of pollution. Through regulatory action and technological innovation the world has addressed problems of smog (new cars emit a fraction of the “smog” they did 40 years ago), “acid rain” and the depletion of the ozone layer. Furthermore, progress on these fronts has been cheaper and generally faster than feared.
More specifically it’s doubtful that action to reduce carbon emissions will result in economic ruin. Various studies, including for Australia, suggest a phased process of carbon mitigation by encouraging the replacement of machines, appliances and buildings with more fuel efficient technologies at the end of their life-cycle and by encouraging low emission electricity infrastructure by putting a price on carbon pollution would cost less than one year’s economic growth (or about 3% of GDP) by 2050.[1] Mitigation efforts will also see various industries benefit.
Since carbon produced today stays in the atmosphere for around 200 years, action needs to start soon and it’s cheaper to start earlier and phase in efficient technology over time than to leave it till later when the problem is more acute and machines may simply have to be scrapped.
Expect increasing action to reduce greenhouse gases
The worldwide response to global warming was the Kyoto protocol, which set targets for greenhouse gas emissions relative to 1990 levels. These were more onerous for rich countries than developing countries as they are better able to afford the cost and can afford to experiment with the best way forward in terms of both regulations and technology before passing it on to poorer nations. In terms of major regions, Europe embraced Kyoto most vigorously and has introduced carbon trading as a means to achieve its targets. This involves allocating “dirty” industries allowances to emit a certain amount of carbon and allowing them to buy carbon credits from other companies that aren’t using their full allowances or from projects in developing countries that reduce greenhouse emissions. This has resulted in a market in carbon and other greenhouse gases. The European system is not without fault, but at least it puts a cost on carbon pollution.
The US and Australia have not ratified Kyoto and so their regulatory response has been patchy. Our assessment is that it’s only a matter of time before firmer action is taken by both the US and Australia, probably in the form of national emissions targets & carbon trading arrangements:
· The public will demand action as climate change becomes increasingly evident;
· Litigation against greenhouse gas polluters and governments is starting to increase;
· Individual states in both the US and Australia are starting to introduce Kyoto style carbon trading; and
· Business will demand action – particularly sectors on the front line of climate change (such as farmers and the insurance sector) and out of a desire for regulatory consistency & certainty given the state measures.
California is often a bellwether of social and regulatory change (eg, the 1970’s pollution standards for cars) and its adoption of aggressive emission reduction targets and carbon trading is a sign of things to come in the US and Australia.
Reasons why it matters for investors
There are several reasons why climate change cannot be ignored by investors. Let’s look at the risks:
Firstly, companies will face climate change risk from several sources[2]:
· The actual physical impact from changes in the weather and sea level (which is directly relevant for the agricultural, insurance and property industries),
· The impact on the competitiveness of companies that fail to respond adequately to climate change risks;
· Market related risks may come if climate change influences customers decisions when buying goods, eg, to shy away from companies/products that have a bad reputation in relation to climate change issues; and
· Regulatory risk is likely to intensify, having the greatest direct impact on industries such as electricity utilities that emit carbon in a big way (or rely heavily on energy), as the cost of doing so will rise.
These considerations have the potential to have a significant impact on the riskiness, profitability and growth potential of companies. This is what motivated the Carbon Disclosure Project (CDP)[3] in an effort by institutional investors to better understand the risks and opportunities faced by companies in relation to climate change and what they are doing about it. The first CDP survey of the top 100 listed companies in Australia found that companies were aware of the risks, but only 25% of respondents indicated a sophisticated understanding of climate change risks.
Secondly, climate change has a significant potential to impact property related investments, particularly in low- lying areas. A rise in the sea level of several centimetres over the next few decades may not seem much, but it would have a huge impact on beach suburbs (particularly waterfronts) and places like Surfers Paradise and Cairns during a severe storm.
Thirdly, climate change could significantly affect the economic growth that partly drives investment returns – but this is a very long term impact and probably not big enough (on current projections) to get too concerned about at present. It’s worth keeping an eye on though.
Climate change also creates opportunities for investors. These include:
· Investment in cleaner technology energy companies, whether via the share market or venture capital funds; and
· Investing in carbon abatement (eg, forests to absorb carbon) or carbon capture projects which can generate carbon credits for sale in carbon markets. The global carbon market will expand as carbon trading expands;
· Investing in companies that have attained a competitive edge by combating any climate change risks they face.
Conclusion
Climate change, driven by greenhouse gas emissions, is a major problem that will have a significant impact on the way we live. Its far-reaching implications mean that it cannot be ignored by investors.
By Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*
[1] See, for example, “A prosperous low carbon future – WWF’s proposal to reduce Australian greenhouse gas emissions by a third by 2030,” World Wildlife Foundation Australia, 2006.
[2] See “Climate Change and Company Value”, AMP Capital Investors and Baker & McKenzie, 2005.
[3] Carbon Disclosure Project Report 2006, Australia and New Zealand, Investor Group on Climate Change, Goldman Sachs JB Were and CDP.
