Innovest Strategic
Value Advisors, Inc.
Testimony Before the U.S. Senate Committee on Environment and
Public Works
Prepared by
Martin Whittaker
March 13, 2002
“The greatest challenge facing the world at the beginning of the 21st century is climate change . . .Not only is climate change the world’s most pressing problem, it is also the issue where business could most effectively adopt a leadership role.”
Proceedings of the World Economic Forum Annual
General Meeting
Davos, February 2000
Climate
change is rapidly becoming a major issue for U.S. companies and
fiduciaries. The increasingly global
nature of industrial competition, institutional investment strategies, and
legislated disclosure requirements mean that company directors and other
fiduciaries in North America should see climate change as a major business risk
- and opportunity.
In the private sector, climate change has rapidly
developed into a major strategic – and practical – issue for both industrial
corporations and their investors. The
competitive and financial consequences for individual companies can be huge:
Innovest’s own research has indicated that the discounted future costs of
meeting even ‘softened’ Kyoto targets correspond to 11.5% of total current market
value for the most carbon-intensive U.S. electric utility to 0.2% in the least;
and up to 45% of current share value.
Increasingly severe climatic events have the potential to stress P&C
insurers and reinsurers to the point of impaired profitability and even
insolvency; indeed, insurance analysts at one major U.S. investment bank are
already known to have lowered their earnings estimates to account for ‘what
appears to be a higher-than-normal level of catastrophes’ during early 2001.
By the same token, recent studies give grounds for
optimism that the right blend of market based policies, if skillfully
introduced, can substantially reduce the direct and indirect costs of
mitigation and perhaps even produce a net economic benefit. Indeed, several leading insurance, fund
management and industrial companies are already poised with risk management
programs and innovative new solutions that promote both GHG emissions
reductions and their own bottom lines.
Our research shows that, for a variety of reasons, businesses practicing
sound environmental management also enjoy enhanced competitive advantage and
superior share price performance.
There is therefore an increasingly compelling need
for corporate board members, pension fund trustees, and asset managers to take
the climate change issue far more seriously than they have to date as a major
and legitimate fiduciary responsibility.
A number of major
drivers are currently converging to propel climate change to a much more
prominent place on the agendas of company directors and executives, as well as
those of a growing number of institutional investors:
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Strengthening Scientific Consensus:
The most recent report
by the IPCC (Intergovernmental Panel on Climate Change) actually strengthened
warnings from its earlier work regarding the rate, extent and consequences of
climate change. The report accelerated
climate change time horizons and identified the possibility that at some
unknown threshold, sudden and largely irreversible shifts in global climate
pattern may occur. Developing countries are predicted to bear the brunt of
future climate turbulence.
A new report by the
U.S. National Academy of Scientists released in March 2002 corroborated these
findings, adding that exceeding the threshold limits could precipitate sudden
and abrupt changes which are far more dramatic than anything that preceded
them.[1] Simulation modeling indicates that the cost
of a single extreme hurricane could reach as much as $100 billion, on the same
scale as the accumulated pollution damage in the USA since industrialization
began.
IPCC scientists also believe
that North America has already experienced challenges posed by changing
climates and changing patterns of regional development and will continue to do
so. Varying impacts on ecosystems and human settlements will exacerbate
differences across the continent in climate-sensitive resource production and
vulnerability to extreme events.
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Growing Recognition of the Gravity of Potential Financial Impacts
from Weather Extremes:
Over the past fifteen years alone, the word has
already suffered nearly $1 trillion in economic losses due to “natural”
disasters, roughly three-quarters of which were directly weather-related.[2]
Munich Re, one of the
world’s largest reinsurers, recently estimated that climate change will impose
costs of several billion dollars each year unless urgent measures are taken to
reduce greenhouse gas (GHG) emissions. In the year 2000 alone, global damage
reached $100 billion, mostly uninsured, and already simulation modelling shows
that the cost a single extreme hurricane could reach $100 billion, on the same
scale as the accumulated pollution damage in the USA since industrialisation
began.
These concerns have now
been echoed by other leading mainstream financial institutions including Swiss
Re, Credit Suisse and Deutsche Bank.
The costs of continued inaction are potentially astronomical, yet there
is growing evidence that aggressive mitigation measures need not cause
the economic harm and dislocation initially feared by many conservative
economic commentators.[3]
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New Understanding of the Breadth of Sectoral Impacts:
“As we
are beginning to appreciate within the reinsurance industry, the effects of
climate change can be devastating...”
Kaj Ahlman,
ex-CEO,
Employers
Re
Conventional wisdom
suggests that the effects of climate change will be limited to sectors directly
associated with the energy value chain (including oil and gas, natural gas,
pipelines and electric utilities on the downside, and renewable energy) and those
industries consuming large amounts of energy (steel manufacturing, smelting and
such like).
Recent research makes it clear, however, that the business
ramifications relate not just to energy-intensive industries but also sectors
such as telecommunications and high-technology (which influence societal
resource consumption and provide enabling technologies); forestry (an integral
part of the sustainable energy cycle); automotive (the primary users of
petroleum products and leaders in fuel cell development); electronics,
electrical industries and other equipment suppliers (where fuel cell
technologies are already creating whole new markets); agriculture (where
industries ranging from animal farming to winegrowing face major potential
impacts), tourism and other sectors.
?
New Evidence on Company-Specific Impacts:
In addition to the
massive aggregate risk exposures noted above, recent evidence on company-level
impacts has revealed:
- That in some high-impact sectors such as
energy and electric utilities, the climate change-driven threat to
shareholder value could represent as much as 30% of the total market
capitalization of major companies; and
- That even within the same industry sector,
firm-specific climate risk can vary by a factor of nearly 60 times.[4]
- Companies are increasingly finding ways of
benefiting from proactive action on tackling greenhouse gases, either
through win-win energy savings activities or the development of new
products and services based around greater energy efficiency or
GHG-reducing technologies[5].
It clearly behooves
fiduciaries and investors to know which industry sectors and companies
are exposed to the greatest risks and opportunities, and what measures if any
are being taken to identify and manage those risks.
?
The Internationalization of Pension Fund Investment:
Ten years ago, only
3.3% of U.S. pension funds’ equity investments were in non-U.S. company
securities. Today, that proportion has
more than tripled to over 11%.[6] A similar internationalization of pension
fund investing is occurring in virtually every OECD country. What this means for U.S. fiduciaries is
simply this: The competitiveness of
their investee companies – and therefore their fiduciary responsibilities –
will not permit them to ignore or remain isolated from climate change policy
and regulatory developments in other parts of the world.
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Legitimization by Mainstream Investment Institutions:
Major international investment houses such as AMP Henderson
and Friends Ivory & Sime have
developed sophisticated guidelines for assessing companies’ strategic and
operational responses to the climate change threat. What is more, they have begun to communicate the importance of
the issue to their clients. This
initiative by a mainstream investors will go a considerable distance towards
“legitimizing” climate change to conservative investors.
A broad coalition of
global institutional investors is already forming to press management at the
world’s largest companies on shareholder risks associated with climate change
via the 'Carbon Disclosure Project’ (CDP).
The CDP is a non-aligned Special Project within the Philanthropic
Collaborative at the Rockefeller Brothers Foundation with the sole purpose of
providing a better understanding of risk and opportunities presented to investment
portfolios by actions stemming from the perception of climate change. To date, institutions representing over $2
trillion in assets have already joined the initiative.
In the U.S., climate
change-related shareholder resolutions are anticipated against ExxonMobil,
Chevron-Texaco, and Occidental Petroleum during the current (2002) proxy
season. Major institutional investors
including the City of New York and the State of Connecticut are beginning to
flex their financial muscles on the climate change issue.
?
Expanded View of Fiduciary Responsibilities:
Historically, fiduciary responsibilities have been interpreted rather
narrowly in both the U.S. and Europe.
Fiduciaries’ principal obligation was the maximization of risk-adjusted
financial returns for pension plan beneficiaries, investors, and
shareholders. Since environmental
performance was widely seen as injurious or at best irrelevant to financial
returns, the prevailing ethos held that they were of necessity beyond the
legitimate purview of fiduciaries. This
ethos has now begun to shift dramatically: A growing body of research is making
it clear that companies’ environmental performance may well affect financial
returns, and is therefore a wholly legitimate concern for fiduciaries. Legislative reforms of pension legislation
in a number of European countries, is codifying this new ethos into law[7].
Recent independent back-test evidence indicates that a diversified
portfolio of more “sustainable” companies can be expected to out-perform one
comprised of their less efficient competitors by anywhere from 150 to 240 basis
points or more per annum. In
particularly high-risk sectors such as chemicals and petroleum, Innovest’s own
research has revealed that this “out-performance premium” for top-quintile
companies can be as great as 500 basis points or even more.
As the chart below illustrates, depending on how much
emphasis was given to environmental performance factors, the out-performance
margin ranged from 180-440 basis points (1.8 – 4.4%). None of this out-performance can be explained by traditional
securities analysis; it appears to be pure “eco-value”.
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New Emphasis on Intangible Value and Disclosure:
“Reputation is something which, unlike a
petrochemical feedstock plant, can disappear overnight. We are increasingly getting firms which are
conceptual and Enron being a classic case whose value depends on reputation and
trust. And if you breach that, that
value goes away very rapidly.”
Alan Greenspan
Chairman of the U.S. Federal Reserve Bank
Speaking at the Senate Enron Inquiry on Capitol
Hill, Washington D.C.
January 25, 2002
As
recently as the mid-1980’s, financial statements captured at least 75% on
average of the true market value of major corporations; today the figure is
closer to only 15%1. That leaves roughly eighty-five percent of a
company’s true market value which CANNOT be explained by traditional financial
analysis The yawning disconnect between companies’ book value (“hard assets)
and what they are really worth – their market capitalization - is at an
all-time historical high.
This
leaves institutional investors and fiduciaries with an enormous information
deficit, as the recent implosion of Enron vividly demonstrated. Intangible value drivers are now the
strongest determinants of companies’ competitiveness and financial performance.
The growing importance of
intangibles to company valuations in the U.S. was underscored in a March, 2002
announcement by the U.S. Financial Accounting Standards Board that it will be
issuing binding disclosure requirements about companies’ intangible assets
within the next 12 months. This will
clearly accelerate the integration of intangibles into mainstream financial
analysis. Internationally, the growing
momentum of other major “transparency initiatives” such as the Global Reporting
Initiative (GRI) are certain to add climate change as a significant new source
of business and investment risk.
?
International
Legislative Momentum:
The European Union has already committed itself to a legally binding
timetable for Kyoto implementation, including compulsory taxes on GHG emissions
above prescribed limits, starting in 2005.
Taxes on greenhouse emissions are either proposed or already in effect
in Scandinavia, and the Canadian, Australian and Japanese governments are also
in the process of establishing national emissions abatement plans. Japan, the U.K. and Canada have both
signaled their intent to ratify the Kyoto Protocol within the coming weeks,
probably before the forthcoming Earth Summit in South Africa. The imperatives of global competition will
clearly impact U.S. companies regardless of any tax or other regulatory
measures which may or may not be forthcoming in the United States.
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Domestic Political Momentum:
In response to both domestic and international pressure for a robust
response to Kyoto, President Bush announced his new climate change policy on
February 14, 2002. The administration’s
Clear Skies Initiative commits the U.S. to reduce it greenhouse gas intensity
by 18% over the next 10 years, and includes substantial financial incentives
for renewables and clean technologies.
The President’s proposed budget for FY’03 increases spending on climate
change mitigation to $4.5 billion per year.
On February 20, 2002, EPA Administrator Christine Whitman launched
one of the key components of the Bush Administration’s new climate policy, the
Climate Leaders protocol. That
initiative encourages companies to report on their emissions of the six major
GHG’s, using a reporting framework developed by the World Resources Initiative
and the World Business Council for Sustainable Development. In concert with similar initiatives
elsewhere, this should make a significant contribution to increasing the level
of transparency of carbon risk exposures and, as a result, increase
accountability for both corporate directors and investment fiduciaries.
In the United States,
there are a number of bipartisan bills, resolutions and legislative proposals
currently before the 107th Congress, several of which, among other
things, propose significantly increased company disclosure of carbon risks,
measurement of emissions, and increased research and development.
?
New Insights into the Economics of Climate Change Mitigation
Measures:
The economics of climate change has been a source of considerable uncertainty and controversy. Several high-profile studies have estimated the costs of mitigation to be extraordinarily high, particularly in the U.S. However, these estimates have invariably used worst-case assumptions that necessarily imply high costs, for example, highly limited or none existent emissions trading activity, a need to meet short term targets, or limited use of non-carbon fuels.
Recent studies give grounds for optimism that the right blend of policies, if skillfully introduced, can substantially reduce the direct and indirect costs of mitigation and perhaps even produce a net economic benefit[8].
?
The Need to Look Beyond the Kyoto Protocol
Effectively addressing climate change can only be achieved via the
adoption of more sustainable development pathways that simultaneously attend to
interdependent social, economic and environmental challenges. While the Kyoto
Protocol is a crucial first step in managing the problem, focusing entirely on
the agreement would encompass too narrow a set of interests and divert
attention away from some of the more fundamental social, environmental,
technological and economic issues at stake.
The broader sustainability context of climate change simply must be
appreciated if the issue is to be effectively managed.
Taken separately, few
of these trends are sudden or radically new.
What is new, however, is their confluence at a single point in
time. Taken together, they form a kind
of “perfect storm” which has already begun to redefine the responsibilities of
fiduciaries in the early 21st century. Together, Innovest believes that they are rapidly moving climate
change to a position of growing prominence on both corporate and institutional
investor’s agendas.
Providing the right
blend of regulatory pressure and market mechanisms to allow institutions to
incorporate climate-related factors into future underwriting, lending and asset
management activities is a critical step.
Directing institutional capital towards supporting organic development
of new clean energy technologies in their investees is also crucial. The renewables and clean power technology
markets are becoming increasingly compelling in the search for ‘win-win’
outcomes; the nascent GHG, CAT bonds, weather derivatives and microfinance/microinsurance
markets also hold substantial promise for strategic finance and insurance
companies.
Ultimately, It is
Innovest’s belief that unleashing the creative instincts of the private sector
is by far the most effective way of dealing with environmental pressures. Our research shows that businesses that
practice sound environmental management also enjoy enhanced stakeholder and
customer capital, operate with reduced costs and less risk, are faster to innovate
and generally foster a higher level of management quality. More importantly, our research also shows
that these benefits translate into sustainable competitive advantage and
superior share price performance. This
linkage between environmental and financial performance therefore creates a virtuous
circle, in which proactive firms are rewarded by investors and encouraged to
continue in their endeavors. Less proactive firms are also provided with a
powerful incentive to adopt more positive responses. In the ensuing battle for best-in-sector leadership, the only
surefire winner is the American public, who benefit from a more competitive
private sector whose interests are better aligned with the broader tenets of
sustainable development, with all the quality-of-life benefits this brings.
INNOVEST STRATEGIC
VALUE ADVISORS, INC.
Innovest Strategic
Value Advisors is an internationally-recognized investment research firm
specializing in environmental finance and investment opportunities. Founded in 1995 with the mission of
delivering superior investment appreciation by unlocking hidden shareholder
value, the firm currently has over US$1-billion under direct sub-advisement and
provides custom research and portfolio analysis to leading institutional
investors and fund managers throughout the world. Innovest’s current and alumni principals include senior executives
from several of the world’s foremost financial institutions, as well as a
former G7 finance minister. The company’s flagship product is the EcoValue 21
platform, which was developed in conjunction with strategic partners including
PricewaterhouseCoopers and Morgan Stanley Asset Management. Innovest is headquartered in New York, with
offices in London and Toronto.
MARTIN WHITTAKER.
Dr. Whittaker is a
Managing Director with Innovest Strategic Value Advisors, Inc., specializing in
the energy and resource sectors. His research serves as critical input into the
equities research, product development and consulting activities of
Innovest. He also spearheads Innovest’s
work in climate change matters, designed to assist the financial community
understand the investment risks and opportunities surrounding climate
change. Martin is a former consultant
with Golder Associates and has worked in the oil and gas industry with Elf
Aquitaine, the French multinational. He
contributes regular analysis and commentary on finance and sustainable
development in the media and has also lectured on subject at several Canadian
business schools. He holds a Ph.D. in
environmental risk management from the University of Edinburgh, as well as
Bachelor's and Master of Science degrees from, respectively, the University of
St. Andrew’s and McGill University, Montreal.