Climate change: investors taking note (slowly)

Climate change is probably the most significant environmental issue faced by the world today. Yet it is probably fair to say that the majority of institutional investors have been slow to play an active role in the climate change debate.

This may seem surprising given the potentially major implications of climate change for the investing community. Direct implications include the physical impact of climate change such as the effects of extreme weather events for water utilities and on the insurance and reinsurance industries. Indirect effects can occur through government action to encourage businesses to reduce greenhouse gas emissions, for example the effects of emissions trading on electricity utilities.

There are, however, signs of change. A number of major institutional investors, including Insight Investment and Hendersons, have actively encouraged companies to adopt more proactive approaches to managing the risks and opportunities presented by climate change. Investors have also collaborated on initiatives such as the Carbon Disclosure Project and the Institutional Investors Group on Climate Change. Perhaps most importantly, climate change has started to become a standard part of 'mainstream' investment analysis.

Policy drives progress

What has led to these changes? There are various possible reasons, including the growing scientific evidence of the causes of climate change, coverage of climate change in the financial and business press, awareness-raising programmes such as those by the Carbon Trust and early broker research on the financial implications of the European Union's Emissions Trading Scheme (EUETS).

However, from interviews with a range of stakeholders - fund managers, pension funds, brokers and investment consultants - it is clear that these were not the critical tipping points for investors to explicitly incorporate climate change into their investment analysis. In fact, the interviewees almost unanimously identified government policy as the key development for them to integrate climate change into their investment analysis.

Two sets of policy measures have been identified as being of particular importance: measures supporting renewable energy - which encouraged the development of a number of renewable energy funds - and the creation of EUETS. The scheme started operation at the beginning of 2005 and has put an economic value on carbon dioxide emissions from specific industrial sectors, including electricity, cement, pulp and paper.

Does this mean that climate change is being integrated into the analysis of all sectors? The answer, as yet, is no.

For the vast majority of sectors - outside those covered by EUETS and possibly also the insurance sector where climate risk is a mature and reasonably well understood issue - investors do not appear to be explicitly considering climate change as a standard part of their investment analysis.

The problem is that investors are unable to put an immediate and quantifiable value on the risks and opportunities resulting from climate change. Specific issues that were identified by interviewees were: (a) uncertainty about future regulations or the strength of government commitment to taking action on climate change; (b) uncertainties in predicting the physical impacts of climate change; and, (c) the fact that some climate change impacts will only be felt over the longer-term.

Influencing investment decisions

From an environmental perspective, it is important that institutional investors take climate change properly into account in their investment analysis.

There are two main reasons for this. The first is to ensure that climate change externalities are reflected in investment analysis, which in turn should provide stronger incentives for companies to reduce their greenhouse gas emissions. The second is to provide further impetus for investors to encourage companies to reduce greenhouse gas emissions.

From the perspective of institutional investors, this should benefit long-term shareholder value, minimising the adverse societal consequences of climate change as well as enabling investors to benefit from investing in the companies that respond best to climate change.

From experience to date, it seems likely that 'soft' policy measures such as education or increased disclosure will not change this situation. Ultimately, if investors are to integrate climate change into their investment decisions, policy measures that assign an economic value to greenhouse gas emissions need to be implemented.

This has been one of the greatest successes of EUETS but its effect has been limited to those sectors covered by the scheme. It seems reasonable to conclude that the integration of climate change risks and opportunities into investment decision-making could be accelerated if policymakers provide a tangible financial value for the risks and opportunities resulting from climate change. Expanding EUETS to other sectors could do this.

This article is based on research conducted by Stephanie Pfeifer for her masters degree in environmental change and management at the Environmental Change Institute, University of Oxford. Rory Sullivan is director of investor responsibility at Insight Investment (the asset management arm of HBOS plc).