Climate change brings a new generation of risks, opportunities and responsibilities for the world’s financial markets, report Nick Robins and George Latham.

Climate change is set to become one of the most disruptive forces on global financial markets over the coming decades. Rising emissions of greenhouse gases are already leading to changing weather patterns, intensified storms and rising sea levels – all with significant implications for asset values, infrastructure and insurance. Government efforts to curb these emissions through carbon taxes, emissions trading and renewable incentives are equally starting to reshape the world’s energy markets.

For those in the sustainable investment community, the writing has been on the wall since the signature of the Framework Agreement on Climate Change in 1992. UK industry started to feel the impact of policy measures to ‘internalise’ the cost of carbon with the introduction of the climate levy later in the decade. But it was only with the launch of the EU Emissions Trading Scheme in January 2005 that mainstream investment managers have finally woken up to the reality of carbon markets.

Carbon price roller coaster

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George Latham,Associate director , SRI Funds

 

The first 18 months of the scheme have been a roller-coaster ride with carbon prices first soaring to more than €30, then crashing to less than e10 in April before recovering in May. Although some have seen this as a warning sign that the system is not working, it represents an early (and perhaps inevitable) correction in a radically new dimension to investment management. For fund managers, the advent of the carbon market clearly introduces additional risks for carbon-intensive sectors whose emissions are now constrained. The cost of pollution needs to be managed alongside other costs of production – and consequently incorporated into analysis of the future prospects for investments across many market segments.

The most direct impact has been in the electricity generation sector, which accounts for the bulk of allowances in the EU scheme. Paradoxically, however, because allowances have been allocated free to producers, the power sector has benefited, with particularly strong gains among those that cut their carbon emissions or have low carbon generation already.

The combination of incorporating the cost of carbon and high gas prices has sent electricity prices dramatically higher across Europe, prompting talk of windfall taxation to claw back some of the benefits. Alongside this, smart utilities have benefited from incentives for clean energy, such as the Renewable Obligation Certificate scheme in the UK, which has become a powerful value driver.

The introduction of this new form of ‘carbon inflation’ has inevitable consequences for energy users, with companies having differing abilities to pass on higher costs to their consumers. For example, Pilkington, in the glass industry, successfully implemented an energy surcharge quite early on and DS Smith, the paper manufacturer, has issued profits warnings in the past 18 months, mostly blaming rising energy costs. As a result, across the wider market, a company’s competence in energy efficiency is becoming an important indicator of business quality.

Investment opportunities

Where there are risks for some, there are also new investment opportunities emerging in companies servicing the new carbon market. A wave of emissions trading firms have listed on the London market, notably Agcert, Camco, Ecosecurities, Econergy and Trading Emissions. Most are seeking to benefit from the Clean Development Mechanism (CDM), one of the Kyoto instruments that allows carbon credits earned through emission reduction projects in emerging markets to be sold into the European trading scheme.

This is an exciting but high-risk arena, where investors need to gain assurance in a number of areas. The CDM is still at an early stage of development and subject to many bureaucratic hurdles. And there is no guarantee that the carbon market will continue beyond the current Kyoto period (2008-2012) – although all the signs point to growing international consensus. In this uncertain environment, the business model needs to be credible and robust, and investors have to be confident in the quality of management, which will make or break businesses.

Fund managers also need to look to the carbon performance of their portfolios. Last year, Henderson was the first to commission a carbon audit of one of its funds, comparing the carbon intensity of its Global Care Income fund with its benchmark, the FTSE All Share. Environmental consultants Trucost concluded that the fund generated 32% less carbon emissions per unit of investment than the All Share. The exercise has been repeated this year, with the fund improving marginally to give a 34% out-performance. With carbon pricing becoming more broad-based, these kinds of measures will become important leading indicators of portfolio returns (see graph below).

Looking ahead, the stage is set for a maturing of carbon markets, with tighter reduction targets in the EU for 2008-2012, a possible extension to cover aviation and increasing use of permit auctioning to counter the windfall effect. Internationally, the CDM will become an increasingly reliable source of carbon credits. And within the next three to five years, the US is likely to come in from the cold, introducing a domestic quota system; for many in US business, the issue is no longer ‘if’ but ‘when’ constraints on carbon are introduced. This will provide further support for the carbon price and remove any lingering doubts about the centrality of carbon to future investment returns.l

www.henderson.com/sri mark.campanale@henderson.com

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