As long term investors, superannuation funds are exposed to climate change across a broad range of sectors globally. While the impact of climate change is a relative unknown, it is imperative that superannuation funds consider the potential risks and opportunities that arise from climate change and how these can potentially be mitigated and accessed. Frontier Investment Consulting consultants ALLISON HILL and JUSTINE O’CONNELL present this special climate change investment guide for trustees and investment committees.
So what is climate change? As some background over the past 120 million years, the earth’s climate has fluctuated quite dramatically. Climate fluctuations can arise due to changes to the earth’s orbit, solar radiation, the positioning of the continents and concentrations of atmospheric greenhouse gases. According to the CSIRO, the changes in surface temperature since the mid-19th century have primarily been affected by Greenhouse gases (GHGs) generated as a result of human activity.
The 20th century was the warmest of the past 1,000 years. The 1990s was the warmest decade of the millennium and 1998 was the warmest year. GHGs trap heat in the atmosphere. If the concentration of such gases in the atmosphere rise, then temperatures will (all other things being equal) be expected to rise.
The main GHGs are carbon dioxide (CO2), methane, nitrous oxide, hydro-fluorocarbons, per-fluorocarbons and sulphur hexafluoride. This group of gases will be referred to collectively as GHGs throughout this article. To what extent global warming has occurred is still debated, however it is clear that the earth’s temperature is rising, in large part due to human activity. The atmospheric concentration of CO2 in 2005 was 379ppm³ compared to the pre-industrial levels of 280ppm³ (according to the United Nations Intergovernmental Report on Climate Change, April 2007). This is its highest level in at least 420,000 years. The increased warming of the earth brings with it a rise in sea levels, shifts in rainfall patterns and more extreme weather conditions, including droughts and floods.
This will have flow through impacts to a decline in overall food production, potential for increased disease and a loss of biodiversity, according to the Intergovernmental Panel on Climate Change (IPCC). The IPCC has concluded that by the year 2100 the earth is projected to warm by 1.4 per cent to 5.8 per cent and that the sea-level is projected to rise between 9cm to 88cm.
To date, experience has been at the high end of predictions. To stabilise the climate, the consensus among most scientists is that the increase in average temperatures should be constrained to no more than two degrees above pre-industrial revolution levels. This target will require significant cuts in global greenhouse gas emissions by the middle of this century. Both the environmental changes, and the required change in work practices, will certainly have a large impact on certain sectors of the economy, with some sectors feeling the effects more severely than others.
Developing countries to lose out again
The impact of climate change will be felt across various sectors and societies. Sectors where the more obvious immediate impact will be felt include energy, water, agriculture and insurance. Vulnerability to climate change will vary between regions, but it is predicted to be highest in developing countries. Developing and third world nations are more exposed by virtue of tending to be at lower latitudes, where impacts such as increased disease and extreme heat and drought will be more pronounced.
Developing countries also derive a larger proportion of their economic output from climate-sensitive sectors such as agriculture, fishing and tourism. In addition, developing countries generally have lower per capita incomes, weaker institutions, and less access to technology, credit and international markets, hence lower adaptive capacity. The general consensus has been that richer countries will generally “do better” economically out of climate change.
Some, particularly those in Northern Europe, will actually benefit in some economic sectors from marginal warming.
An example of this is the recent emergence of cropping in Greenland owing to more suitable climates. In Australia, the IPCC reports that as a result of reduced precipitation and increased evaporation, water security problems are projected to intensify by 2030 in southern and eastern Australia. Production from agriculture and forestry by 2030 is projected to decline over much of southern and eastern Australia due to increased drought and fire. The IPCC also stated that Australia has substantial adaptive capacity due to well-developed economies and scientific and technical capabilities but there are considerable constraints to implementation and major threats from extreme events.
Investors to feel the heat
The impacts for investors from this change will be large. It is worth firstly assessing the consequences on economic growth – the backdrop for all investments. While the economic impacts from client change are difficult to quantify, most estimates suggest they will be large. Interestingly, the majority of reports appear to indicate that early action in addressing climate change will reduce the overall cost to the domestic and global economies.
The Stern Report proposed that by the middle of this century, climate change will account for a loss of at least 5 per cent in global growth each year. If climate change’s impact on environment and health and knock-on effects is accounted for, it could be as much as 20 per cent of annual global GDP. In contrast, the review argues that the cost of taking action would be as little as 1 per cent of global GDP growth per annum.
For Australia, the Business Roundtable found that delayed action could lead to a reduction in GDP growth of 0.3 per cent per annum until 2050. In contrast, by addressing climate change and targeting emission reductions of 60 per cent by 2050, the reduction in GDP growth is projected at around 0.1 per cent per annum. There are a sizeable range of cost predictions and we acknowledge that measuring the impact of climate change is an extremely complex process and no one source of information can necessarily be relied upon.
Whatever the outcome, the consensus is that early action is vital and will reduce the negative impact on GDP over the longer term. The impact of climate change detailed in the Stern Report in particular is severe and far reaching. However, immediate impacts on GDP include the negative impact on the tourism industry due to physical damage to attractions like the Barrier Reef; the agricultural industry which may be impacted by more severe heat stress, disease and reductions in carrying capacity; and the constraints related to insufficient water supply.
In addition to the negative effect on GDP from the physical impacts of climate change, there are the costs associated with mitigating and adapting to climate change. The potential negative impact on GDP is likely to flow through to virtually every sector in the economy. There are also a number of potentially positive outcomes from the effort to reduce emissions. This could result in opportunities for growth in sectors driving low carbon emission technologies. In this sense, it can be argued that tackling climate change is a growth strategy as society is driven to become more efficient.
Climate change and resulting policies will also certainly have an effect on inflation, or the real return superannuation investors will receive. Climate change is anticipated to drive up the cost of fuel, the cost of food and the cost of water, placing upward pressure on inflation and reducing growth in other sectors. Pressure on food commodity prices has been experienced as a result of global biofuel production but this may not continue over the longer-term given its negative impact on food prices and the environment.
Domestically, the current drought impacting most of Australia is likely due in part to climate change and has contributed to higher inflation over recent years. As previously noted, changes in climate will mean increased frequency of droughts, as much as 40 per cent more in eastern Australia by 2070 which will lead to more severe and frequent food price spikes. The higher incomes of China and India are increasing the demand for meat and in turn boosting the demand for cereals to feed animals, further inflating food prices. Prices for petrol, energy and water will also continue to face upward pressure due to both the direct impacts of climate change and the introduction of policy mechanisms designed to address climate change.
Australia experiences significantly lower energy costs than virtually any other developed nation due to the supply and proximity of natural resources. The predicted increase in energy costs is one factor that will influence inflation. Renewable energy, for example wind, is around double the price of coal and gas is around 20 per cent more expensive than coal. In order to control inflation, there will be upward pressure on interest rates, putting increased pressure on the economy, with consumer confidence and disposable income declining further. Having noted all this, what does this mean for institutional investors?
The uncertainty surrounding future regulation on climate change and related issues in Australia has made it difficult for investors and companies to value the impact of climate change. Regulation has the scope to increase costs or to drive new product opportunities, reduce or increase the size of existing markets, create new markets or render some markets or products obsolete. Technology shifts driven by government policy could lead to significant changes in markets which could be positive for some firms and industries while negative for others.
Looking forward, there is a significant degree of uncertainty for superannuation funds as to the opportunities and risks from an investment perspective. To capture some of these opportunities, numerous climate change funds have been and will continue to be launched with investments that range from a portfolio of climate change-aware companies to infrastructure assets such as waste management and renewable energy assets. It is a difficult task for investors to discern between funds and some of these types of vehicles will lack strong investment fundamentals and may fail to meet investor expectations over the longer term.
It is important not to get caught up in the opportunistic side of this issue, that is, the proliferation of products will make it important for due diligence to be undertaken to uncover the ones that will both make money for investors and meet the climate change imperative. For the remainder of this article, we try to flesh out some of the opportunities, and risks, by asset class, or climate change innovation (in the case of the emerging carbon market) as they stand for Australian superannuation investors.
The Carbon Market
The carbon market refers to a market in which various forms of carbon credits are traded. Carbon trading is often viewed as a preferred method of reducing emissions compared with a direct carbon tax or direct regulation, although this is yet to be proven. Carbon trading can be cheaper and politically preferable due to the grandfathering process. The potential issues with a carbon trading scheme are problems of complexity, monitoring, enforcement and sometimes disputes or inefficiencies regarding the initial allocation methods.
Generally cap and trade models have been adopted globally. A cap and trade model entails setting a desired cap on the amount of GHG emissions. The trading of emission credits or allowances then occurs between over and under emitting firms. Gradually the emission credits or allowances are reduced in order to reach the targeted cap. The international carbon market grew from $US10 billion in 2005 to $US30 billion in 2006, according to The World Bank’s ‘State and Trends of the Carbon Market’ report from May 2007. The European Union Emissions Trading Scheme (EU ETS) accounted for the majority of these funds in 2006 ($US24 billion). There is a well-developed secondary market for carbon in Europe which is essential for a successful program as this increases liquidity.
Spot and futures contracts also trade on the over-the-counter market as well as exchanges such as the European Climate Exchange and Powernext. Already there are a small number of investment firms who are looking to profit from this market. This can either be via the more liquid futures markets, or more niche hedge fund type strategies which involve a manager sourcing ‘cheap’ credits, usually from emerging markets countries, and selling them into Europe, the most regulated developed market.
While there is a huge amount of hype regarding carbon trading and its benefits, it is possible that it will not have any real impact on driving investments relating to climate change and will not impact sectors to the degree currently supposed. The European experience to date indicates that achieving the outcome intended is difficult and relies hugely on effective regulation and policy making. An unnamed finance company CEO recently stated: “carbon trading could be the financial scam of the 21st century.” This is obviously not the general consensus, but is a real risk and worth considering before entering into investments of this nature.
Equity earnings growth is highly leveraged to GDP growth. However, GDP growth is not the only determinant of equity growth. There are a multitude of social and financial factors in particular which influence equity growth and these can differ by sectors and countries quite significantly. However, it is fair to conclude that a decline in GDP growth as generally predicted from a climate change perspective is not a positive for equities in aggregate.
Australia will need to adapt to higher costs generally. The higher costs will be primarily the result of increased energy costs and higher basic food prices. Despite this, global demand for commodities is projected to continue to rise dramatically over the coming years. This will be driven partly by developing countries, partly by the need to repair and build new infrastructure to cope with the changing environment and partly by the drive for innovation in certain sectors.
This is positive for Australia as a net exporter of commodities and a country rich with natural resources. As a result, we believe that despite the potentially negative impact of climate change policies on dominant sectors such as coal and iron ore, the outlook is relatively positive for Australian equities. Australia is also well-placed to develop a range of renewable energy sources.
While Australia has been slow in supporting these industries to date, the new government has committed to high renewable energy targets and support for these technologies is probable. We believe the outlook for this sector is relatively positive. The impact on equities globally will differ between sectors and geographies. Emerging market countries tend to be highly exposed both physically and economically to climate change. The economic impact will vary depending on global climate change policies and the price of resources such as coal and iron ore.
Europe has been addressing the energy and related issues for a number of years and is arguably better placed to deal with the negative economic impacts of climate change, than say the US, over the coming years. The impact of climate change will depend on the response by companies to climate change and specific regulation and policies. Simply because a company or a sector is a high emitter of GHGs, it does not necessarily follow that the company will be negatively impacted by climate change policies and regulation. The impact of climate change and climate change policy is not straightforward and is, to a large extent, likely to be company specific.
Globally, the impact of carbon trading on lowering emissions has been relatively benign to date. That is not to say this will be the case in the future and it is imperative that fund managers assess this, and other climate change related risks, on a case by case basis although including these aspects into a valuation process is challenging. Overall, Frontier believes it is important that funds managers are considering issues such as climate change, policies and carbon pricing when assessing companies. Superannuation funds need to determine the process fund managers use to price potential risks of climate change and how possible opportunities are sourced.
Infrastructure, by definition, exists to support the social and economic activities of society. When these activities change, the impact can be quite significant, both positively and negatively. Positively there may be opportunities to invest in renewable energy assets, natural gas distribution networks, transport infrastructure and other climate-friendly infrastructure assets. In addition, this sector has traditionally been viewed as a solid inflation hedge given a sizeable amount of the revenue is pegged to inflation.
Some of the more ‘traditional’ areas of infrastructure do not face such a positive outlook from a climate change perspective. Airports are linked to climate change through their symbiotic relationship with the airline industry which is GHG emission intensive. The potential impact on airports is threefold. A carbon price on aviation emissions may result in changes to passenger numbers due to the direct impact on the cost of air travel.
The indirect impact of reduced economic growth as a result of climate change may reduce discretionary travel. Finally, due to physical changes in the environment, for example the continued bleaching of the Great Barrier Reef, passenger growth may reduce and travel routes may alter. This is unlikely to be a direct issue for a number of years but passenger growth should be monitored.
The negative impact on GDP coupled with the heightened price of air travel may impact quite significantly on airlines and therefore airports. This impact will also depend on the carbon price and other regulation approaches. There are a number of strategies that may reduce these negative impacts such as income diversification within the airport and reducing the industry’s carbon footprint through the use of alternative fuels, more efficient engines and flight paths, shorter take-off and landing routes and passengers choosing to offset their emissions.
Toll roads may be an area of concern but there has been limited indication to suggest this to date. Given the GHG emissions produced by cars coupled with continued high oil prices, traffic numbers may reduce. Research has generally predicted that energy costs and climate awareness are only likely to impact on discretionary travel. It is unclear whether there will be additional investment in rail and other public transport infrastructure to aid in reducing society’s reliance on cars although this makes sense. The increased take up of hybrid and other types of low GHG emitting and lower cost vehicles may mean that traffic levels do not reduce meaningfully, therefore limiting the negative impact on toll roads.
Generally, the solutions available to reduce the impact of climate change on toll roads appear simpler than for airports. There are a number of opportunities in the renewable energy sector. These too are not without risks due to the early stage of the sector, particularly in Australia. There will be a number of technologies that may benefit greatly from climate change however predicting which technologies and renewable alternatives will be adopted depends on a number of factors that tend to be outside the control of investors, such as regulation, subsidies and the price of carbon.
There may also be elements of the supply chain such as energy services companies which may benefit depending on the industry dynamics, but these are yet to be identified. Water saving and recycling technology is another potential growth area. Historically water infrastructure has lacked appropriate capital expenditure and this may present attractive investment opportunities. Some parts of Europe are now facing more severe water shortages and investment in water storage infrastructure is required. In Australia there will be increased demand for a host of water saving, recycling and other water management technologies which should support growth in the sector.
Timber is a potential beneficiary of climate change policies due to its ability to sequester CO2. Forestry and timber is the only carbon positive sector of the economy and can benefit from both emissions trading and bioenergy opportunities. It is important to be fully informed of the carbon pricing and trading mechanics that will eventuate in Australia however, and this may not be known for some time.
Small and mid-sized companies will play a particularly important role in addressing climate change and an investment in private equity provides access to these companies. Climate change poses numerous opportunities for private equity, particularly venture capital, for example via cleantech funds.
There have been an increasing number of managers offering cleantech and other similar funds more recently. In the US, cleantech has become the fifth largest venture capital investment category, after biotechnology, software, medical and communications. This is quite substantial growth and over a short period of time. Analysts have predicted that growth in the clean energy market from its present $US40 billion to $US167 billion. BP has predicted a market for solar, wind, hydrogen and gas at $US600 billion by the year 2020. Any investment made will need to consider the risks and stage of the investment and ensure diversification across the sector. There is growing demand in this sector, therefore the opportunity set is ever increasing with a range of investments across the risk spectrum.
Given the development of the market and broader recognition of climate change, the exit opportunities are also developing and becoming more predictable.
The property sector, particularly commercial property, is likely to feel the effects of climate change directly and relatively quickly, if not already. Property insurance costs are rising, as is the cost of energy and property maintenance. Commercial buildings are responsible for 8.8 per cent of Australia’s GHG emissions, with electricity use representing the dominant source of these emissions (89 per cent of all commercial building emissions, according to the Australian Greenhouse Office).
The Building Code of Australia contains energy efficiency provisions for the design and construction of all Class 5-9 commercial buildings such as offices, shopping centres and hospitals. The property sector has witnessed increasing numbers of concerned occupiers as governments and large institutions aim to lease energy efficient buildings.
For instance, the Commonwealth Government released its ‘Green Lease Schedule’ in July 2007, requiring new leases by Commonwealth Government tenants (greater than 2000 square metres) to target at least a 4.5 star ABGR (Australian Building Greenhouse rating). These changes in attitudes may negatively impact the valuations of properties that are unable to comply with energy efficiency standards.
Rental values for less efficient commercial sites may fall and have a negative impact on valuations and the transferability of these energy-inefficient buildings in the near future. The changes to legislation and consumer preferences will most likely lead to accelerating obsolescence for some assets and portfolios. However, in response to the increasing obsolescence of buildings, investment in development properties may be stimulated and the building sector more broadly may experience higher demand for services.
Climate change is a far reaching and complex issue facing society and investors. There are uncertainties across virtually all sectors of the economy. For investors, there are both potential risks and opportunities. While research has concluded that the physical impact and the costs associated with mitigating and adapting to climate change will negatively impact GDP growth, the cost of inaction is expected to be higher.
Further, there are a number of sectors that will benefit from the drive for new technology, increased investment and policy changes. Investors should engage with managers on climate change issues to discuss how the climate change analysis is incorporated into their investment process. This is too large an issue to ignore. It is important to understand how managers price and assess risk and how this is incorporated into the valuation process across all asset classes. Adequate consideration and analysis of risk will ensure there is limited downside to investors. Every manager is likely to view and analyse the potential impacts of climate change differently.
As demonstrated by this article, there are numerous uncertainties and no one approach to analysing climate change is necessarily appropriate. However, ignoring the issue is clearly inappropriate across almost all sectors. At present, the physical impact of climate change and the regulatory and policy response is still unclear. As such, it is necessary to continually consider the impacts of changes to regulations in response to climate change and other factors such as higher food prices that may impact the economy and specific sectors.
Clarity on carbon trading, regulation and the global response to climate change will aid in providing a clearer direction for investors.