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GIRO 2007 - Implications for Assets

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Cash/short term bonds

These investments are highly liquid, and therefore their value does not fluctuate much and is not vulnerable to external shocks. Therefore, Climate Change is unlikely to have a large direct impact on the value of these assets.

Long-term bonds

The value of long-term bonds is typically affected by the market’s perception of future inflation, interest rates, and governments’ or companies’ ability to pay, as well as levels of uncertainty over these values (i.e. the higher the uncertainty, the lower are bond values). The direct impact of Climate Change on these variables is difficult to assess. However as a first guess, large climate impacts are likely to increase uncertainty and thus negatively affect bond yields. Therefore by holding bonds, there is a possible mismatch whereby Climate Change has a positive impact on liability values with a negative impact on Asset values.

Equity

Climate change has the potential to affect the whole world economy, and this will have an impact on all equity as companies’ profits are ultimately linked to economic growth. Notwithstanding this macro effect, within the equity sector, Climate Change will affect different sectors, countries and companies to varying extents. There will be winners as well

as losers; climate change will have an asymmetric impact on individual companies in the same sector as well as its impact on the sector as a whole. For example, a study of the effect of climate policy generally on the global automobile industry (Austin et al, 2003), concluded that the effect of carbon constraints on the corporate earnings of individual

companies ranged from an increase of 9 percent to a decline of 10 percent. The 2005 US hurricane season provided an example of how Climate Change can have large, uncertain and unknowable effects on equity value. Hurricane Katrina damaged 20 oil rigs and 8 oil refineries. This caused a spike in oil prices to $71 a barrel, increasing the value of energy

companies, but having a negative impact on other shares (the Dow Jones was down 12 points on that day) (Edwards (2005)). However, Hurricane Rita caused oil prices to fall, and hence energy shares to fall, as demand for crude was reduced by the shutdown of refineries (Hoyos et al (2005)).

Property

Like equity, the property sector could suffer from both direct and indirect impacts. Direct impacts include the increased probability of acute events such as storms, sea surges and flooding, as well as long-term impacts such as subsidence, sea level rises or lack of availability of water. Property can also be affected by indirect impacts, for example

legislation on carbon emissions from buildings or maximum legal temperature for work. Some properties will become more desirable and their price will rise; we believe the negative effect on pricing will dominate.

Current practice and its flaws

It is standard practice to monitor investment performance over short time periods, for example annually or even quarterly, even when liabilities are long term (Rappaport, 2005). The result is that fund managers concentrate on short-term performance to retain existing

business and attract new investments. This feeds back to companies and directors who are encouraged to boost short-term performance. The result is that long-term value drivers can be overlooked as they have little impact on short-term earnings. For example if oil and gas prices increase, an oil company will be faced with a choice between developing ways of extracting more oil from marginal sources or developing alternative energy sources. The former would be likely to have a quicker pay-off than the latter. Therefore long-term performance is achieved through an accumulation of short-term decisions.

Investor Initiatives

Investors are increasingly becoming interested in how Climate Change might affect their assets and have created various investor initiatives.

• The Carbon Disclosure Project (CDP)writes annually to the largest companies in the world, requesting information about carbon emissions.
• The Global Reporting Initiative (GRI) is a non-profit organization which aims to make sustainable reporting by companies as routine as financial reporting.
• The Climate Risk Disclosure Initiative (CRDI) aims to improve corporate disclosure worldwide to help investors make better informed investment decisions.
• Institutional Investor Group on Climate Change(IIGCC)is a forum for collaboration between pension funds and other institutional investors and seeks to promote better understanding of the implications of Climate Change.
• The United Nations Environment Programme Finance Initiative (UNEPFI) is a global partnership between UNEP and the financial sector and aims to understand the impacts of environmental and social considerations on financial performance.

What to do?

Options fall into two categories – passive and active. Active approaches can be further split into two: either to try to actively influence the investments that the insurer holds (the corporate governance or “engagement” approach) or to invest in “climate friendly” funds (aka

the SRI approach). This gives three broad approaches which have their inherent advantages and disadvantages. Passive monitoring will have limited impact if the information is not used; investors may only have limited impact on companies’ decisions, and even if you do not invest in a climate “unfriendly” company, someone else will. Part of the problem can be addressed by tackling short-termism in the investment decision making process. This could be partly achieved by looking at the investment mandate and reward structure, for example deferred bonuses contingent on extended performance would encourage “long-termism”. The best strategy is probably a combination of the three.

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