The $20,000,000,000,000 question

The global financial community is waking up to the risk of climate change, and the opportunities arising from doing something about it. But a smarter regulatory framework is urgently needed, says Nick Robins of Henderson Global Investors.

The climate crisis results from a tragic misallocation of financial resources towards activities that fail to account for their environmental impacts. If we are to make the bridge to a secure climate future, then fresh thinking is urgently required on how to steer the world’s immense investment resources towards energy options that simultaneously deliver sustainability and decent returns for the world’s savers. The task ahead is daunting, but early signs are promising.

The total value of all the companies listed on the world’s stock markets now amounts to over twenty trillion US dollars ($20,000,000,000,000). To date, precious little of this store of financial wealth has taken account of the cost of carbon emitted from these companies’ products and processes. And, looking ahead, business-as-usual projections from the International Energy Agency suggest that over $16 trillion will be invested in the world’s energy infrastructure up to 2030, mostly in fossil-fuel facilities, generating an additional 60% in greenhouse gas emissions. All indications suggest that this capital will be mobilised.

The multi-trillion dollar question is therefore how to mould those old financial drivers of “fear and greed” so that they work with the grain of a low carbon future rather than against.

This process has already started. The introduction of the European Union Emissions Trading Scheme on 1 January 2005 has transformed the way that financial markets value companies affected by the scheme. The scheme has created a new market in carbon dioxide allowances estimated at some Euro 35 billion (US$43bn) per year, potentially rising to over Euro 50 billion per year by the end of the decade. Investment banks now regularly factor in a cost of carbon into their valuation spreadsheets for affected sectors. For Chris Rowland, a leading City analyst, “it’s possibly the biggest change the European utilities industry has seen since the industrial revolution”.

The carbon caps might not have been as tight as many had hoped, but already the price for carbon dioxide allowances has risen from just Euro 7 in April 2004 to over Euro 28 in April 2006. This is equal to the UK government’s mid-point estimate of the actual damage done by a tonne of carbon dioxide of £19 (Euro 28).

It should be noted how easily financial markets absorbed this shift in costs. The sky hasn’t fallen in, and capital has started to move to those companies best positioned for a carbon-constrained future.

Climate change and the investment chain

Other parts of the investment chain have also taken action. The socially responsible investment (SRI) community has been at the vanguard of the shift. At my firm, Henderson Global Investors, we now see long-term growth opportunities in the companies providing solutions to climate change, whether in cleaner energy systems, efficiency enhancements or sustainable transport systems. In 2005 we also commissioned Trucost to carry out a pioneering carbon audit of one of our Sustainable and Responsible Investment (SRI) funds, which shows that incorporating sustainability factors into the selection of investments can yield real environmental benefits for investors.

More broadly, the Carbon Disclosure Project has mobilised 143 leading institutional investors to request improved disclosure on climate change from the world’s leading 500 companies. And at the recent Institutional Investor Summit on Climate Risk in New York, two dozen US and European institutional investors with over three trillion dollars of assets under management issued a ten point call to action. This urged pension funds, fund managers, companies, and financial regulators to intensify efforts to provide the analysis and disclosure needed to manage climate risks. The group also committed to deploy $1 billion towards business opportunities emerging from the drive to reduce emission.

These are all positive developments, but they will still be insufficient to tip the investment balance unless smarter policy frameworks are introduced. Even in the UK, where the government has developed a relatively sophisticated approach, the word “investor” is still strangely absent from its climate change programme. Certainly, making sure that the cost of carbon is reflected in commodity prices is a necessary step – and large funds, such as those backing the Institutional Investors Group on Climate Change now support the UK’s long-term carbon reduction target of 60% by 2050.

Markets and a climate-constrained world

But to be truly “joined up” from a financial perspective, policy should also address other parts of the investment chain. Financial regulation now lags behind economic realities. This means it is still possible for companies to list on the world’s leading stock markets without disclosing potential carbon costs and liabilities; this gap needs to be closed.

In addition, the duties of investors need to be brought into line with a carbon-constrained world. Managers of institutional investments – whether pension or mutual funds – are governed by the concept of fiduciary duty, ensuring that their decisions are prudently made in the best interests of the end-beneficiaries. This has commonly been interpreted as meaning the maximisation of short-term returns, without regard to wider social or environmental realities. The harsh facts of climate change – along with other sustainability threats – should prompt governments to modernise this interpretation. Inspiration can be sought by looking once again at the long-standing “prudent investor rule”, challenging trustees and managers to recast the ancient virtue of prudence in light of climatic realities.

Financial markets move on sentiment, and investors are now awakening to the deep risks associated with climate change and the potential opportunities in finding ways to respond effectively. By updating financial regulation and investor duties to take account of carbon, governments would not only make the achievement of climate goals more likely, but could also help secure stable investment returns at a time of a global pension crisis. The prize is clear, and it’s worth at least twenty trillion dollars.