Climate change: now risk not uncertainty For professional investors only June 2015 1 Executive summary 2 Assessing the risk 3 Towards an investment response 4 Divestment in practice 5 Positioning for outperformance
1 June 2015 By Ian Simm Chief Executive, Impax Asset Management Ian Simm is the Founder and Chief Executive of Impax Asset Management Group plc. Ian has been responsible for building the company since its launch in 1998, and continues to head the listed equities and real assets investment committees. Prior to Impax, Ian was an engagement manager at McKinsey & Company advising clients on resource efficiency issues. In 2013 he was appointed by the Secretary of State (Senior Minister) for Business, Innovation and Skills as a member of the Natural Environment Research Council (NERC), the UK s leading funding agency for environmental science. He has a first class honours degree in physics from Cambridge University and a Master's in Public Administration from Harvard University. 1. EXECUTIVE SUMMARY As we learned from the recent financial crisis, systemic issues can wreck portfolios and undermine investor confidence for years. For many, climate change is emerging as a major systemic issue facing investors: economic damage from extreme weather and shifting climatic belts is likely to get worse, and governments are unlikely to sit on the side-lines. Investors need to act now, developing a coherent, flexible strategy to manage the risk of intervention. The unburnable carbon issue has become polarised. Those advocating full divestment are seen by many as extreme, particularly as divestment entails the wilful avoidance of dividend streams and a risk of underperformance if energy prices rise. However, recent statements from fossil fuel E&P companies to challenge the analysis behind stranded asset risk and/or downplay its significance have been less than persuasive. Asset owners are increasingly frustrated, particularly if faced with rising stakeholder pressure to reduce exposure to fossil fuels. Although there have been a few high profile announcements of wholesale divestment, for the vast majority, the default response is to do nothing and wait for further developments. Polarised responses are irrational for two reasons. First, recent developments in science and policy have had a major impact on the climate change issue, recasting it as a risk rather than an uncertainty, thereby facilitating the use of traditional investment management tools, particularly asset allocation. And second, developments in energy efficiency markets have created options for investors to mitigate some of the risks implied by divestment.
2 June 2015 2. ASSESSING THE RISK Investors struggle to deal with uncertainty, where the magnitude and timing of a potential impact cannot be readily estimated, but are typically comfortable with incorporating risk information into their decisions, particularly the level of allocation to different types of asset. For many years, the mainstream investor reaction to climate change has been that the science and likely policy response have been too uncertain to justify action. However, the UN Intergovernmental Panel on Climate Change report of September 2013 reported a strong scientific consensus over the causes of climate change and the likely consequences for the planet of the current trajectory of greenhouse gas emissions. Subsequent announcements from both the United States and China of specific plans to limit emissions of carbon dioxide have materially raised the chances of policy intervention. Investors can now legitimately consider scenarios in which major economic blocs pass legislation to restrict CO2 emissions within the next decade, for example through a significant Carbon which will affect the economics of both energy producers and consumers. 3. TOWARDS AN INVESTMENT RESPONSE Investors generally have three types of response to higher levels of risk: lower exposure to the assets concerned, reduce the risk and/or hedge it. Faced with a material probability of a Carbon within a decade, a timescale that matters for decisions taken today, it is rational for investors to lower their exposure to assets that could be affected. On the one hand, it is likely that the effect on today s valuations of these lower wholesale prices is drowned out by myriad other drivers of prices, for example political risk. On the other hand, a Carbon may render those assets with a higher marginal cost of production stranded, or potentially worthless (Figure 1). It is these assets that should be targeted for selective divestment. To mitigate risk, investors should challenge the companies whose fortunes could be improved by a change of strategy, for example oil majors that could cut back on capital expenditure into high marginal cost assets, possibly with a commensurate increase in dividend levels. Figure 1: Illustrative oil (or coal) market and lower wholesale price (P1) Lower wholesale price (P1) Illustrative oil (or coal) Supply 2 on carbon Carbon introduced Stranded Assets
3 June 2015 Although the wholesale energy price is depressed by a Carbon, the retail energy price can be expected to rise (Figure 2). By reinvesting the proceeds of selective divestment of fossil fuel assets into energy efficiency related business opportunities, investors not only hedge the risk that they miss out on future energy price rises, but also create exposure to energy prices that should increase in line with government intervention to limit greenhouse gas emissions. At the heart of this issue is the scarcity of useful data, particularly around marginal production costs. Alongside their divestment plans, investors should request additional information from the companies they hold and consider supporting wider initiatives to persuade stock exchanges and financial market regulators to oblige companies to provide further public disclosure. 5. POSITIONING FOR OUTPERFORMANCE Figure 2: higher retail price (P2) on carbon Supply 2 Policy to reduce greenhouse gas emissions isn t developed in a vacuum. We won t wake up one morning and discover a material Carbon has been imposed overnight. Nevertheless, governments have a nasty habit of ratcheting up their intervention to solve important policy problems, so investors who can anticipate government action and take pre-emptive measures to protect themselves are likely to outperform. Stranded Assets 4. DIVESTMENT IN PRACTICE Taking a risk-analysis approach to the impact of future climate change policy, investors may rationally decide to reduce their exposure to fossil fuel assets rather than full divestment. We recommend that a plan of action includes four components. First, examine individual assets to determine their marginal cost of production (and thereby their potential exposure to Carbon Pricing); this is likely to be difficult except for discrete assets or for companies with high levels of disclosure. Second, develop scenarios for the level of Carbon s and the probability and timing of their introduction; we recommend a simple model to start with which can be developed further as circumstances change. Third, divest in line with the probabilityweighted loss per asset, i.e. multiply the loss per asset in the scenario by the probability of the scenario occurring; this will be far from an exact science, so it makes sense to start with conservative assumptions, i.e. a relatively low level of divestment. Fourth, consider reinvesting the divestment proceeds into the energy efficiency sector; this may introduce additional risks, for example exposure to the industrial capital expenditure cycle.
4 June 2015 CONTACT INFORMATION Ian Simm Chief Executive +44 (0) 20 7434 1122 i.simm@ clientservices@ +44 (0) 20 7434 1122 www. Disclaimer This document has been prepared by Impax Asset Management Limited (Impax, authorised and regulated by the Financial Conduct Authority). The information and any opinions contained in this document have been compiled in good faith, but no representation or warranty, express or implied, is made to their accuracy, completeness or correctness. Impax, its officers, employees, representatives and agents expressly advise that they shall not be liable in any respect whatsoever for any loss or damage, whether direct, indirect, consequential or otherwise however arising (whether in negligence or otherwise) out of or in connection with the contents of or any omissions from this document. This document does not constitute an offer to sell, purchase, subscribe for or otherwise invest in units or shares of any fund managed by Impax or otherwise. It may not be relied upon as constituting any form of investment advice and prospective investors are advised to ensure that they obtain appropriate independent professional advice before making any investment. This document is not an advertisement and is not intended for public use or distribution. Impax is a wholly owned subsidiary of Impax Asset Management Group plc, whose shares are listed on the Alternative Market of the London Stock Exchange. Authorised and regulated by the Financial Conduct Authority. Registered in England and Wales, number 03583839. Registered Investment Advisers with the SEC. Norfolk House, 31 St James's Square, London SW1Y 4JR. This document is for Professional Investors only.