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June 03, 2005
Report Equips Investors With Tools To Analyze Climate Risk in Uncertain Policy Atmosphere
by William Baue
Investor Network on Climate Risk and World Resources Institute team up on a report that provides a
framework for valuating climate risk in the absence of regulatory clarity.
SocialFunds.com --
The fifth point of the ten-point "Call for Action" issued
by the Investor Network on Climate Risk (INCR)
at a United Nations summit last
month asked investment managers to improve their analysis of risks and opportunities associated
with climate change. Yesterday, INCR (a consortium of two dozen US and European institutional
investors with over $3 trillion in assets) issued a report written by the World Resources Institute (WRI) Capital Markets Research team entitled Framing Climate
Risk in Portfolio Management. The report maps the landscape of climate risk assessment and
equips portfolio managers with some of the tools necessary to analyze the potential impacts on
corporations operating in increasingly carbon-constrained markets.
 "This report offers investors a way to begin
to analyze climate risk," write report authors Fred Wellington and Amanda Sauer of WRI. "However,
to analyze these financial and competitive implications accurately, investors need more clarity on
the eventual structure of climate policy in the United States."
"This uncertainty also
extends to the degree of interaction between policies in the United States and abroad," they
continue. "Prudent investors will move beyond asking whether some form of climate policy is
on the US horizon to considering when and in what form."
Helpfully, the
report opens by distinguishing between risk ("a mathematical distribution of potential
outcomes around known parameters") and uncertainty ("lack of information.") It also
distinguishes between risks and uncertainties surrounding the physical unfolding of climate change
and the risks and uncertainties due to an undeveloped regulatory response to climate change in the
US. Essentially, the report describes how to navigate along the continuum from the shaky ground of
uncertainty to the more stable footholds of risk assessment, focusing less on the geophysical
(which is partly outside human influence) and more on the regulatory (a purely human construct).
The report lists the regulatory steps being taken by many foreign countries and individual
US states, highlighting the irony of the US government's advocacy for voluntary corporate action on
climate change. Most corporations do not exist in a vacuum circumscribed by US borders, but rather
conduct business in regions promulgating climate change regulations, making the absence of US
regulation a liability instead of a benefit. The report cites at least three companies that
explicitly recognize the inevitability of regulation and express frustration over US governmental
foot-dragging, which only heightens the atmosphere of regulatory uncertainty they must operate
within.
"In an uncertain regulatory climate, these decisions [optimal power plant
location, design, permitting, and engineering] must be made at the risk that they will not be
optimal once the existing uncertainty is finally resolved," states Cinergy (ticker: CIN) in its report to
shareholders analyzing potential impacts of greenhouse gas (GHG) regulations. "Cinergy works hard
to manage this risk, and has done so successfully for years, but clearly, the prompt adoption of
a clear long-term federal environmental policy would benefit all [emphasis added by WRI
authors]."
The report cites similar statements from power producers American Electric
Power (AEP) and
TXU (TXU).
"All three companies were concerned that taking proactive measures in GHG mitigation in the
short term could harm the company when future rules are adopted," the report states. "Indeed, TXU
argued that any investment in voluntary emissions reductions was unwarranted until the company
understood the shape of a future GHG regulatory program."
The uncertainty of how to
mitigate climate risk besets not only companies, but investors as well. The report remedies this
by recommending two specific strategies for pinning down climate risk.
The first is cash flow
adjustments whereby "investors can separate cash flows into those that will likely be affected by
GHG constraints and those that will not."
"This approach is probably better suited for an
environment in which the regulatory structure is known, or becoming clear, even if implementation
of the policy is less certain," the report states.
The second is risk-adjusted discount
rates, which leaves cash flow estimates unadjusted and instead applies a risk premium to companies
in sectors with greater exposure to GHG constraints. The pros to this approach: it is "easily
understood" and "analytically uncomplicated" and can be readily applied across diversified
portfolio, and is particularly appropriate in a period of policy uncertainty. The cons:
"[T]his method is very imprecise because it fails to fully incorporate competitive dynamics
around carbon constraints," the report states. "Using climate risk-adjusted rates poses an
additional problem: this approach reflects an implicit assumption that climate risk is distributed
evenly across time."
"This is unlikely to be the case because competitiveness, and
therefore financial impact, is not static," it adds.
©
SRI World Group, Inc. All Rights Reserved.
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