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January 13, 2012

Emerging Markets Investors Advised to Factor for Cost of Carbon
    by Robert Kropp

SinCo and Trucost produce a report that identifies risks of a carbon tax to high-emitting companies, while analyzing the carbon footprints of South African equity funds.

SocialFunds.com -- The attention of sustainable investors has been very much on South Africa and the African continent recently, where the COP17 climate change conference was held in the city of Durban last month.

Many investors with sufficient appetite for risk consider Africa to represent the final frontier of emerging markets investment. A 2010 report found that foreign direct investment in Africa increased from $9 billion in 2000 to $62 billion in 2008.

Sustainable investors are hopeful that the development necessary to lift the continent's people out of poverty can leapfrog the environmental, social, and corporate governance (ESG) compromises usually associated with economic development, and become sustainable instead. A report authored last year by SinCo, a Capetown-based investment advisory firm, found that sustainable investment in southern Africa has reached $125 billion.

That Africa succeeds in doing so is all the more critical because the continent is expected to be among the regions of the world hardest hit by the effects of climate change.

The nation of South Africa itself has institutionalized a number of steps to help make sustainable development a reality. During 2011, the Institute of Directors in Southern Africa issued a Code for Responsible Investing in South Africa (CRISA), making South Africa only the second country to encourage institutional investors to integrate ESG issues into investment decision-making.

Also, the Johannesburg Stock Exchange (JSE) has taken a leading role in fostering sustainable development; for instance, since 2010 it has mandated that its more than 450 companies produce integrated reports, in which ESG information is included in corporate financial reports.

The mandatory reporting of the JSE has resulted in levels of corporate disclosure that provide researchers with a wealth of information on the materiality of factors that are often considered externalities; that is, when the cost of corporate activity is borne by society rather than companies themselves, as in greenhouse gas (GHG) emissions that lead to climate change.

In early December, a report commissioned by the JSE found that an overwhelming percentage of South Africa's largest companies were addressing climate change, but also that there is significant room for improvement in decreasing operational emissions and setting long-term emissions reduction targets.

The report was authored for the JSE by EIRIS, an investment research firm.

A second report, published this week by SinCo and Trucost, focuses on the carbon risks of the 40 largest companies listed in the JSE. Given the reporting requirements of the JSE, it is not surprising that the report, entitled Dirty Feet: Portfolio Carbon, found that ESG disclosure by the companies is high, compared to those in other emerging markets.

Nevertheless, climate change-related risks do remain, especially for companies in high-emitting industry sectors. If South Africa, which is among the highest-emitting nations in the world primarily due to its reliance on coal, decides to impose a carbon tax—a step the nation has been considering for several years—then the impact on corporate earnings could be considerable.

Overall, the report found, if a tax rate of $8.97 per ton of CO2e for direct operational emissions were established, the cost to the 40 largest companies could amount to $974 billion, or one percent of earnings before interest, taxation, depreciation or amortization (EBITDA). Should a higher tax rate be levied in the future, the cost could approach three percent of earnings.

For companies in the highest-emitting sectors, of course, the cost of a carbon tax would be much higher. The report estimated that the tax rate of $8.97 per ton of CO2e could cost companies in the Oil & Gas sector 14% of their earnings.

"Companies and their investors can no longer easily externalize their negative ESG costs onto society," the report states. "Climate risks will be factored into future regulations at company, country and investor levels."

While the report notes that carbon taxes are planned for South Africa in the future, "Active lobbying of the Energy Intensive User Group (EIUG) of South Africa, will likely influence when, at what price and how carbon taxes finally play out," it states. The report describes EIUG as "a voluntary, non-profit association of large-scale, high-intensity energy consumers whose members currently account for approximately 44% of the electrical energy consumed in South Africa."

According to Graham Sinclair, Principal at SinCo and President of AfricaSIF, the African sustainable investment forum, beacuse 2012 is an election year the implementation of a carbon tax is unlikely to occur before next year.

The report also analyzed the carbon footprints of the 10 major South African equity funds, and found that seven of them had higher footprints than the 40 largest companies.

However, the report stated, "Fund managers can rebalance fund holdings based on carbon intensity to reduce carbon risk while closely tracking the financial performance of the underlying Index." As an example, the report continued, "Trucost created a carbon optimized version of the FTSE/JSE Top 40 Index with a 7% smaller carbon footprint."

The report concludes by voicing the widely-held expectation that mandatory reporting, limits on emissions, and a price on carbon are likely to become global realities in the near future. "With externalities of carbon-intensive industries properly priced in for the first time," the report observes, "Many company market valuations could be under water."

Barriers to sustainable investment in Africa and other emerging markets remain. However, the report concludes, "Diagnosing carbon footprints, and tilting portfolios to minimize exposure to carbon-intensive companies, provides long-term investors with access to carbon-efficient companies to help manage financial risk from corporate greenhouse gas emissions."

© SRI World Group, Inc. All Rights Reserved.

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