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The Actuary The magazine of the Institute & Faculty of Actuaries

Environment: Changing finance, financing change

Climate change is widely recognised as perhaps one of the most complex challenges facing the global economy in the years ahead. In his landmark review of the Economics of Climate Change, published in 2006, Lord Stern stated: “Climate change is the greatest and widest-ranging market failure ever seen”. It is not self-evident, but by implication, this would include a failure of the world’s capital markets to effectively price the externalities caused by the greenhouse gas emissions generated primarily by the burning of fossil fuels and the conversion of natural ecosystems, notably through tropical deforestation.

The consequences of ‘business as usual’, Stern argued, are potentially catastrophic, posing risks of “major disruption to economic and social activity on a scale associated with the great wars and the economic depression of the first half of the 20th century”. More optimistically, however, he concluded that “we have the time and knowledge to act, but only if we act internationally, strongly and urgently” (Stern, 2006).

Since Lord Stern reported the scientific, political and financial case for tackling climate change, it has become even more pressing. But the ‘urgent’, ‘strong’ and ‘international’ response that he called for has yet to fully materialise – either in the worlds of policy or finance. The Fourth Report of the Intergovernmental Panel on Climate Change (IPCC), released in 2007, laid to rest any remaining doubts about the reality of global warming, the causal link to fossil fuel consumption and land-use change and the serious implications for water availability, food production, coastal regions and human health if ‘pollution as usual’ continues.

Just one of the IPCC’s six scenarios for future emissions offers a chance of keeping global average temperature increases close to 2 degrees centigrade above pre-industrial levels, judged by many (including the EU) as the threshold for dangerous climate change. This would involve global emissions peaking in 2015, and then being cut by 50 – 85% from 2000 levels by 2050. The Bali conference capped 2007 with the agreement of a negotiating mandate to design a ‘global deal’ by the end of 2009, with the aim of succeeding the Kyoto Protocol which expires in 2012. Negotiations have now begun, but immense obstacles will need to be overcome if a deal is to be done in Copenhagen next year.

Historically, capital has been allocated and investments made without regard for either the damage being done to the global climate system, or the risks of a changing climate in terms of increasing incidence of floods, droughts, storms and other extreme weather events. Hard science, tightening policy and new market dynamics all mean that taking account of climate change is becoming a normal part of ‘fiduciary duty’.

Even before the Stern Report, the investment consultant, Mercer, was advising pension funds that “fiduciaries active management of climate change risks would be in the interests of all beneficiaries” (IIGCC, 2005). Investor alliances such as the Carbon Disclosure Project are working to improve the quality of corporate reporting, and so enable investors to make increasingly informed choices. Shareholder activism is also extending to the governance of climate risk, while tightening climate change and renewable energy policies are driving a wealth of upside investment opportunities.

Last year, for example, HSBC launched its Global Climate Change Benchmark Index (see The Actuary, October 2007), aiming to capture the evolving opportunity set. According to the World Bank, the value of the global carbon market more than doubled in 2007 to $64 billion. Alongside this, clean energy investment surged by more than 60% in 2007 to some $148 billion, according to New Energy Finance. But investments in fossil fuels are often equally or more attractive, and the rate of global emissions continues to accelerate - so that the global economy is currently re-carbonising when it should be de-carbonising.

Looking forward, the secretariat of the UN Framework Convention on Climate Change has estimated that a substantial investment shift will be required to first peak and then reduce global emissions. About US$150 billion extra will be required for investments in energy efficiency each year by 2030, matched by significant reductions in investment in fossil fuel extraction and generation, as well as in energy transmission and distribution (see figure 1 below).

Further capital shifts will also be required to ‘climate proof’ economies from the physical impacts of climate change, though here there is far greater uncertainty. The amount of investment required to adapt infrastructure; for example, ranges from US$8 billion to some US$130 billion (see figure 2 below).

These projections need to be put into context. While the figures for annual investment may seem large, they have to be put into some perspective. The US$150 billion per annum extra needed for investments in energy efficiency by 2030 represents a small percentage of total annual investment and a tiny percentage of global GDP, even in current terms. Furthermore, the analysis has been based on the assumption of continued global growth and some form of economic convergence where the less developed (poorer) countries catch up with the more developed (richer) countries with the latter, by and large, maintaining their standard of living. As pointed out in the articles by Anthony Day (The Actuary, July 2008 http://www.the-actuary.org.uk/801285) and Oliver Bettis (http://www.the-actuary.org.uk/801044), this may not be a smooth process.

Against this backdrop, the role the actuary should play is in question. How can the actuarial profession “make financial sense of the future” if that future is going to be heavily influenced by both the response to climate change and the still highly uncertain effects of a changing climate itself. The profession should be well equipped to guide the institutions they advise given their wide range of expertise in both assets and liabilities i.e. their financial and risk management skills.

It is clearly a very difficult and time-consuming task to assess the potential impact of climate change on long-term investment strategy. Nevertheless, a number of observations can be made.

>> The net investment in new technologies to develop sustainable energy (refer to figure 1) will throw up investment opportunities in a range of industries – solar, nuclear, wave power, tidal, biofuels, hydroelectric, sustainable agriculture and forestry. Similar comments apply to the opportunities for adaptation (refer to figure 2). These opportunities will probably present themselves in the normal investment cycle of scientific discovery, technological capability, visionary entrepreneurs seeking venture capital, additional financing, public offerings etc. Some companies with the right technology at the right time will be successful; many will disappear through bad technology or bad management in the normal way. The challenge for actuaries is to understand how the climate shift will play out: will it be any different to the IT transformation we have seen in the last 30/40 years, or the globalisation phenomenon? Likewise, the UNFCCC forecasts suggest that there are some industries which currently represent large sectors in global equity portfolios that will be adversely affected and could become “stranded” assets. How is the actuary to assess these risks and determine the likely adverse impact of the financial health of their clients?

>> Although most attention to date has been devoted to equity markets, climate change is likely to affect all asset categories, including fixed income and property. By way of illustration, the progressive tightening of the EU Emissions Trading System over the years ahead could severely challenge the prevailing business models of carbon-intensive sectors, such as power generation. How would this affect the debt they have issued and what will happen to their credit ratings? And what is the potential impact on UK pension funds that have restructured their assets to have a focus on liability driven investments?

>> Similarly, accounting standards for pension funds are linked to corporate debt – what are the implications for solvency if there is a structural change in the rating of swathes of the corporate bond market. Actuaries have learnt that it is not sufficient to establish reserves and ‘top them up’ from year to year in some way linked to the value of their liabilities. In some senses, it is essential to match assets to liabilities. So, for a financial institution that has liabilities linked to climate change, are there any hedging instruments – if not, what are the implications for the level of capital needed to support those liabilities? If there are strategic changes in the structure of markets how and when is it best to capture it in a portfolio.

>> Most politicians, scientists, economists, and financiers refer to the very long time horizons involved in the projections. In one sense, this is familiar territory for the actuary. But, our training has taught us several pertinent lessons in this area. The longer projection period introduces more scope for model error and more uncertainty in the possible outcomes. There is more scope for the (adverse) effects of uncertainty; the ‘unknown unknown’ that could have significant impact [The Black Swan: The Impact of the Highly Improbable. Taleb, Massim Nicholas. Penguin 2008”. In addition, markets will generally discount information and forecasts quickly – looking at the valuation basis of growth companies.

The issues of climate change are complex; the science and technology is changing quickly, and in some cases faster than we can model. Global political will is difficult to direct and produce meaningful actions as the current deadlock in the Doha round of trade negotiations demonstrates. In this context, some might argue that there is no need for any structural change in the way that actuaries conduct their business; perhaps the profession can simply continue to be a taker of policy signals and respond incrementally to the projected disruption caused by global warming, with no major changes to conventional risk or portfolio management.

There are always a thousand reasons for doing nothing, and inertia can often be an implacable force. We would suggest that not only are there material reasons of analysis for the profession to act – and anticipate the changes brought about by climate change in the guidance it provides – but also that the climate agenda itself could benefit from a more profound actuarial perspective. In addition, the cost to the profession, and its regulators, of doing nothing could both damage its reputation and have adverse financial consequences. Law suits in the USA related to climate change have already started to appear [Climate change and liability – Everything you need to know about climate change and liability. Ebert, Ina, Funke, Guido. Munich Re. Topics 1/2008”, even though none have apparently been successful and lawyers and insurers seem to think that the chances of success are remote.

However, in one such case, banks had to defend themselves against the accusation that when awarding loans to companies that use fossil fuels they disregarded environmental regulations. It is comforting to disregard the legal foundation of these claims. As Trevor Maynard observed at The Profession’s sessional meeting on climate change in November 2007, similar comments could have been made with regard to tobacco litigation in the USA in the early days.