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The Actuary The magazine of the Institute & Faculty of Actuaries

Investment: Climate change investing

In recent years, we have seen a significant growth in interest in ‘green investing’, particularly in areas such as renewable energy and clean technology. Various factors have contributed to this interest: the strengthening scientific evidence on the physical impacts of climate change (in particular, the reports of the Intergovernmental Panel on Climate Change); the Stern Review on the economics of climate change; Al Gore’s film An Inconvenient Truth; nongovernment organisation (NGO) campaigns and regulations (in particular, regulation supporting the development of renewable energy; and, more generally, the European Union’s Emissions Trading Scheme).

Short-term investment fad?
The question for investors is whether sustainable, long-term investment value can be derived from focusing on climate change as an investment theme, or whether climate change will just become another short-term investment fad? Our view is that the threat presented by climate change to the planet, the consensus among many policymakers that strong policy/regulatory action is required, and the high media profile of climate change means that it is, and will remain for some time to come, a central investment theme. Indeed, from the investor interest that has surrounded areas such as solar energy, it is clear that many investors are already excited by the opportunities presented in the climate change arena.

However, we also believe that investors need to be careful about how they invest. There are three dimensions that we would like to highlight. Firstly, it is by no means a given that companies with a lower carbon footprint — for instance, reduced greenhouse gas emissions — will be better investments over the short or medium term. While such companies should be better investments over the longer term, the reality is many sources of greenhouse gas emissions are not presently regulated and, in many countries, the future direction of climate change policy remains uncertain. Outside of the European Union, there are relatively few requirements even for heavy industries to reduce their greenhouse gas emissions, beyond those incentives provided by higher fuel or energy prices.

Secondly, stocks that seem attractive because of their exposure to the climate change theme may not be so appealing when a fuller analysis of the subject and other environmental and social impacts is considered. One of the most concrete examples of this is biofuels. Throughout 2005 and 2006, driven by high fuel prices, energy security fears and concerns about climate change, governments around the world introduced targets or standards to make the use of biofuels mandatory, and/or introduced tax breaks or subsidies to make biofuels more competitive. These regulations catalysed significant growth and investment in the sector. However, by mid to late-2006, there were signs of trouble. Biofuels ignited a fierce so-called ‘food versus fuel’ debate, as some biofuels were implicated in causing significant environmental damage and the CO2 ‘footprints’ of some biofuels were determined to be not as small as once purported. It soon became clear that ‘first generation’ biofuels were not a panacea for the world’s energy security and environmental concerns. For example, RWE’s npower unit (Germany/UK) cancelled its project to convert its Littlebrook power station in the UK to run on palm oil because it could not secure enough of the feedstock from sustainable plantations, and National Express (UK) cancelled biodiesel trials at its UK operations after consulting ‘green’ groups regarding sustainability issues.

Thirdly, investors need to look outside of the renewable energy sector for opportunities. Our research into the global lighting sector suggests that this sector is showing signs of significant structural changes, due in large part to concerns about climate change. Conventional incandescent light bulbs (which are extremely energy-inefficient) are being replaced with more environmentally friendly alternatives, namely compact fluorescent lights (CFLs) and light-emitting diodes (LEDs). This shift is being driven by both voluntary initiatives (for instance, numerous retailers have committed to phasing out the sale of incandescent light bulbs by 2011, many municipalities are replacing conventional street lighting with more environmentally friendly alternatives), and regulation (Australia and Canada have banned incandescent bulbs as of 2010 and 2012, respectively).

One part of the picture
In conclusion, climate change is an interesting and exciting topic, and we believe that companies that position themselves to proactively respond to this issue are likely to be long-term winners. However, as with all investment themes, exposure is just one part of the picture. Investment fundamentals remain key, and prudent investors should consider the whole series of factors beyond climate change – for example, the nature of the company’s activities, the quality of the company’s management, cash flows and balance sheet strength – that are relevant to the investment decision.

Rory Sullivan is head of responsible investment at Insight Investment
Jennifer Kozak is research manager, responsible investment at Insight Investment