Climate change: the nature and scale of the problem

Climate change has now entered the mainstream of public debate and is a key concern for consumers, politicians and businesses alike. But how should investors respond? Does climate change really pose that much of a risk? Does it present an investment opportunity? Professor Michael Grubb of Cambridge University and The Carbon Trust and Marc Brammer, Director of Research for Innovest Strategic Advisors addressed Schroders' investors on the subject.

Climate change science has been around for a long time. But, according to Professor Grubb, the nature of the debate has changed in the last few years. Ten years ago, commentators were more focused on the extent of environmental change - how great would temperature rises be? Today, the debate is driven by evidence. The impacts of climate change are clear (look, for example, at the disappearance of mountain glaciers) and the problems associated with it fairly 'known'.

However, these impacts are inherently unpredictable and the main issue is that, while we are agreed that change is occurring, we don't know exactly when it will occur. For example, Indian monsoon season transformation is likely - the big question is when? This uncertainty unsettles people and brings instability to many markets. What is clear, however, is that this problem will play out over a long period. For instance, it will take a long time - centuries - before we see CO2 and temperature stabilisation. A big consideration, particularly in the fund management industry, is how you factor in a centuries-long scale problem with a market that focuses more on shorter-term concerns.

The impact of the Stern review

A key event in the debate on climate change was the publication in 2006 of The Stern Report, a report compiled by Nicolas Stern for the UK government which has had a huge impact globally. In his report, which argued that the world must act now on climate change or face dramatic consequences, Stern challenged the methods previously adopted by economists to calculate the costs and benefits of action on climate change. He concluded that the main risks were more related to inaction than action. Stern advised to deal with the problem through a 'cap-and-trade' system and reasserted the need for a negotiated international regime.

Professor Grubb argued that Stern had such an impact because he has stature; a 'mainstream' economist of international reputation, Stern is deeply embedded in the World Bank community. Grubb concluded that the Stern report constituted an aggressive attack on the sanguine view of many advisers to the US government and that it took the world out of what was a politically uncertain situation.

Business response: broad-based acknowledgement of the risks

As Marc Brammer outlined, climate change poses numerous risks to businesses in almost all industries: it's not just insurance companies that will be affected. There are clear economic, social and environmental implications of significant climate change: the impact of Hurricane Katrina on New Orleans was a striking example; rising energy costs and potential population changes are others. Brammer also noted that it was perhaps no coincidence that the areas of the world which suffer most from terrorism or social instability are often those where climate change is having an impact - for instance, drought-affected countries such as Somalia and Afghanistan.

International corporate responses are diverse. Professor Grubb noted that a huge amount of companies are now declaring action on climate change - it's not just the likes of BP or DuPont (which both have long experience of being targeted as large polluters), but others in engineering, electricity and financial services are now declaring positions, setting emission targets and increasingly calling for stronger action.

The mother of all investment themes

This shifting behaviour among companies presents opportunities to the investment world; Marc Brammer noted that climate change could be the singe largest macro trend going forwards. The question is, beyond simply investing in renewable energy stocks, how do you incorporate this trend into portfolio management? Brammer cited a number of risks associated with climate change that investors should consider when analysing companies. Among these were technology trajectory (the level of progress a company has made in adapting production technologies for a carbon-constrained environment); energy intensity, source mix and consumption patterns; and product mix (the direct, indirect and embedded levels of carbon intensity). Regulatory trends are also important - for instance, in the US at State level there are now renewable portfolio standards that require electric utilities to generate a certain amount of power from renewable sources by a specific date. Investors should above all consider where the impact of climate change will come in the value chain - will the impact be felt most in the products or in its operations?

Transforming the energy system

Professor Grubb concluded that transforming our energy systems will not come cheap and will require a significant switch of capital from fossil fuels to renewables. He also stated that we should be mindful to spread money across a range of renewable energies and not invest predominantly in lower risk, more developed energy sources such as onshore wind farms. Society must look long term.

The big challenge - agreed by all at the seminar - is how to get measures and regulation agreed globally. There are dialogues in progress and the Carbon Disclosure Project has moved significantly towards measuring the scale of the problem for investors. In the US, an alternative strategy has emerged - that of circumventing the Administration in Washington and dealing directly with individual US states that are committed to working on credible solutions to the problem. However, when US states are involved, how do you legally enforce them to act, as they cannot be bound by international treaties? China and the Middle Eastern states are big emitters of greenhouse gases - these countries are completely out of the system and it will take a lot to get them on board. China has a huge rural population that cares more about economic survival and growth than the environment, while in the Middle East the options are either to drill for oil or become poor. In the industrialized countries of the west, meanwhile, will climate change grab politicians or their electorates enough to force change?

This conflict between economic growth and global action against the effects of climate change lies at the heart of the debate today - as Stern argues in his report, climate change poses a real threat to the future of the planet unless collective action is agreed upon and global standards or regulations created.

Download Professor Michael Grubb's presentation.

Download Marc Brammer's presentation.

Important information:

These notes are based on presentations by Professor Michael Grubb of Cambridge University and The Carbon Trust and Marc Brammer, Director of Research for Innovest Strategic Advisors, dated 31 May 2007, and do not necessarily represent Schroder Investment Management's house view. Please note that these notes have been complied by Schroders staff and are not directly attributable to the speakers. This document is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation of any offer to buy securities or any other related instrument described in this document. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The information herein is believed to be reliable but Schroders Investment Management Ltd (SIM) does not warrant its completeness or accuracy. This does not exclude or restrict any duty or liability that SIM has to its customers under the Financial Services Markets Act 2000 (as amended from time to time) or any other regulatory system.

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