The year 2015 featured a wealth of global warming headlines: the December Paris Agreement on climate change, the Pope’s Encyclical, the collapse of oil prices, the Obama administration’s Clean Power Plan, France’s mandatory carbon reporting and the New York Attorney General’s subpoena of Exxon Mobil. It was also the warmest year on record.
Global warming headlines in 2016 have been slimmer¹ but the threat of global warming has not diminished. NASA reported that each month from January to June in 2016 set new temperature records with the average temperature nearly 1.3°C above preindustrial levels. Estimates from the IPCC (see image below) imply that the atmosphere can only absorb 20 more years of carbon dioxide (CO2) emissions at current levels if we wish to preserve a two-thirds chance of keeping global warming below 2°C.
Progress towards reducing carbon emissions will come through the actions of the private sector, as the main driver of innovation and investment, and also via the public sector, as both actor and enabler. Technological progress proceeds unabated and regulation has moved forward. Changes in these two domains will provide some of the catalysts for distinct winners and losers, which could have significant impact on investment portfolios sooner than many anticipate.
Thus, from a fiduciary perspective, it is not necessary to accept the full version of climate change. Looking at the response of key participants to the underlying science and economics may prove sufficient. Two new political developments illustrate this theme clearly.
First, a federal appeals court ruled that the U.S. Department of Energy acted appropriately when it issued rules promoting energy efficiency in refrigerators. Second, the White House Council on Environmental Quality provided guidance for federal agencies to use when studying the potential environmental impact of their decisions.³ In essence, these events indicate that considering the “social cost” of carbon, and not just its private cost, is appropriate for both government policy and regulation.
These are major developments because carbon pricing is the public sector’s simplest and most transparent lever for addressing global warming. The Obama administration estimates that a socially efficient carbon price would be $36/ton.4 How big would such a tax be in practice? A $36/ton tax on carbon translates to $0.36 per gallon at the gasoline pump. This would constitute a substantial increase in gasoline prices, but not an outsized one, given fluctuations in energy prices over the last decade. As many commentators have indicated, the revenues of such a tax could be deployed for a variety of purposes, including possible progressive rebates and supporting more carbon efficient technologies.
Corporate profits could be substantially hurt by such a carbon tax. Indeed, if direct emissions of all companies in standard global equity indices were taxed at $36/ton and none of the tax were passed on to consumers, corporate profits would fall by 10%. Furthermore, just 10% of companies (and the same proportion by market capitalization) are responsible for 75% of emissions. For this 10% of companies, profits could fall by three-quarters!
Thus, it should not be surprising that organizations like the New York Common Retirement Fund, CalSTRS and the Universities of Maryland and Minnesota are pursing low carbon investments.
Yet low carbon investing should not focus solely on avoiding high carbon risks by eschewing carbon-intensive companies. Low carbon investing should also involve accessing positive opportunities by investing in companies that will benefit from and contribute to the transition to a low carbon economy.
Indeed, it is common for many investors to see the opportunity in upstream power generation such as solar and wind. The pace of technological change in this segment of the economy has been so rapid that wind and solar are now cost competitive in significant parts of the U.S.5
The opportunity set, however, is much broader. Opportunities exist along the full energy value chain from production, transportation and distribution to generation, transmission and usage. Utilities will need to access and manage alternative energy sources; industrial, equipment and service companies will be able to create emissions saving technologies; and energy-intensive companies stand to benefit most from reducing their direct carbon footprint.
Investors looking for a guide to these opportunities would be wise to follow two adages: sell picks to miners and find the pinch point in the value chain. Some companies are already seeing and realizing these attractive downstream opportunities: Oracle purchased Opower for its utilities-focused energy efficiency cloud services and Honeywell purchased Elster’s electricity metering.
At Commonfund, we believe the transition to a low carbon economy will have a material impact on financial markets. Both the high carbon risks run by certain traditional companies and the low carbon opportunities created by many innovators are exceptionally high. We would argue that it is essential for fiduciaries to actively consider developments of this magnitude. Inaction due to active choice is different from inaction due to inattention. Finally, low carbon investing aligns with the missions and stakeholder interests of many institutional investors and thus may be worth considering for a range of nonfinancial reasons.
1 Two important headlines include Exxon Mobil supporting a revenue neutral carbon tax and the Philippines suing mining companies for damages caused by climate change. Both have clear implications for investors. In addition, the National Academy of Sciences released a report supporting the probabilistic linking of real time extreme weather events, such as heat waves, to climate change.
2 Estimate derived from the average of the 10th and 90th percentile scenarios for cumulative CO2 emissions and 37 Gt CO2 current annual emissions. IPCC, 2014: Climate Change 2014: Mitigation of Climate Change. Contribution of Working Group III to the Fifth Assessment Report of the Intergovernmental Report on Climate Change. [Edenhofer, O., R. Pichs-Madruga, Y. Sokona, E. Farahani, S. Kadner, K. Seyboth, A. Adler, I. Baum, S. Brunner, P. Eickemeier, B. Kriemann, J. Savolainen, S. Schlomer, C. von Stechow, T. Zwickel and J.C. Minx (eds.)]. Cambridge University Press, Cambridge, United Kingdom and New York, NY, USA.
3 “Climate Change May be Doubted by Some, But Now It’s the Law” by Eric Roston for Bloomberg News.
4 Based on the social cost of CO2 as of 2015 using a 3% discount rate. The estimate is the average across a series of models. The average social cost may not be an appropriate risk measure. In financial modeling, value-at-risk measures commonly employ a 95th percentile. The 95th percentile of CO2 social costs would be $105/ton. Technical Support Documents: Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis – Under Executive Order 12866 – Interagency Working Group on Social Cost of Carbon, United States Government, May 2013 revised July 2015.
5 The levelized cost of wind and photovoltaic solar have fallen 60-80% over the last six years (Lazard, 2015).