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June 03, 2005
Report Equips Investors With Tools To Analyze Climate Risk in Uncertain Policy Atmosphere
    by William Baue

Investor Network on Climate Risk and World Resources Institute team up on a report that provides a framework for valuating climate risk in the absence of regulatory clarity.

The fifth point of the ten-point "Call for Action" issued by the Investor Network on Climate Risk (INCR) at a United Nations summit last month asked investment managers to improve their analysis of risks and opportunities associated with climate change. Yesterday, INCR (a consortium of two dozen US and European institutional investors with over $3 trillion in assets) issued a report written by the World Resources Institute (WRI) Capital Markets Research team entitled Framing Climate Risk in Portfolio Management. The report maps the landscape of climate risk assessment and equips portfolio managers with some of the tools necessary to analyze the potential impacts on corporations operating in increasingly carbon-constrained markets.

"This report offers investors a way to begin to analyze climate risk," write report authors Fred Wellington and Amanda Sauer of WRI. "However, to analyze these financial and competitive implications accurately, investors need more clarity on the eventual structure of climate policy in the United States."

"This uncertainty also extends to the degree of interaction between policies in the United States and abroad," they continue. "Prudent investors will move beyond asking whether some form of climate policy is on the US horizon to considering when and in what form."

Helpfully, the report opens by distinguishing between risk ("a mathematical distribution of potential outcomes around known parameters") and uncertainty ("lack of information.") It also distinguishes between risks and uncertainties surrounding the physical unfolding of climate change and the risks and uncertainties due to an undeveloped regulatory response to climate change in the US. Essentially, the report describes how to navigate along the continuum from the shaky ground of uncertainty to the more stable footholds of risk assessment, focusing less on the geophysical (which is partly outside human influence) and more on the regulatory (a purely human construct).

The report lists the regulatory steps being taken by many foreign countries and individual US states, highlighting the irony of the US government's advocacy for voluntary corporate action on climate change. Most corporations do not exist in a vacuum circumscribed by US borders, but rather conduct business in regions promulgating climate change regulations, making the absence of US regulation a liability instead of a benefit. The report cites at least three companies that explicitly recognize the inevitability of regulation and express frustration over US governmental foot-dragging, which only heightens the atmosphere of regulatory uncertainty they must operate within.

"In an uncertain regulatory climate, these decisions [optimal power plant location, design, permitting, and engineering] must be made at the risk that they will not be optimal once the existing uncertainty is finally resolved," states Cinergy (ticker: CIN) in its report to shareholders analyzing potential impacts of greenhouse gas (GHG) regulations. "Cinergy works hard to manage this risk, and has done so successfully for years, but clearly, the prompt adoption of a clear long-term federal environmental policy would benefit all [emphasis added by WRI authors]."

The report cites similar statements from power producers American Electric Power (AEP) and TXU (TXU).

"All three companies were concerned that taking proactive measures in GHG mitigation in the short term could harm the company when future rules are adopted," the report states. "Indeed, TXU argued that any investment in voluntary emissions reductions was unwarranted until the company understood the shape of a future GHG regulatory program."

The uncertainty of how to mitigate climate risk besets not only companies, but investors as well. The report remedies this by recommending two specific strategies for pinning down climate risk.
The first is cash flow adjustments whereby "investors can separate cash flows into those that will likely be affected by GHG constraints and those that will not."

"This approach is probably better suited for an environment in which the regulatory structure is known, or becoming clear, even if implementation of the policy is less certain," the report states.

The second is risk-adjusted discount rates, which leaves cash flow estimates unadjusted and instead applies a risk premium to companies in sectors with greater exposure to GHG constraints. The pros to this approach: it is "easily understood" and "analytically uncomplicated" and can be readily applied across diversified portfolio, and is particularly appropriate in a period of policy uncertainty. The cons:

"[T]his method is very imprecise because it fails to fully incorporate competitive dynamics around carbon constraints," the report states. "Using climate risk-adjusted rates poses an additional problem: this approach reflects an implicit assumption that climate risk is distributed evenly across time."

"This is unlikely to be the case because competitiveness, and therefore financial impact, is not static," it adds.


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