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.
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]."
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
"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.