February 27, 2007
Citigroup, Lehman Brothers, and UBS Report on Climate Risks and Opportunities for Investing
by Bill Baue
Lehman Brothers and UBS agree climate change represents a market failure for neglecting to price
carbon externalizations in valuations, while Citigroup makes specific stock picks.
A graph charting the number of pages discussing climate change in reports by investment analysts
from traditional brokerages would resemble the renowned "hockey stick" graph of temperatures over the last
1,000 years. The graph would be essentially flat at zero until about three years ago, when the
United Nations Environment Programme Finance Initiative (UNEP FI) request for
analyst research on environmental, social, and governance (ESG) issues sparked a sudden spike in
The line has continued its upward trajectory this year, with over 350
pages published over the past month in reports from Citigroup, UBS, and Lehman Brothers. All three reports
cover similar ground discussing the scientific, social, regulatory, business, and investing
implications of climate change. The title of the UBS report--Climate Change: Beyond
Whether--encapsulates a common attitude of all three reports.
"Whether or not you
agree with the view that human activity is influencing the climate system is largely irrelevant to
the investment thesis," state report co-authors Klaus Wellershoff, global head of UBS Wealth
Management Research, and Kurt Reiman, head of thematic research there. "What is important is that
numerous policies to combat the threat of global warming are converging to influence people's
behavior, alter the risk profile of various businesses, and improve the investment outlook for
The UBS and Lehman Brothers reports concur that climate change represents a
classic market failure where company valuations neglect to take into account negative
externalizations--in this case, predominantly the emission of carbon dioxide CO2, the primary
greenhouse gas (GHG).
"The free market fails to limit climate-damaging emissions
sufficiently, because polluters do not have to pay for the damage they cause," states John
Llewellyn, senior economic policy advisor at Lehman Brothers, in The Business of Climate Change:
Challenges and Opportunities. "A basic role of policy in such cases is to 'internalize' such
costs into emitters' cost structures--the 'polluter pays' principle."
UBS advances nearly
the identical analysis, and extends it.
"Moreover, many policies, infrastructure, and
institutions presently distort market outcomes to favor fossil fuel use, inefficient energy
practices, and rising greenhouse gas emissions," states the UBS report. "Without the cost of
climate change embedded in market prices, there is less of an incentive for the private sector to
reduce greenhouse gas emissions and provide the conditions necessary to maintain a stable climate."
"Therefore, free markets underestimate the future costs to society that would arise if the
climate experienced a drastic transformation: a result which many scientists now predict will
happen if there is no change to influence free market outcomes," it continues.
change, one of the most studied environmental phenomena, represents a market failure, one can only
wonder to what degree the legion of lesser-studied environmental and social externalities are not
being priced into corporate valuations.
Dr. Llewellyn of Lehman Brothers predicts that
regulation will eventually correct this market failure and charge companies for the "social cost"
of emissions, whether through carbon trading or carbon taxation. He also suggests that an
"economically rational society" may choose to charge more than the social cost of emissions,
because it cares about the environment in its own right (beyond simply balancing environmental
costs and benefits), and because it wants to hedge against risk even further than this equilibrium.
So companies may have to overcompensate with internalizations, essentially making up for their
historical backlog of externalizations.
Where the three reports differ most is on their
investment advice. The Citigroup report--Climatic Consequences: Investment Implications of a
Changing Climate--is the most explicit in naming names. It identifies 74 companies across 21
industries and based in 18 countries that authors Edward Kerschner and Michael Geraghty consider
well-positioned to seize climate opportunities.
General Electric (ticker: GE), the
conglomerate the reaches across a large swath of the economy, reaches throughout this report due in
large part to its Ecomagination division of environmentally friendly products and services. GE
Wind is the second-largest wind turbine producer in the world, with $3 billion in annual revenues
and 18 percent of the market--behind Vestas (VWSYF.PK--with 29 percent.) GE
controls 46 percent of the gas turbine market, which generates $2.5 billion in annual revenues.
These turbines play a key role not only in burning natural gas but also in integrated gasification
combined cycle (IGCC) plants--considered the "cleaner" of the coal options though this being called
into question by an upcoming MIT study.
GE also generates $1 billion annually in the
market for nuclear power, which is considered by some to be a viable climate change solution due to
minimal CO2 emissions associated with it. However, the Citigroup report acknowledges that "some
options for reducing GHGs [such as nuclear] are not necessarily environmentally friendly"
(emphasis in original.) Dr. Llewellyn points out in the Lehman Brothers report that GE may
"[S]o far [GE] does not appear to be trying to market nuclear equipment
under the Ecomagination label, even
though such an inclusion could be justified in terms of a low-carbon energy source," states Dr.
Llewellyn in the report.
The Lehman Brothers reports surveys investment opportunities not
on the company level but rather across 16 sectors. It also includes an appendix outlining how its
socially responsive investing (SRI) team at Neuberger Berman address
climate risks and opportunities.
The UBS report takes an even more general look at how
climate change impacts investment, highlighting a series of strategies. These include SRI,
underweighting high carbon-intensity companies, exposure to renewables and energy efficiency, and
venture capital and private equity focusing on environmental technologies, among other strategies.