Companies Hold Trillions in Subprime Carbon Assets: Al Gore
In 2007, banks and other asset owners held mispriced subprime mortgages on their books. Today, according to Al Gore, companies are holding “trillions of dollars in subprime carbon assets.”
TO THEIR DISMAY, Al Gore and David Blood have watched some institutional investors, money managers, corporations and analysts show dwindling interest in sustainability. The former vice president of the U.S. and the ex-CEO of Goldman Sachs Asset Management want to reenergize the debate while there’s still time. Heading into 2007, Gore recalls, asset owners and other capital markets participants were increasingly coming around to the idea that long-term investors should care about ESG matters — those related to the environment, social responsibility and corporate governance. But the stress and uncertainty of the worldwide economic collapse left many investors and corporations fixated on immediate concerns. “We came to believe that in the aftermath of the global crisis, momentum had slowed,” Gore tells Institutional Investor.
Ironically, what Gore and Blood call unhealthy capitalism, including short-term behavior by investors and company management, and misalignment of interests between companies and owners, helped trigger the crisis. Because a sustainable approach to capital markets and investing seeks to avoid such calamities, the case for it has never been stronger.
Last month, as part of an effort to bring attention back to the issue, Gore and Blood published a white paper called “Sustainable Capitalism” through the foundation established by their firm, Generation Investment Management. The pair founded London-based Generation in 2004 to practice what they preach. Their fundamentally focused shop aims to prove that sustainable investing not only works but can be a superior way of managing money.
In its paper the Generation Foundation defines sustainable capitalism as “a framework that seeks to maximize long-term economic value creation by reforming markets to address real needs while considering all costs and stakeholders.” Investors in Generation’s main global equity fund, currently closed, include the California State Teachers’ Retirement System and the pension plan of the U.K. Environment Agency.
The traditional investment management industry can’t take all the blame for tuning out sustainable investing, says Blood. He thinks proponents haven’t always done a good job of conveying the empirical evidence that supports their message. “We have not been rigorous enough and clear enough about the business case for sustainability,” says the Generation senior partner.
The white paper makes that case by pointing to a growing body of evidence. For example, it cites Maastricht University finance professor Rob Bauer and then–finance Ph.D. candidate Daniel Hann’s 2010 study “Corporate Environmental Management and Credit Risk,” which links proactive environmental practices and lower financing costs. The Generation Foundation’s report also quotes a 2011 Financial Analysts Journal paper titled “Pricing Climate Change Risk Appropriately” that explains why investors should address the cost of carbon on corporate balance sheets.
Beyond this intellectual appeal, the foundation lays out five calls to action. They include integrating ESG issues into companies’ financial reports, aligning compensation with long-term performance and getting shareholders to invest for the long haul through securities that foster a buy-and-hold mind-set. In the latter case a company might offer a financial incentive for investors to hold shares for an agreed-upon period. “We acknowledge this is not complete,” Blood says of the document. “We hope we will inform the conversation around sustainable capitalism.”
Orin Kramer, former chairman of the New Jersey Division of Investment, which oversees the state’s $69.6 billion pension plan, thinks Blood and Gore have hit the mark. “Fiduciaries will come to regard this as a seminal statement of the case for sustainable investing,” says Kramer, CEO of New York–based hedge fund Boston Provident Partners. “This will be an evolving dialogue, but these issues aren’t about some set of policy or ideological values; they’re about risk management,” he adds. “Frankly, their message and lines of argument should, in my view, be core elements of fiduciary training.” Kramer chairs the Robert F. Kennedy Center for Justice & Human Rights, a nonprofit that promotes the discussion of sustainability among institutional investment fiduciaries.
The Generation Foundation study calls for the identification of so-called stranded assets — those that would be unprofitable under scenarios such as enforcement of a fair price on carbon and water or higher labor standards in emerging economies — and their incorporation into financial reporting.
Gore likens the cost of carbon emissions to subprime mortgages and the banking crisis. In 2007 banks and other asset owners held mispriced subprime mortgages on their books. Accurately pricing those securities wiped out value estimated in the trillions of dollars, bringing on the recent crisis.
Today companies are holding “trillions of dollars in subprime carbon assets,” Gore says. When that risk gets fairly priced, they’ll feel the pain. As the former vice president points out, it’s already happening. Last November, Australia established a carbon tax; the next month Hong Kong–based utility CLP Group announced that it was writing down the value of its carbon-emitting assets in Australia, a move that lost the company almost $250 million. “Their Australian subsidiary held assets whose carbon assets were mispriced,” Gore notes of CLP.
Robert Litterman, former head of firmwide risk for Goldman, Sachs & Co. and now a partner at New York quantitative hedge fund firm Kepos Capital, likes the report’s proposal about stranded assets. “If we priced carbon appropriately today, there are a lot of investments that would not make sense,” says Litterman, author of the FAJ climate change risk paper cited by the foundation. “Carbon will be priced much more quickly than people think, and investors should get ahead of that.”
Talk of climate change can leave the impression that Generation is about so-called green investing. Gore, the firm’s chairman, is strongly identified with the green movement: His 2006 documentary, An Inconvenient Truth, helped take the climate change debate mainstream. Generation does have a private equity fund called Climate Solutions that it launched in 2007 to take advantage of emerging opportunities. But the vast majority of its assets are in the main global equity fund, which treats climate change as part of a much bigger picture. (Generation doesn’t disclose assets under management, but estimates put them at about $6 billion.)
Long-term economic value creation lies at the heart of Generation’s sustainability thesis. The firm argues that pension plans, foundations, endowments and sovereign wealth funds are investors for the coming decades and into perpetuity — and should act accordingly because it’s in their best interest and a better way to make money. It goes back to the notion of fiduciary responsibility, or what Blood describes as “understanding the risks associated with and the ability to meet long-term liabilities.”
Generation encourages long-term thinking, both among its investors and more widely. Five percent of profits go to the Generation Foundation, which was set up to promote sustainable capitalism. Generation’s fee structure eschews the typical yearly or quarterly schedule: In the global equity fund, fees are paid three years after the investment and then on a rolling three-year basis.
Now, Generation is exhorting the financial community to change its time horizon. Perhaps the most radical of the paper’s five calls to action is for companies to stop automatically issuing quarterly earnings guidance. As Blood makes clear, this doesn’t mean companies wouldn’t produce quarterly reports or hold quarterly calls with shareholders. Instead, they would forgo an expected quarterly earnings bogie in favor of a time horizon that is appropriate for their business.
Some CEOs, such as Paul Polman of Anglo-Dutch consumer goods conglomerate Unilever, no longer offer quarterly earnings guidance to analysts. But Blood admits that driving widespread change will be tough — partly because a swath of the investment industry, including many hedge funds and electronic trading houses, takes a short-term outlook. “Those that operate on short-term information are traders, not investors,” he says. Also, Wall Street makes much of its commission revenue from short-term trading.
Still, Gore is optimistic. Thanks to Europe’s debt woes and the subprime meltdown, “the problems associated with unsustainable forms of capitalism are on vivid display,” he says. By 2020, Gore predicts, Generation’s long-term approach will be mainstream financial thinking. Sound far-fetched? Six years ago almost no one realized that the global economy stood on the brink of disaster. • •