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Is Climate Change The Next New Thing In Investing?

Countries are increasingly looking to exploit the opportunities of a low-carbon future.

Is climate change the next new thing in investing? The issue of global warming is moving up the political agenda as the Obama administration pushes for the introduction of a cap-and-trade scheme to limit U.S. carbon emissions and governments around the world seek to reach a new agreement by the end of this year to contain greenhouse gases. There is no guarantee that these initiatives will succeed, especially in the short run. But climate change promises to exert a growing influence on investment decisions, from whether to fund the development of alternative-energy sources like wind and solar power to how to value the big carbon-emitting industries like automobiles, steel and utilities.

"Technology is something that has impacted every single industry on the planet," says Jan Babiak, global head of climate change and sustainability services at Ernst & Young. "Low-carbon transformation is very similar. Every industry, every household, every government, every country, every part of society will be impacted by it."

Some 800 funds worldwide, managing $95 billion, focus on climate change or clean energy, according to New Energy Finance. The London-based consulting firm, along with DB Climate Change Advisors, an arm of Deutsche Asset Management, recently surveyed more than 100 institutional investors managing a total of more than $1 trillion and found that 75 percent of them expected to increase investments in clean energy by 2012.

Recent programs undertaken by many countries to restart their economies are giving an added boost to the sector. Deutsche estimates that $106 billion of the U.S.’s $787 billion stimulus package is earmarked for spending on energy conservation, renewable energy, mass transit, a smart energy grid and related areas. The European Union has committed $60 billion to similar initiatives.

To be sure, investment opportunities in climate change depend significantly on the price of energy. The surge in oil prices to more than $145 a barrel last year made many alternative-energy sources economically viable and conservation measures compelling. Carbon’s impact on corporate bottom lines dwindled when oil prices collapsed, though. The HSBC Climate Change index, which tracks about 350 stocks that are expected to benefit from climate change, outperformed the MSCI World index by more than 60 percentage points between January 2006 and May 2008, but it gave up most of its gains over the following five months. The rebound in oil prices to $70 a barrel in recent months promises to provide a fresh impetus.

More and more, governments are seeking to impose rules curbing carbon emissions at national, sectoral and even corporate levels through measures ranging from cap-and-trade plans to energy-efficient building requirements to vehicle exhaust limits.

The EU led the way, with the introduction of its Emissions Trading Scheme in 2005. Australia and New Zealand are also considering cap-and-trade systems to limit carbon emissions. In the U.S., where Congress is debating such a program as part of an energy bill, ten Northeastern and Midwestern states have already introduced carbon trading and emission limits under the Regional Greenhouse Gas Initiative.

"When a price gets put on carbon, what we do for a living is going to be important in bringing capital to solutions," says Kevin Parker, CEO of Deutsche Asset Management in New York. Deutsche, which sees climate change as a megatrend that will have a major effect on investment activity in coming decades, drew attention to the issue in June by launching a carbon counter — a real-time indicator showing the estimated levels of greenhouse gases in the atmosphere — on a giant billboard outside New York City’s Pennsylvania Station.

Carbon trading volume rose 37 percent in the first quarter of this year from the previous quarter, to 1,927 million tons, but the value of those trades declined by 16 percent, to $28 billion, reflecting weaker energy prices, according to data from New Energy Finance.

"Climate change has hit first in companies that have significant direct emissions — particularly in Europe, because of the Emissions Trading Scheme — so we are talking about utilities, steelmakers, cement and so on," says F&C Investments associate director Vicki Bakhshi, who covers the oil and gas and insurance industries for the London-based money management firm and heads its climate change program. "Every equities analyst worth their salt who is analyzing one of these companies will, as a matter of course, incorporate carbon emissions as part of their evaluation."

Rory Sullivan, head of responsible investment at Insight Investment Management in London, argues that it is misguided to assume that the size of a company’s carbon footprint equates directly to its climate risk and ability to profit from climate change — and, therefore, to its share price. "Where climate change or carbon liabilities are material, it is already in the numbers," he asserts. "The really interesting issue is the strategic one — to what extent are companies looking further into the future and looking at their supply chains? That is where it is less clear-cut. It is an open question as to how much investors are really analyzing those issues at the moment."

A recent report by the Carbon Trust, an independent agency set up by the British government to advise businesses on climate change, underscored the potential for carbon to have a big impact on corporate valuations. The report focused on seven global sectors, with a current combined market value of some $7 trillion, where it said that climate change regulation had the potential to either generate new profits or impose new costs. For example, in the aluminium sector, it said, companies that took early action to reduce their carbon footprint could increase their market valuations by as much as 30 percent, whereas those that did not risked seeing their valuations drop by 65 percent. For the auto industry the range extended from +60 percent to –65 percent; in building materials the potential value change ranged from +80 percent to –20 percent.

"In most cases, carbon is just one factor among many in an investment decision," points out Tom Curtis, global co-head of DB Climate Change Advisors. "A lot of it comes down to data, and that is getting better all the time. We are starting to get to the point where an investment manager can start to quantify the carbon exposure."

Some of the best potential investments may be in the U.S., according to a recent research report by Joaquim de Lima and Vijay Sumon, quantitative equity analysts at HSBC in London. (That’s ironic, given the U.S.’s checkered history in the debate about climate change.)

"The U.S. now has an opportunity to become the engine for growth in climate change investing," they wrote. The U.S. accounted for 18 percent of global climate revenue last year, and that figure has been growing at a compound annual rate of 26 percent since 2004 even though the country did not ratify the Kyoto Protocol or enact federal climate change legislation.

The report identifies energy efficiency and low-carbon energy production — in particular solar power — as key potential growth sectors, because they are the biggest beneficiaries of the Obama administration’s economic stimulus package. It also highlights potentially key drivers of activity, such as the need to smarten the electricity grid and improve the energy efficiency of buildings.

Analysts at Deutsche forecast that investment in clean energy, energy efficiency and other climate change sectors could hit $650 billion a year over the next 20 years, up from $150 billion in 2007.

"We are actively engaging in developing the low-carbon technologies," says Curtis. "We are also quite excited about energy efficiency. We think it is low-hanging fruit." Deutsche believes that the most promising investment targets are makers of insulation and smart meters as well as developers of new window technology, all of which increase energy efficiency in buildings; low-carbon transportation, such as electric car technology; and renewable energies like solar and wind power.

The Universities Superannuation Scheme, the second-largest U.K. pension fund, with £23 billion ($38 billion) under management, takes carbon emissions into consideration when making investments. "We look at how companies are managing a shift to a long-term environment where the cost of carbon is likely to be higher and there will be political and policy imperatives to reduce emissions, and what that means for them," explains David Russell, co-head of responsible investment at the fund.

USS is currently talking with a company in India about plans for the possible introduction of carbon emission regulations in that country. "We are asking the company how it is looking at this issue over the next ten, 15, 20 years, where infrastructure developed now will be around for potentially decades; how they are factoring in the implications of a cost of carbon and emission reductions, or the physical impacts of climate change, into their developments now," says Russell, who declined to identify the firm.

Although some organizations are taking steps to limit their carbon footprints, others are doing more talking than acting. "Companies are starting to market themselves around their environmental performance," notes Seb Beloe, director of responsible investment at Henderson Investments in London. "Three or five years ago, that wouldn’t have happened. The need to look behind the message has always been there, but it is much more of an issue now."

Henderson has avoided investing in corporations whose green spin it deemed to be well ahead of commercial reality, says Beloe. One such case is Japan’s GS Yuasa Corp. The company’s share price soared recently after it drew attention to its production of lithium ion batteries for electric cars, but Beloe point out that the overwhelming majority of GS Yuasa’s output is lead acid batteries. And despite the fact that Brazil’s Cemig is part of the Dow Jones Sustainability index, Henderson has steered clear of it as well because of its involvement in a controversial dam in the Amazon.

Henderson is also prepared to lobby businesses for changes in behavior. Beloe cites the case of China’s Suntech Power, a maker of solar power equipment whose share price tanked last year after the Washington Post reported that the company was dumping its waste on farmland. Henderson prodded Suntech to address the issue, and it responded by putting tough environmental clauses in its supply contracts.

Investors need to keep a close eye on regulatory and political developments. Ernst & Young estimates that 250 pieces of major climate-related legislation have been introduced around the globe in the past year alone. The outcome of the United Nations talks in Copenhagen this December could also have a significant impact on markets in the short term. But whatever happens in coming months, the effect of climate change on the market is likely to grow.

"We are well positioned for whatever happens at Copenhagen," says Henderson’s Beloe. "If it succeeds, then tougher targets will come in over a shorter time period. If Copenhagen fails to come up with a strong agreement, international renewable companies would be hit, and some of the carbon traders would definitely be hit. But it is not going to derail the whole thing."

See related article, "Climate Talks Heat Up".

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