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Climate Economics: ESG Matters

By Robert A.G. Monks, J.D., Co-Founder GMI Ratings, Kimberly Gladman, CFA, Ph.D., Director of Research and Risk Analytics

Financial professionals reading in the media about climate change may think of it as a scientific issue, unconnected to their day-to-day work. In fact, however, over the last few decades climate change has been studied extensively not only by scientists but also by economists, who have quantified its potential effects in monetary terms. Using a number of techniques also used in portfolio management, their models account for risk and uncertainty, and estimate a range of possible outcomes. Their work demonstrates that climate change is virtually certain to have a significant impact on GDP around the world-and consequently also on investment markets.

One of the main tools of climate economics is Integrated Assessment Modeling (IAM). Because climate will affect the economy in many different ways, Integrated Assessment Models combine a variety of methodologies. At the simplest level, they examine effects on economic sectors for which prices already exist or can be fairly easily calculated, such as agriculture, energy use, and forestry. They also estimate effects-both positive and negative-on industries like fishing, construction, and outdoor recreation.

Next, IAMs address factors for which a monetary value must be estimated, such as increased mortality from climate-related diseases and pollution. Techniques for valuing human life and health sometimes start from an established economic technique called "willingness to pay" (WTP), which estimates what people are typically willing to spend to avoid or decrease risks of various kinds. However, because individuals' WTP can vary with their overall level of wealth, the models are often adjusted to ensure that lives in low-income and high-income countries are valued equally.

Even the most comprehensive current models, however, likely underestimate the economic impacts of climate change because they omit the effects of broad societal responses to it, such as political conflict (e.g., over water rights), migration (e.g., of refugees from flooded or drought-stricken areas), and the flight of capital investment from badly-affected regions or industries.

Many older IAMs assumed climate change would progress gradually. However, the more sophisticated recent models incorporate the fact that climate change increases the likelihood of extreme weather events, and that temperature rises may produce intensifying feedback loops (e.g., if permafrost melts and the methane it contains is released). Some of these models, such as the one used by the Stern report produced by the UK government several years ago, address these possibilities by using Monte Carlo simulation, which is also used in financial modeling. Given a predetermined range of possible parameters, this technique chooses random values for each of many model runs, generating a probability distribution of results rather than a single estimate. Across this distribution, the net costs of climate-related damage and adaptation costs are subtracted from a baseline projection of the GDP growth that would occur without climate impacts.

The results of IAMs naturally vary depending on their individual assumptions and methodological differences. However, taken together, the leading models suggest that climate change may already be reducing global GDP by at least 5%, and that this dampening effect could increase to as much as 20%. Moreover, emerging market economies are expected to be hardest hit, due to factors including disadvantageous geography, more fragile infrastructure, and a lack of resources to devote to disaster recovery or adaptation. This is especially concerning news for investors who are looking to emerging markets to fuel the world's economic engine in the coming decades, particularly as growth slows in the highly leveraged economies of Europe and the US.

Investment Analysis

Since macroeconomic developments of this scale are likely to impact nearly all portfolios in some way, many investors are examining the climate impact of the companies in which they invest. Some investors are building climate effects into their macroeconomic assumptions; others seek to invest in companies with lower climate impacts, assuming that regulators will eventually compel companies to internalize climate-related costs.

A principal way companies contribute to climate change is through their emissions of heat-trapping greenhouse gases (GHGs), which include methane, nitrous oxide and carbon dioxide. In order to compare the warming effects of different GHGs, they are frequently converted into their equivalents in terms of carbon dioxide (often referred to simply as "carbon"). A summary number can thus be produced which expresses a company's overall GHG impact in terms of carbon emissions.

At GMI Ratings, we include carbon dioxide intensity data sourced from Trucost, a specialist environmental research firm. The Trucost carbon intensity ratio estimates the quantity of a company's carbon emissions per million dollars of revenue. It can thus be used to make an apples-to-apples comparison between companies, and to show which are producing sales the most (or the least) efficiently in carbon terms. Carbon intensity is one of the Key Metrics on which our ratings are based, and it is flagged for any company whose carbon intensity is in the top 10% of its sector peer group. We also display in each of our company products the sector average for this metric in comparison to a market benchmark, so that clients can identify those sectors (e.g., utilities, coal, or oil and gas) with particularly high carbon intensity.

Sample Companies

A selection of companies that are flagged for carbon intensity because they rank in the highest 10% of their sector peers on this metric as of April 2012 is given below.

Company

Exchange

Ticker

Country

Region

Industry

Bayer AG

ETR

BAYN

DEU

Western Europe

Pharmaceuticals - Diversified

Boston Scientific Corporation

NYSE

BSX

USA

North America

Advanced Medical Equipment

Darden Restaurants, Inc.

NYSE

DRI

USA

North America

Restaurants

Eli Lilly & Co.

NYSE

LLY

USA

North America

Pharmaceuticals - Diversified

Gecina SA

EPA

GFC

FRA

Western Europe

REIT - Residential / Commercial

MGM Resorts International

NYSE

MGM

USA

North America

Casinos / Gaming

Owens Corning

NYSE

OC

USA

North America

Construction - Supplies / Fixtures

Tate & Lyle PLC

LON

TATE

GBR

Western Europe

Food Processing

TUI AG

ETR

TUI1

DEU

Western Europe

Leisure / Recreation

United Microelectronics Corp.

TPE

2303

TWN

All Other

Semiconductors

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.