In response to increasing legislation and policy, major economies have started regulating carbon and energy using a variety of approaches which will have differing implications for investors. Below is a brief summary of the second Climate Change Whitepaper - Climate Change Related Regulation.
Forms of domestic regulation
Most major economies have started regulating carbon and related issues like air pollution. A number of approaches have been undertaken with mixed success. Policy responses include:
- Carbon pricing (emissions trading or direct taxes)
- Emissions standards (carbon and other related pollutants e.g. mercury, particulate matter etc)
- Energy efficiency and renewable energy incentives (renewable energy targets, feed-in tariffs, direct subsides)
- Forest and farming programs
- Other initiatives including removal of fossil fuel subsidies, disclosure requirements and changes to approval processes
Carbon regulation has seen significant advancements globally. Countries who are not providing investment and business certainty through low-carbon regulatory frameworks may be placing their domestic businesses and economies at a competitive disadvantage by perpetuating regulatory uncertainty.
Various factors will influence the ability to account for and act on the regulatory risks associated with climate change. These include the investment approach (e.g. active vs passive, growth vs quality etc), asset class and time horizon of the investor. Investors can employ various strategies to manage regulatory risks including:
1. Incorporation of carbon costs for individual assets or companies
While on the surface incorporating a carbon cost into valuation models is relatively straight-forward, an understanding of market dynamics and a company’s ability to pass through costs or reduce emissions should be considered. In addition other regulatory interventions for related issues like air pollution should also be considered. For some companies regulation around carbon and other pollutants may put them at a relative advantage, particularly those who have acted early to reduce emissions or whose business model allows them to benefit from regulatory tailwinds.
2. Assumptions related to other capital/operating expenditure
A critical risk for investors is how companies decide to invest capital and the life cycle of carbon intensive capital assets. While transition risks and stranded assets are covered in the next paper in this series, changing carbon regulations can accelerate these risks. For example, early closures of coal-fired power generators to avoid the cost of upgrades when pollution standards change can dramatically shift the financial position of some companies. Additional costs associated with early closures like a lack of balance sheet recognition for site remediation should also be considered. Conversely many companies can achieve significant savings through energy efficiency and investment in lower cost clean energy alternatives.
3. Assessing supply chain risks
Some companies will be better able to pass on the costs of carbon regulation than others. Understanding whether a company or an asset is likely to have costs passed on to it or is able to pass costs on is a normal dimension of supply chain analysis which can be extended to carbon regulations, albeit with some important differences. These considerations are covered in more details in the following paper on transition and stranded asset risks.
4. Portfolio construction
In addition to incorporating carbon regulation into company analysis and valuations, some investment strategies now incorporate specific emission reduction targets. For example, smart beta strategies have been developed which reduce carbon exposure while aiming to maintain overall portfolio risk and return characteristics.
These carbon reduction strategies have increased in popularity in recent years because they provide an explicit and measureable reduction at the portfolio level in a risk aware and cost efficient manner. This measurability allows for rigorous ongoing monitoring of portfolios against the reduction targets. However care must be taken, whether through smart beta or any other strategy with explicit carbon footprint reduction targets. One issue is that around half of companies globally do not disclose emissions and so are estimated by third party providers based on industry averages which lifts some companies while dragging others down. This underlies the importance of engagement on initiatives such as the Taskforce for Climate-Related Financial Disclosure (TCFD) and CDP to continue to improve company disclosure.
A singular focus on emission reductions also risks missing and in some cases unintentionally increasing exposures to other climate change risks like stranded asset risks. For example some approaches will invest in pipelines and mining services companies rather than oil and gas companies in an effort to maintain energy exposure with lower emissions even though these companies may have less flexible business models. Similarly some electric utilities may be excluded for higher emissions when they are often best placed to transition to a low carbon economy.
For a full list of comprehensive strategies, please refer to Climate Change Whitepaper #2.
Carbon and related pollution regulation has taken various forms around the world and has grown significantly in the last several years. Compared to physical risks, investors have a much greater ability to incorporate carbon and related pollution regulations into company analysis and valuations, portfolio construction and engagement.
Good governance, transparency and positive advocacy around climate change regulation are as important for investors as they are for the companies invested in.