Leveraging the Carbon Disclosure Project

Corporates are doing well in carbon disclosure, so why are investors lagging?

by Matthew Kiernan | October 9th, 2007

On September 24 in New York City, the fifth annual iteration of the Carbon Disclosure Project report was launched amid considerable fanfare. While most of that fanfare derived from the appeal of the principal speaker – former U.S. President Bill Clinton, the report itself did document some important progress. In an astonishingly short space of time, climate change has morphed from an esoteric, largely scientific issue to what is arguably the most compelling business, public policy, and investment issue of our times. This year’s report was written on behalf of 315 institutional investors from all over the world, with combined assets of $41trillion under management. The request was sent to 2,400 of the largest quoted companies in the world by market capitalization, and for the fifth time, Innovest Strategic Value Advisors was selected to analyze the responses from the Financial Times Global 500 (FT500) companies.
An analysis of those responses reveals several encouraging trends. Perhaps most importantly, this year’s CDP reveals, for the first time, that corporate awareness of climate related risks and opportunities is now beginning to translate into the development and implementation of meaningful strategies – and actions.
The second positive trend is the substantial increase in awareness and engagement among major institutional investors – compare CDP5’s 315 signatories with aggregate assets under management of $41 trillion with the 35 institutional investors with $4.5 trillion under management in CDP1.
Unfortunately, however, this heightened awareness and apparent appetite for change has yet to manifest itself in concrete and widespread changes in behaviour on the investor side; the vast majority of institutional investors do not yet seem to be utilizing systematically any climate-driven company research which might capture the premium “carbon beta”. Until and unless this happens on a consistent and systematic basis, important risks will remain hidden, opportunities missed on the upside, and the pace of the necessary corporate transition to a global low-carbon economy will be delayed.
While institutional investor awareness of climate risk has increased dramatically, only a tiny handful have moved beyond rhetoric and shareholder resolutions to take concrete investment action – namely, incorporating climate risk considerations directly and systematically
into their actual stock selection and portfolio construction processes.
It is at that level –where the “rubber meets the road“—that investors can send the strongest message to companies, produce significantly changed company behaviour, and, most importantly, improve their long-term, risk-adjusted returns. Unfortunately, however, we currently estimate that far less than .1% of the CDP signatories’ $40 trillion+ in assets is currently invested in any investment strategy which explicitly and systematically takes climate risk into account. Historically, there have been a number of reasons for this:

• Investment professionals have long believed that company resources devoted to environmental issues are either wasteful or actually injurious to their competitive and financial performance and therefore to both the performance of the companies themselves and investor returns;
• As a direct result, money managers, pension fund consultants, and even pension fund trustees have historically regarded explicitly addressing environmental factors in their investment strategies as incompatible with the proper discharge of their fiduciary responsibilities;
• Until recently, there has been a dearth of robust, credible research evidence and analytical tools linking companies’ environmental performance directly with their financial performance, as well as a shortage of institutional quality, company-specific research to help investors.

Before this situation can change significantly, investors will require at least four things:

• Compelling evidence that integrating climate risk analysis can in fact enhance risk-adjusted financial performance – in short, a robust investment case;
• Compelling evidence that the variance in net climate risk exposure among companies is sufficiently large to warrant investor attention;
• A comprehensive and sophisticated analytical framework for assessing relative and absolute climate-risk; and
• Company-specific information and analysis

We noted earlier that, while major global corporations appear to be narrowing the historic awareness/action gap, the same cannot yet be said for their owners – the large institutional investors. It is true that a few exceptional, leading-edge pension funds including ABP, PGGM, CalPERS, and CalSTRS are investing in specialized climate-driven opportunities, notably clean tech private equity and carbon emissions trading funds. Such initiatives are to be applauded, but from a climate perspective, they address only a tiny portion of the overall capital spectrum, and therefore the overall risk and opportunity set. We would argue that precisely the same global, climate-driven forces creating these investment opportunities and risks in the smaller, unlisted markets are also bearing down on the other 95% of the asset class spectrum as well, most notably the public equities, fixed-income, and real estate markets.
With intra-sector risk variances of thirty times or more among companies, and given the inherent dangers of relying on non-verified company disclosure alone, we believe that it behooves investors and fiduciaries to avail themselves of much more robust company research and analysis as a matter of course. Based on some additional research undertaken by Innovest to complement the CDP, the financial rewards for doing so would appear to be significant.
At the request of CDP, Innovest compared the top performing companies according to its Carbon BetaTM Rating platform with the companies identified in the CDP5 Climate Disclosure Leadership Index (CDLI) and the MSCI World. In other words, the objective was to investigate any performance differentials which might exist between “carbon leaders” selected purely on the basis of publicly disclosed information and those selected using a more research-intensive, multi-factor model. The graph (see attached download) demonstrates the results, over the most recent 3-year period:
In general this analysis suggests two things:

• Companies providing superior disclosure of carbon risks, performance, and strategies do indeed tend to produce stronger share price performance. This suggests the existence of some sort of “carbon management quality premium”.
• Even greater returns can be generated by investors who look beyond disclosure, and use more sophisticated, multi-factor carbon risk research.

As these return differentials become more widely recognized and understood, we would expect to see a growing demand for research which goes well beyond the voluntary disclosure of emissions, and address all four dimensions of the climate risk equation:

• An analysis of companies’ absolute and relative carbon footprints, adjusted to acknowledge the differential impacts of different national and regional regulatory imperatives;
• An assessment of the robustness of each company’s risk management architecture;
• An assessment of companies’ abilities to both identify and seize climate-driven competitive and commercial opportunities on the upside; and
• A longitudinal assessment of companies’ performance improvement trajectory – or the lack thereof.

The Carbon Disclosure Project is doing its job, and the corporates appear to be making great strides as well. Now it’s over to responsible investors.
Dr. Matthew Kiernan is founder & chief executive of Innovest Strategic Value Advisors