Doha special: What would make regulators and investors really take account of GHG emissions?

Investors have been waiting for global regulation of greenhouse gas emissions and a nice neat indicator of costs through a global carbon price for some time now. The recent letter from investor coalitions to the Doha COP 18 taking place this week called for a new dialogue between investors and governments. Yet perhaps the opportunity lies in talking to the financial regulators rather than just the environmental regulators. It is clear that the mainstream myopic financial system does not currently take climate change risks seriously. Indeed, there are structural flaws in current market frameworks which place serious obstacles in the path of investors. The result? As our Unburnable Carbon report revealed in 2011, there has been a massive over-investment in fossil fuels risking large scale stranding of assets in a low-carbon world. This was confirmed by the International Energy Agency in its World Energy Outlook 2012, concluding that “without a significant deployment of CCS, more than two thirds of current proven fossil-fuel reserves cannot be commercialised in a 2 °C world before 2050.”
One of these flaws is short-termism, which has been dissected by the Kay Review and the UK government’s recent response to it. Crucially, within the UK Government, The Department for Business, Innovation and Skills (BIS) has endorsed the need for clarifying fiduciary duty as recommended by Fair Pensions as essential to enable institutional investors to confront intergenerational risks such as climate change for all their beneficiaries.
Another structural constraint that limits the options available to investors is the indices used as benchmarks, either passively or to assess fund performance. Theylead to a focus on incremental short-term tweaks, such as the recent call for “greener oil sands”, which can’t address the fundamental business model problems and current direction of travel. In the same way that low tar cigarettes have not changed the business of tobacco, the energy sector is facing a similar carbon addiction. The recent calls in the US from 350.org, an NGO that is targeting institutional investors, for divestment from coal primarily appeal to those funds that can take a moral stance on the issue. But backward-looking benchmarks that are not adjusted to respond to the future challenges of climate change mean that most mainstream funds could not exit or substantially reduce their exposure to fossil fuels even if they judged it to be the prudent thing to do. Investors in US coal mining stocks will have already lost half their shirts in 2012 (Arch Coal, Alpha Natural Resources and Patriot Coal lost over 50% of their market value in the first 6 months of 2012). This is the result of a combination of cheaper gas, community opposition to new plants and tightening mercury regulation. Perhaps the most obvious barrier to change though is simply the lack of good quality information. Investors have already called for greater disclosure on sustainability issues, with Aviva leading the charge at the Rio+20 summit. As regulators consider how to address this agenda it is critical that they focus on the material issues, and provide forward-looking information. At present, the UK may miss the opportunity to provide useful information to investors. The UK’s mandatory GHG reporting requirements announced at Rio+20 are very narrow, and do not address the most material issues for coal, oil and

gas extractives companies. We have proposed to the Department for Food, Rural Affairs and Agriculture (DEFRA) that they require these sectors to report on the GHG potential of the reserves they have an interest in. Following on from this, BIS are proposing the introduction of a new strategic review in their shake-up of narrative reporting. This will require consideration of environmental and social issues along with future corporate strategies and business models. Understanding how carbon intensive the future assets and revenues of the company is surely the most material issue for investors. Without an assessment of how exploitation of reserves fits within future emissions scenarios, investors will be left in the dark. Other financial markets are also considering this issue. There is a French coalition developing a programme around ‘2 degrees investing’.The South African Government Employees Pension Fund has analysed the South Africa market with Carbon Tracker to understand the level of risk concentration. South African investors have a restriction on the level of overseas holdings, and therefore have a limited universe of equities from which to choose. They therefore need to ensure that companies are aligning with the government’s future carbon budget. Requiring information on the emissions potential of reserves is the only way regulators can assess this systemic risk to their markets. We need a thermometer in each market telling investors what level of global warming they are aligned to. Perhaps most importantly, linking the financial markets to climate change commitments sends a strong message to investors that governments are serious about securing strong international climate change commitments.

James Leaton is Project Director at Carbon Tracker