Global warming – too hot to handle?

Since the late 1970s, the issue of global warming has been a topic of great debate.

Today, climate change and global warming are increasingly impacting our everyday lives; from the way we water our gardens and clean our cars to the purchase of carbon credits to offset the carbon dioxide we emit in our day-to-day activities.

Global warming and associated climate change have major implications for all of us, not just in terms of our lifestyle, but also in terms of our investments. It has emerged as a major market-moving force that is likely to influence how people invest for decades.

Why it matters for investors

There are several reasons why climate change cannot be ignored by investors. Let’s look at the risks:

Firstly, companies will face climate change risk from several sources:

~ the actual physical impact from changes in the weather and sea levels (which is directly relevant for the agricultural, insurance and property industries);

~ the impact on the competitiveness of companies that fail to respond adequately to climate change risks;

~ market-related risks may arise if climate change influences customers’ decisions when buying goods (for example, to shy away from companies/products that have a bad reputation in relation to climate change issues); and

~ regulatory risk is likely to intensify, having the greatest direct impact on industries such as electricity utilities that emit carbon in a big way (or rely heavily on energy), as the cost of doing so will rise.

These considerations have the potential to significantly impact on the risk, profitability and growth potential of companies.

This is what motivated the Carbon Disclosure Project (CDP), as institutional investors struggled to better understand the risks and opportunities faced by companies in relation to climate change and what they are doing about it.

The first CDP survey of the top 100 listed companies in Australia found companies were aware of the risks, but only 25 per cent of respondents indicated a sophisticated understanding of climate change risks.

Secondly, climate change has a significant potential to impact property related investments, particularly in low lying areas. A rise in the sea level of a few centimetres over the next few decades may not seem much, but it would have a huge impact on beach suburbs (particularly waterfronts) and places like Surfers Paradise and Cairns during a severe storm.

Thirdly, it has the potential to significantly affect the economic growth that partly drives investment returns — but this is a very long-term impact and probably not big enough (on current projections) to get too concerned about at present. It’s worth keeping an eye on though.

Climate change also creates opportunities for investors. These include:

~ investment in clean energy technology companies, whether via the share market or venture capital funds; and

~ investment in carbon abatement (for example, forests to absorb carbon) or carbon capture projects, which can generate carbon credits for sale in carbon markets. The global carbon market will expand as carbon trading expands.

The science of climate change

When the issue of global warming was first raised, there was speculation that carbon emissions would lead to a ‘greenhouse effect’, whereby heat from the sun would be trapped in the atmosphere causing an increase in the world’s temperature. The greenhouse effect and resulting climate change is now more generally accepted by most scientists, and the debate has moved from whether it’s happening to the magnitude of its impact.

The scientific consensus is that global warming, driven by greenhouse gas emissions (for example, carbon dioxide, methane and fluorinated hydrocarbons) is now a reality. Records from ice core samples suggest carbon dioxide in the atmosphere was stable at around 280 parts per million (ppm) up until the industrial revolution, but it’s now around 380 ppm.

On current trends, if left unchecked, it’s likely to rise to around 800 ppm by the year 2100. Naturally, there are various scenarios around this, but none of them show a decline in carbon dioxide in the atmosphere, and many present an even bleaker picture of the speed at which we will reach a worse case scenario.

The general consensus amongst scientists is that carbon needs to be stabilised somewhere around or below 550 ppm if major calamities are to be avoided.

The balance of evidence suggests rising greenhouse gas concentrations in the atmosphere are contributing to a gradual increase in average global temperatures (0.6 degrees Celsius over the past 100 years).

This in turn is showing up in rising sea levels — arctic sea ice is melting at 9 per cent a decade — and as climate change in the form of more extreme weather events. For example, 2005 saw the worst hurricane season on record in the Gulf of Mexico, it was also the world’s hottest year on record and Australia is experiencing its worst drought on record.

Long-term impact

Without urgent measures to reduce carbon emissions, the impact of climate change will accelerate. Below are just some of the expected implications:

~ average temperatures are predicted to rise two to three degrees Celsius this century, but with a range of up to six degrees Celsius;

~ sea levels are projected to rise by up to a metre by 2100 — enough to flood 17 per cent of Bangladesh and create serious problems for cities like New York and Sydney;

~ with this will come even more extreme weather events;

~ a 2.5 per cent rise in average world temperatures has been estimated to reduce world gross domestic product (GDP) by around 3 per cent. Very cold countries would benefit, but already hot countries would be hit the hardest. However, the GDP impact dramatically understates the cost of global warming, as it ignores the huge potential loss of property and the impact on the quality of life.

On the basis of GDP alone, Hurricane Katrina was good news for the US economy — but New Orleans residents may not see it that way; and

~ Australia is predicted to be two degrees Celsius hotter by 2030, with the south hardest hit by reduced rainfall.

It’s not all hopeless

Much of the debate about global warming makes it sound like a hopeless situation. Some see it as unstoppable and so think it’s impossible to turn around corporate and individual behaviour. Others fret that action to redress the problem will lead to economic ruin. Most scientists would say it’s not too late and the history of environmental change suggests it’s not hopeless.

Problems of air pollution have been dealt with before. In the mid 1970s there was talk of global cooling (Newsweek actually ran a cover story on “The Cooling World”) due to sulphur pollution in the atmosphere reflecting sunlight, but this was dealt with by efforts to control that sort of pollution.

Through regulatory action and technological innovation the world has addressed problems of smog (new cars emit a fraction of the smog they did 40 years ago), acid rain and the depletion of the ozone layer. Furthermore, progress on these fronts has been cheaper and generally faster than initially thought possible.

More specifically, it’s doubtful action to reduce carbon emissions will result in economic ruin. Various studies, including for Australia, suggest a phased process of carbon mitigation by encouraging the replacement of machines and buildings with more fuel efficient technologies at the end of their lifecycle and encouragement of low emission electricity infrastructure by putting a price on carbon pollution would cost less than 3 per cent of GDP by 2050. Mitigation efforts will also see various industries benefit.

Since carbon produced today stays in the atmosphere for around 200 years, action needs to start soon, and it’s cheaper to start earlier and phase in efficient technology over time than to leave it till later when the problem is more acute and machines may simply have to be scrapped.

Expect increasing action to reduce greenhouse gases

The worldwide response to global warming was the Kyoto Protocol, which set targets for greenhouse gas emissions relative to 1990 levels. These targets were more onerous for rich countries than developing countries, as they are better able to afford the cost and can afford to experiment with the best way forward in terms of both regulations and technology before passing it on to poorer nations.

In terms of major regions, Europe embraced Kyoto most vigorously and has introduced carbon trading as a means to achieve its targets. This involves allocating ‘dirty industries’ allowances to emit a certain amount of carbon and allowing them to buy carbon credits from other companies that aren’t using their full allowances or from projects in developing countries that reduce greenhouse emissions. This has resulted in a market in carbon and other greenhouse gases. The European system is not without fault, but at least it puts a cost on carbon pollution.

The US and Australia have not signed up to Kyoto and so the regulatory response in both has been more patchy. Our assessment is that it’s only a matter of time before firmer action is taken by both the US and Australia, probably in the form of targets and national carbon trading arrangements, because:

~ the public will demand action as climate change becomes increasingly evident;

~ litigation against greenhouse gas polluters and governments is starting to increase;

~ individual states in both the US and Australia are starting to introduce Kyoto-style carbon trading; and

~ business will demand action — particularly sectors at the frontline of climate change (such as farmers and the insurance sector) and out of a desire for regulatory certainty given the emerging state measures.

California is often a bellwether of social and regulatory change (for example, the 1970s pollution standards for cars) and its adoption of aggressive emission reduction targets and carbon trading is a sign of things to come in the US and Australia.

Conclusion

Global warming appears to be gradually but powerfully changing the economic landscape. As the effects of climate change are more widely felt we see more and more companies investing in new and innovative ways of enabling us to drive, fly and manufacture materials. It is the way in which consumers, governments and corporations react that will create new investment opportunities.

Climate change, driven by greenhouse gas emissions, will have a significant impact on the way we live. Its far-reaching implications mean investors cannot ignore it.

Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors .