Environmental Alpha E-Book

Angelo Calvello

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 718

Veröffentlichungsjahr: 2009

Beschreibung

The definitive guide to how institutional investors shouldapproach the risks and opportunities associated with climatechange Environmental Alpha provides institutional investors withthe comprehensive framework they need to assess the risks andinvestment opportunities tied to climate change. Climate change will present institutional investors with some ofthe most important risks and opportunities they will face forgenerations to come. Climate change has the potential to affectmany sectors in radically different degrees over time, andinstitutional investors need to have a thorough understanding ofthe multi-dimensional risks and opportunities that could influencenearly every investment in their portfolios. This volume iscomposed of contributions by leading experts in environmentalinvestment, moving beyond the theoretical or academic nature ofmuch of the current discussion on the topic to provide you withreal-world insights into an emerging market. * Examines the climate change-related drivers of returns(science, economics, policy, and technology) that makeenvironmental alpha possible * Explores fiduciary duty and climate change * Contains in-depth explanations of each of the major categoriesof environmental investing and examines related environmental alphaopportunities * Discusses practical implementation issues * Presents real-world case studies and examples Climate change will be one of the most important investmentthemes of the next twenty years; the related environmentalinvestment opportunities will provide institutional investors withsome of the greatest "alpha" opportunities for years to come. Thisbook will put you in a better position to assess and access theseopportunities.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Epigraph

Preface

THE NATURE OF THE CLIMATE CHANGE CHALLENGE

A TAXONOMY OF ENVIRONMENTAL INVESTMENTS

INTENDED AUDIENCE

STRUCTURE OF THE BOOK

FINAL THOUGHTS

REFERENCES

Acknowledgements

PART One - Introduction to Climate Change Issues and Consequences

CHAPTER 1 - The Science of Climate Change

HUMAN-CAUSED CLIMATE CHANGE: THE EVIDENCE

OTHER HUMAN INFLUENCES ON CLIMATE

CHALLENGES IN PROJECTING FUTURE CLIMATE CHANGE

FUTURE CLIMATE CHANGE WITH AND WITHOUT EMISSIONS REDUCTIONS

SUMMARY

NOTES

REFERENCES

CHAPTER 2 - The Economics of the Climate Change Challenge

CONSIDERING THE CASE FOR ACTION

THE POLICY FRAMEWORK

SUMMARY AND CONCLUSION

ACKNOWLEDGMENTS

NOTES

REFERENCES

CHAPTER 3 - Climate Change Policy What Investors Need to Know

OVERVIEW OF POLICY AND POLICY DRIVERS

WHY INVESTORS CARE ABOUT POLICY

CLIMATE POLICY AND REGULATION: AN OVERVIEW

DESIGNING A DOMESTIC APPROACH

THE IMPACT OF OTHER POLICIES

DESIGNING AN INTERNATIONAL APPROACH

LOOKING FORWARD

SUMMARY: IMPLICATIONS FOR INVESTORS

ACKNOWLEDGMENTS

REFERENCES

PART Two - Climate Change and Institutional Investors: Key Strategic Issues

CHAPTER 4 - Risks and Their Impact on Institutional Investors

FOUR CATEGORIES OF CLIMATE RISK

INVESTOR ENGAGEMENTS WITH COMPANIES AND POLICY MAKERS ON CLIMATE RISK ...

INVESTOR ACTION ON CLIMATE RISK

MARKET MELTDOWN: DOOM OR BOON TO GREEN ECONOMY?

ACKNOWLEDGMENTS

REFERENCES

BIBLIOGRAPHY

CHAPTER 5 - The Case for Climate Change as the Paramount Fiduciary Issue Facing ...

THE FRESHFIELDS REPORT

UNITED NATIONS PRINCIPLES OF RESPONSIBLE INVESTMENT

THE CHALLENGE OF CLIMATE CHANGE

BUSINESS RISKS AND OPPORTUNITIES

ENERGY AND INSURANCE AND REINSURANCE

CONCLUSIONS

REFERENCES

BIBLIOGRAPHY

CHAPTER 6 - SRI or Not SRI?

A MISSED OPPORTUNITY

AFTER AWARENESS, THEN WHAT?

SRI OR NOT SRI?

THE LIMITATIONS OF CURRENT APPROACHES

LEVERAGING CARBON BETA IN THE EQUITY SPACE

THE CARBON BETA MODEL ITSELF

WHITHER CARBON FINANCE?

ACKNOWLEDGMENTS

NOTES

REFERENCES

BIBLIOGRAPHY

PART Three - Environmental Alpha: The Investment Case for Climate-Related Strategies

CHAPTER 7 - Taxonomy of Environmental Investments

CLIMATE CHANGE: A CLUSTER CONCEPT

THE DRIVERS OF RETURNS

CATEGORIES OF ENVIRONMENTAL INVESTMENTS

THE RISKS AND CHALLENGES OF ENVIRONMENTAL INVESTING

THE BENEFITS OF ENVIRONMENTAL INVESTMENTS

CONCLUSION

REFERENCES

BIBLIOGRAPHY

CHAPTER 8 - Investing in Climate Change

PERSISTENCE OF CLIMATE CHANGE AS AN IDENTIFIABLE SOURCE OF EXCESS RETURNS

FUNDAMENTAL ATTRIBUTES OF THE CLIMATE CHANGE UNIVERSE

APPLYING CLIMATE CHANGE TO DIFFERENT ASSET CLASSES

BENEFITS OF INCLUDING CLIMATE CHANGE IN ASSET ALLOCATION

MARKET DEMAND AND SUPPLY

CONCLUSION

DISCLAIMER

REFERENCES

BIBLIOGRAPHY

CHAPTER 9 - Carbon as an Investment Opportunity

THE KYOTO PROTOCOL AND EMISSION TARGETS

THE CLEAN DEVELOPMENT MECHANISM AND JOINT IMPLEMENTATION

THE EUROPEAN UNION EMISSIONS TRADING SCHEME

EMERGING CARBON SCHEMES

FLAVORS OF CARBON

WHY INVEST IN THE CARBON SPACE TODAY?

CARBON WILL BE A HUGE MARKET

ALPHA, INFORMATION, AND RESOURCES

CONCLUSIONS AND OUTLOOK

CHAPTER 10 - Market-Based Solutions to Reduce Emissions from Deforestation and ...

SECTION ONE: SCIENCE AND POLICY

SECTION TWO: MARKET-BASED SOLUTIONS

CONCLUSION

NOTES

REFERENCES

BIBLIOGRAPHY

CHAPTER 11 - Effective Clean Tech Investing

CLASSIFYING THE SCOPE OF CLEAN TECH INVESTMENTS

THE PACE OF CLEAN TECH INNOVATION AND FUTURE PROSPECTS FOR INVESTING

FITTING CLEAN TECH INVESTMENTS INTO AN EFFECTIVE AND DIVERSIFIED PORTFOLIO

CONCLUSIONS AND IMPLICATIONS

BIBLIOGRAPHY

CHAPTER 12 - Sustainable Commercial Property

BACKGROUND AND CONTEXT

BUILDINGS AND CLIMATE CHANGE: A GLOBAL CHALLENGE

SIZE OF THE MARKET FOR SUSTAINABLE PROPERTY

SUSTAINABLE PROPERTY DRIVERS AND BARRIERS

THE INVESTMENT THESIS FOR SUSTAINABLE PROPERTY

SUSTAINABLE PROPERTY INVESTMENT OPPORTUNITIES

FUTURE TRENDS AND RISK: A PERFECT STORM?

NOTES

REFERENCES

CHAPTER 13 - Liquid Alpha The Case for Investing in Water

THE IMPACT OF ACCELERATING DEMAND ON WATER SUPPLIES

STRUCTURAL IMPACTS ON WATER SUPPLY

IMPACT OF CLIMATE CHANGE

INVESTING IN WATER

CAPTURING LIQUID ALPHA

RISKS TO INVESTING IN WATER

SUMMARY

ACKNOWLEDGMENTS

NOTES

REFERENCES

PART Four - Practical Considerations

CHAPTER 14 - A Collaborative Response to Climate Change

DIARIES OF AN INVESTMENT CONSULTANT

WHY MIGHT A COLLABORATIVE APPROACH TO CLIMATE CHANGE BE APPEALING?

WHAT ARE THE PITFALLS OF COLLABORATION?

A COLLABORATIVE FRAMEWORK APPLIED TO CLIMATE CHANGE

COLLABORATION IN ACTION: ASSET/LIABILITY MODELING AND SCENARIO ANALYSIS

CONCLUSION

REFERENCES

BIBLIOGRAPHY

CHAPTER 15 - Corporate Responsibility and Environmental Investing

WHAT IS CR AND ER?

WHAT COMPRISES AN ASSET MANAGER’S ENVIRONMENTAL FOOTPRINT?

WHAT ROLE DOES ER (AND CR) PLAY IN A CORPORATE ENTITY’S BUSINESS MODEL?

WHAT ER STATEMENT SHOULD AN INVESTOR EXPECT FROM A CORPORATION?

AN INVESTOR’S APPROACH TO ER

CONCLUSION

APPENDIX: AN INTERVIEW WITH MICHELLE CLAYMAN OF NEW AMSTERDAM PARTNERS

REFERENCES

CHAPTER 16 - Beyond Best Practices

STEP 1: UNDERSTANDING CLIMATE CHANGE AND THE VIRTUAL TEAM

STEP 2: ASSESSMENT (ENVIRONMENTAL STRESS TEST)

STEP 3: FROM THEORY TO PRAXIS

STEP 4: GENERAL OBSERVATIONS

CONCLUSION

NOTES

REFERENCES

About the Author

About the Contributors

Index

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Library of Congress Cataloging-in-Publication Data:

Environmental alpha : institutional investors and climate change / [edited by]

Angelo A. Calvello.

p. cm. - (Wiley finance series)

Includes bibliographical references and index.

eISBN : 978-0-470-54338-2

1. Environmental economics. 2. Climatic changes. I. Calvello, Angelo A., 1956-

HC79.E5E5749 2010

363.738’746-dc22

2009017150

To Lisa, Giana, Joseph, and Michael.Tolle Lege, Tolle Lege

Climate change, as a fundamental alteration of global reality, requires another paradigm shift in the calculation of risk, and a consequent response—only this time the stakes are much higher. The flow of capital has world-changing force, and now that carbon has caught up with fiduciaries, they have the opportunity—and the undeniable duty—to help lead us away from a remorseless tragedy of universal ruin.

—Michael Northrop and David Sassoon, “Climate Change Now a Fiduciary Duty—and Opportunity,” 2006

Preface

The genesis of this book could be traced to a meeting I had with Kerry Brick, manager of pension investments for Cargill, in 2007. We were discussing a new fund that my then-employer was offering, a fund that was to build and operate integrated coal mines/power plants in China’s Shanxi province. The fund’s return would be tied to the sale of the electricity generated by the power plant and—here’s where it gets interesting—the sale of the carbon credits the fund would earn because of the environmentally efficient manner in which it mined the coal. The operation was structured so that it would be certified by and registered with the United Nations Framework Convention of Climate Change as a Clean Development Mechanism project, allowing it to receive emissions credits (certified emission reduction credits, or CERs). Each CER signifies an emission reduction of one tonne of CO2 equivalent and could be traded in various market-based systems.

The fund offered a play on emerging markets, China, commodity prices, and energy, but at the end of the day it was the carbon credits that clearly got Kerry’s attention. Carbon was a new and real source of return. He—and other institutional investors with whom I later spoke—quickly understood that this strategy potentially offered attractive risk-adjusted returns because skillful managers could gain and exploit material advantages. In a word, they saw that this strategy offered an environmental alpha—a skill-based return resulting from an investment in assets whose value is primarily driven by climate change-related issues. But they also saw that the source of these returns—climate change—presented them with new and profound risks.

As I left Kerry’s office, I felt like the prisoner in Plato’s “Allegory of the Cave,” who has been freed of his chains. That conversation allowed me to see that I was previously living in a shadow world that failed to fully reveal the investment risks and opportunities presented by changes in climate. Since that time, I have continued my ascent out of the shadow world, toward a higher form of investing—environmental investing. And like Plato’s prisoner, it took my eyes quite a while to adjust to the light. But I soon understood that climate change would require institutional investors to rethink how they manage and invest the assets under their control. More specifically, I came to understand that environmental investment strategies could offer excess returns and diversification and that climate change was the driver of these benefits.

I knew I had to return to the cave to share this intellectual (and commercial) insight with those remaining captive in the shadow world. I wanted to create a resource that would help fiduciaries like Kerry move beyond their intuitive appreciation of environmental investments and thoroughly understand key topics that institutional investors need to understand in order to prudently direct and commit capital in the time of climate change.

This book marks the beginning of my return to the cave. I knew I could not return alone. The topics of climate change and environmental investing were simply too overwhelming for me to manage on my own. So I searched for portfolio managers, academics, investment consultants, institutional investors, and other industry participants who had made this same ascent and solicited their help in writing this book.

THE NATURE OF THE CLIMATE CHANGE CHALLENGE

Understanding the nature of the challenge begins with a definition of environmental investing and environmental alpha. The definition of environmental investing is developing before our eyes, partly because of the newness of the inquiry and partly because of the nature of the subject matter itself. After discussions with people in different disciplines and with different perspectives, I have chosen a definition that focuses on the drivers of return instead of content of the opportunity set. Environmental investing is simply too dynamic to be defined by investment approach or function. This book defines environmental investing as investing directly or indirectly in assets whose values are affected primarily by climate change. Environmental investing can be further described as a type of thematic investing, and the theme that drives/underlies environmental investing is climate change.

The climate change theme, like all other investment themes, is impacted by macroeconomic and broad sociopolitical issues, but the specific thematic factors affecting environmental investments—the drivers of returns—can be reduced to the following four climate change-related factors:

1. Science

2. Economics

3. Policy and regulation

4. Technology

The climate change theme can be narrowly defined as “The scientific community has reached a strong consensus regarding the science of global climate change. The world is undoubtedly warming. This warming is largely the result of emissions of carbon dioxide and other greenhouse gases from human activities including industrial processes, fossil fuel combustion, and changes in land use, such as deforestation” (Pew Center on Climate Change 2009). In order to solve the climate change problem, we need to mitigate greenhouse gas (GHG) emissions to a specific level within a defined time period and adapt to the possible consequences of climate changes already in the pipeline. Mitigating and adapting to climate change will require changes in behavior and the development and dispersion of an evolving portfolio of market-based technologies.

However, it is critical that readers understand that the climate change theme is actually much bigger than simply “global warming.” In this book, climate change is a “cluster concept” and encompasses both the above-mentioned narrow definition and such direct environmental topics as (Kiernan 2009):

• Water quality

• Air pollution

• Waste management

• Deforestation and land degradation

• Chemical and toxic emissions

• Biodiversity loss

• Depletion of the ozone layer

• Quality of fisheries and oceans

And such broader social issues as:

• Energy supply

• National security

• Human development

• Population growth

• Global changes in demographics

• Poverty and income disparity

• Public health

• Human rights

• Labor rights

• Human resource management

In order to fully understand the risks and opportunities arising from climate change and to properly assess and access the environmental investment universe, investors should understand the scientific definition while recognizing the cross-disciplinary meaning of climate change.

More importantly, investors should recognize that “climate change” is the concept chosen to express this cluster of topics because while each of the related topics represents a critical issue, only climate change comes with the exigency of time. Action unquestionably needs to be taken with regard to the other issues, but only climate change demands timely action be taken if we are to avoid an ecological “tipping level ... a measure of the long-term climate forcing that humanity must aim to stay beneath to avoid large climate impacts” (Hansen et al. 2008). Said another way, where the other topics might come with a moral imperative, climate change comes with a temporal imperative.

For investors, this means the market-based solutions used to solve the climate change problem—environmental investments—could not only mitigate GHGs and help us adapt to changes in climate, they could produce broader results that might help remediate these other related issues. For example, developing clean power sources (like wind or solar) that could eventually be used at scale will not only result in reduced GHGs emissions but could also result in reduced air pollution, reduced chemical and toxic emissions, improved water quality, improved public health, and potentially improved working conditions. Such clean technologies also improve a country’s native energy supply and could make it less reliant on foreign sources of energy, thereby improving national security.

Climate change, broadly considered, reveals other attributes of the climate change theme: it is a long-term, secular theme that cuts across asset classes, investment approaches, styles, and geographies, making it the mother of all themes.

It’s important to recognize that climate change is not some distant, abstract risk; it is upon us now. “Companies are already being impacted in financial terms due to the effects of climate change on their costs, revenues, assets or liabilities” (Mercer Investment Consulting 2005). Also, “believing” in climate change is not a prerequisite condition for environmental investing. Whether or not an investor believes in climate change, events are occurring that will give rise to significant risks that will impact existing portfolios and to new investment opportunities that could benefit these same portfolios. Environmental alpha opportunities, like Plato’s Forms, exist independent of investors’ beliefs. In some ways, many of these opportunities exist even independent of climate change itself. For example, we still face limited supplies of fossil fuels and need to find alternative sources of energy. Developing and implementing new clean replacement technologies makes sense from the standpoint of energy supply, national security, economic efficiencies, and clean air. Additionally, the opportunity to earn significant risk-adjusted returns will continue to arise. Science will continue to produce new ideas that will be transformed into market-based solutions. Policy will continue to be developed and implemented that will shape market-based solutions and impact the companies’ performance and behavior.

So investors do not need to believe in climate change; they simply need to understand that this theme will materially affect their current portfolio and investment decisions for years to come.

Correlatively, while climate change might be a value-charged topic, environmental investing as discussed in this book has no necessary connection to investors’ values or worldview and it does not necessarily involve extra-financial considerations such as social benefits. There is no need to include such value judgments in the investment process. Environmental investing is about economics, not ethics; alpha, not absolution. (See Chapter 6 for Matthew Kiernan’s delineation of this issue.) For this reason, environmental investing is not “similar to SRI in that both are strategies driven by investors desire to achieve financial return while maximizing social good” (Chhabra 2008). Maximizing social good is neither a sufficient nor necessary condition of environmental investing. For this reason, environmental investing, in spite of its name, cannot be lumped into another subset of socially responsible investment (SRI), ESG—environmental, social, and governance.

Let me be clear: there is nothing inherently problematic about SRI or ESG, but classifying environmental investing as a type of SRI raises all kinds of specious issues:

• Definitional confusion.

• Investment returns are constrained.

• Fiduciary responsibility is compromised.

• Incorporating environmental issues into existing investment approaches is a challenge (Taylor and Donald 2007).

These issues could unnecessarily distract investors from examining the risks and considering the genuine benefits of environmental investing. However, climate change does require investors to take a more active role in the management of their assets. Because a company’s exposure to climate risks is not always readily available, institutional investors cannot easily determine the risks inherent in their portfolio. Investors have a duty to understand as much about the risks—climate-related or otherwise—as possible so they can make informed decisions to “meet the real needs of our members and beneficiaries” (Mercer Investment Consulting 2005).

This could require institutional investors to collaborate with their peers and industry organizations, asset managers, and governmental agencies to create uniform reporting standards on climate risks. (These ideas will be discussed in Chapters 5 and 14.)

A TAXONOMY OF ENVIRONMENTAL INVESTMENTS

Environmental investments break down into five major classifications:

1. Carbon

2. Land use, land-use change, and forestry (LULUCF)

3. Clean technology

4. Sustainable property

5. Water

This taxonomy—and the details of each category—will be discussed in detail in Chapters 7 through 13. Briefly, though, the rationale for this taxonomic scheme is the following:

• Carbon is the currency of climate change.

• LULUCF, clean tech, and sustainable property represent market-based initiatives to mitigate emissions from sources such as agriculture, forestry, power, transportation, industry, and built property, which collectively account for almost all the sources of global anthropogenic GHGs.

• Water is a primordial resource that will be significantly impacted by climate change.

Regardless of the classification, it is critical to understand that the climate change theme provides the opportunity for alpha in each of these investment classifications—hence the name of the book, Environmental Alpha, or alpha derived from investment opportunities arising from climate change.

Environmental alpha refers to the return earned as a result of manager skill, as opposed to return earned from market exposure (beta). It exists because the drivers of return—science, economics, policy, and technology—are dynamic, opaque, and complex, making it possible for certain investors to gain advantages that they could skillfully exploit to generate a return that is not attributable to market exposure. These advantages could be access to and understanding of relevant information (e.g., better understanding of Chinese climate policy, new “clean” coal technologies, or the working of the UN Clean Development Mechanisms) or access to scarce resources (like the optimal site for a wind farm).

In this sense, environmental alpha is like other alphas. It also shares two other attributes: environmental alpha should have a low correlation with the market, and it is subject to three universal constraints: alpha is scarce, transitory, and capacity constrained. However, because the source of the alpha arises out of the phenomenon of climate change, the potential for continually evolving alpha opportunities is great.

All Alpha factors will fade into the background eventually. . . . Therefore, it becomes a question of how long the trend can last. Given the 40-50 year investment horizon and the size of the problem—$45 trillion of investment needed in energy markets alone—we believe that climate change will remain the source of identifiable Alpha for many years ahead.

“Investing in Climate Change 2009,” DB Advisors, 2008

INTENDED AUDIENCE

This book has value for all investors but it is specifically written for institutional investors such as defined pension funds, endowments, foundations, insurance companies, and superannuation funds, organizations with “delegated investment responsibilities” (Taylor and Donald 2007). Institutional investors differ from individual investors in that they oversee and invest assets on behalf of an enterprise/organization or group of individuals. Many operate under trust law, which imposes a fiduciary obligation on the trustees and the advisors to these funds. While the nature and scope of this obligation varies from jurisdiction to jurisdiction, in general “. . . any investment strategy chosen by a trustee must be founded on objective evidence, which has been rigorously analyzed and carefully considered by the trustee” (Taylor and Donald 2007).

As fiduciaries, institutional investors are required to make informed and reasonable decisions. This requires that they understand the material risks facing their portfolio and suggests that they likewise understand new investments available to them. This was precisely what was proving to be problematic for institutional investors when they considered the China carbon fund and other environmental investments. These investment opportunities presented them with a variety of material but unfamiliar issues, all related to climate change: the current and potential Chinese and international climate policy issues; how the UN CRM worked and whether the fund would be able to comply with its standards; the workings of the international carbon markets; and transformative clean technologies. More generally, investors all seemed to need help understanding four main topics covered in the book:

• The nature of the challenge and the opportunity presented by climate change

• Climate change and fiduciary duty

• The opportunity set and associated challenges

• Practical matters

This book is structured to provide institutional investors with information on all of these topics.

Environmental Alpha is intended for institutional investors because climate change will impact them more profoundly and comprehensively than other investors. This is because institutional investors are universal owners, which is defined as:

. . . a large financial institution, such as a pension or mutual fund, which owns securities in a broad cross-section of the economy. Because of the diversified portfolio of stocks, bonds and other asset classes, investment returns (especially long-term ones) will be affected by the positive and negative externalities generated by the entities in which the universal owner invests. Being external means they are not controlled by the entity and therefore can be viewed in terms of potential risk (for negative externalities) or opportunity (for positive ones).

“Universal Ownership: Exploring Opportunities and Challenges,” Mercer Consulting Conference Report, 2006

Climate change is a negative externality or risk that will broadly impact every asset class, sector, industry, and investment in different ways and at different times. “The fact of climate change is unlike any other ‘risk factor’ that our modern financial system has ever confronted. It contains no reciprocal or alternative opportunity. It is a universal threat that will spare no nation, no market, and no industry” (Northrop and Sassoon 2006).

Professor Sir Graeme Davies, Chairman, Universities Superannuation Scheme Ltd. phrased it as follows:

The question that you may be asking is why should a pension fund be interested in a long-term issue like climate change, when many of us live or die by quarterly or yearly performance data? Given that this is the case, why does USS as a pension fund believe that we should be addressing climate change as an issue for our fund? There are two reasons: Firstly, we are universal owners. Secondly, we need to meet the real needs of our members and beneficiaries.

“A Climate for Change: A Trustee’s Guide to Understanding and Addressing Climate Risk,” Mercer Consulting, 2005

Institutional investors are the intended audience also because their size and goals allow them to positively affect the climate change problem. Environmental investments are ultimately market-based solutions that attempt to mitigate GHG emissions or adapt to the impact of climate change. Because of the scope of the problem, the market-based solutions require an enormous amount of investment capital in order to be effectively developed and deployed at a meaningful scale. Some estimate that the capital cost alone of transforming the U.S. power sector would be on the order of $10 trillion, or one year of U.S. gross domestic product (GDP) (see Chapter 9). Governments will not be able to single-handedly provide the necessary capital, especially during financially trying times like we are experiencing today. Institutional investors—with over $40 trillion in assets under management—are an obvious source of this capital, especially as environmental investment opportunities cut across their portfolio allocations and offer the possibility of robust uncorrelated returns.

Environmental Alpha seeks to create an alignment of interests: institutional investors need to manage a significant externality and to find skill-based returns that will help them achieve their investment objectives; society needs large, long-term sources of investment capital to fund the development and dispersion of the transformation technology that will help solve the climate problem.

STRUCTURE OF THE BOOK

This book is a compilation of essays tied together by a common goal of providing institutional investors with the information they need to prudently assess and respond to the risks and opportunities associated with climate change. Its division into four parts corresponds with the four major areas of need mentioned earlier:

1. The nature of the challenge and the opportunity

2. Climate change and fiduciary duty

3. The opportunity set and challenges

4. Practical issues

Part One: The Climate Change Challenge

Part One provides the critical background information investors need to understand the phenomenon of climate change and, more specifically, the four basic drivers of returns of environmental investing: science, economics, policy and regulation, and technology.

In Chapter 1, Dr. Richard Betts, head of Climate Impacts at the Met Office Hadley Centre, presents the science of climate change. Dimitri Zenghelis, chief economist of the Cisco Systems’ Climate Change Practice, extends this discussion in Chapter 2, where he examines the economic consequences of climate science. In Chapter 3, David Gardiner, principal of David Gardiner & Associates, then explains the myriad of current and potential climate change policies intended to shape our individual and collective responses to climate changes and how they could potentially impact environmental investments.

Part Two: Climate Change and Fiduciary Duty

Climate change presents institutional investors with a new set of risks, which, because institutional investors tend to be universal owners, could potentially impact their entire portfolio.

Mindy Lubber, president of Ceres, begins Part Two with a discussion of the four major climate change risks facing institutional investors: physical, regulatory, reputational, and litigation. Paul Watchman uses Chapter 5 to extend his groundbreaking work in the United Nations Environment Programme Financial Initiative Report, “A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment” (or what has come to be called the Freshfields report), and makes clear that climate change is the overarching risk facing fiduciaries and that fiduciaries must incorporate environmental issues into their investment decisions. In Chapter 6, Innovest CEO Matthew Kiernan’s analysis of Carbon BetaTM dispels the commonly held view that environmental investing is simply another flavor of SRI, and in so doing frees investors from the constraining yoke of SRI.

Part Three: Environmental Investing

With this foundational information, the book moves to environmental investing proper.

In Chapter 7, I provide the taxonomy of environmental investing, as well as delineate the idiosyncratic challenges of environmental investing that give rise to the opportunities to generate environmental alpha. In Chapter 8, Mark Fulton and Bruce Kahn of Deutsche Asset Management’s Climate Group examine the opportunities set in more detail and situate environmental investments in a portfolio context.

Experts in each of the major classifications then provide a detailed explanation of the specific climate change-based investment thesis and opportunity set associated with each category. In Chapter 9, Jurgen Weiss of Watermark Economics and Veronique Bugnion of Point Carbon begin by examining the carbon markets and the related alpha opportunities. In Chapter 10, Charles Palmer and Stefanie Engel of the Institute for Environmental Decisions link this discussion of the carbon markets to specific financing solutions that seek to reduce emissions from deforestation and degradation (REDD), and Martin Berg of Merrill Lynch explains the investment opportunities associated with REDD activities. Russell Read and John Preston of C Change Investments next delineate clean tech investing and discuss clean tech’s coming of age. In Chapter 12, Tim Dixon, professor of real estate and director of the Oxford Institute for Sustainable Development (OISD) in the School of the Built Environment at Oxford Brookes University, United Kingdom, takes on the challenge of defining and explaining the relationship between climate change and sustainable commercial property as a source of environmental alpha.

Part Three concludes with Rod Parsley, portfolio manager of the Perella Weinberg Oasis Fund, and his colleague Hua Liu, deconstructing the water market from an investor’s perspective.

Part Four: Practical Considerations

This understanding of the categories of environmental investing leads to a discussion of three practical issues. In Chapter 14, Danyelle Guyatt, principal in Mercer’s Responsible Investment team, explores how institutional investors could most effectively/efficiently confront/respond to the global, transgenerational challenge of climate change and convincingly suggests that collaboration is the model of choice. In Chapter 15, Nick Hoskins and Martin Batt of the Virtuous Circle tackle the larger issue facing institutional investors, the convergence of climate change, corporate agendas, and environmental investing.

The book concludes with my suggestions of how institutional investors could practically approach and exercise their fiduciary duties in this time of climate change.

FINAL THOUGHTS

Climate change is upon us. “The stakes, for all life on the planet, surpass those of any previous crisis. The greatest danger is continued ignorance and denial, which could make tragic consequences unavoidable” (Hansen et al. 2008). It requires a response, especially from fiduciaries. This book hopes to act as a cairn on the path out of the cave.

ANGELO A. CALVELLO

REFERENCES

Chhabra, R. 2008. Environmental investing: Is the grass always greener? JP Morgan, Investment Analytics and Consulting Newsletter. April.

DB Advisors. 2008. Investing in climate change 2009: Necessity and opportunity in turbulent times. Deutsche Bank Group. October. www.dbadvisors.com/deam/stat/globalResearch/climatechange_full_paper.pdf.

Hansen, J.M. Sato, P. Kharecha, D. Beerling, R. Berner, V. Masson-Delmotte, et al. 2008. Target atmospheric CO2: Where should humanity aim? Open Atmospheric Science Journal 2 (November): 217-231. www.bentham.org/open/toascj/openaccess2.htm. Accessed March 1, 2009.

Kiernan, M. 2008. Investing in a sustainable world: Why green is the new color of money on Wall Street. New York: AMACOM.

Mercer Investment Consulting. 2006. Universal Ownership: exploring opportunities and challenges. Conference Report. Saint Mary’s College of California, April 10-11.

Mercer Investment Consulting. 2005. A climate for change: A trustee’s guide to understanding and addressing climate risk. The Carbon Trust. www.thecarbontrust.co.uk/trustees.

Northrop, M., and D. Sassoon. 2006. “Climate Change Now a Fiduciary Duty—and Opportunity.” The Environmental Forum. September/October.

Pew Center on Climate Change. Global warming basic introduction.www.pewclimate.org/global-warming-basics/about. Accessed March 8, 2009.

Taylor, N., and S. Donald. 2007. Sustainable investing: Marrying sustainability concerns with the quest for financial returns for superannuation trustees. Russell Investment Management, August.

Acknowledgments

This book is truly a collaborative effort. I’d like to thank each of my contributors for their substantial efforts, patience, shared vision, and help in the editorial process. Editing is not a skill that comes easily, especially to a guy who started in the business as a floor trader. I tried to bite but not leave teeth marks. No study is immune to errors; for those, I alone am responsible.

In addition to the named contributors, others have supported me in this endeavor: my mother confessor, Lia Abady; my facilitator, Rob Challis; my advisor, Tony Ryan; and my booster, Bill Weldon. Others also have contributed their special skills. Emma Baldock was an invaluable conduit to ideas and sources. Stuart Mason, Chris Suedbeck, Jerome Malmquist, and their colleagues at the University of Minnesota generously supported the creation of the case study. Matthew Kiernan acted as a matchmaker in more than one case. Bob Jaeger provided regular doses of realism that challenged me to rethink some basic assumptions. Matt Bassista witnessed the genesis of this project and his suggestions helped shape the scope and content, especially with regard to the water chapter. Steven Howard provided valuable direction on how to present the science of climate change. Jamey Sharpe and Phil Ruden offered their insights into practical fiduciary issues. Philip Payne, Bob Ratliff, and Christian Gunter helped create the sustainable property case study. And the friends who have helped me with my thoughts, design, writing, and proofreading: Sara DiVillo, Mandy Kristufek, Valerie Oseguera, and especially Phil Schneden, who has been with me on this journey since Proviso East.

The people at John Wiley & Sons contributed greatly to this project. I’d like to thank my editor, Pamela van Giessen, for believing in me—again—and Emilie Herman, Kate Wood, and Rosanne Lugtu for their patient and gentle support.

Finally, I want to thank my wife, Lisa, for her unwavering confidence and support, and my children, Giana, Joe, and Michael, for believing in me and giving me the courage to take on this project. To them and all of those who have helped, namaste.

A. A. C.

PART One

Introduction to Climate Change Issues andConsequences

CHAPTER 1

The Science of Climate Change

Richard A. Betts, PhDa

Climate change is a complex scientific problem, but its implications could have major consequences for the human species and indeed the rest of the world. Moreover, human actions to reduce climate change and adapt to its effects could also have major consequences. In order to make informed decisions about our responses to the issue, we require robust scientific understanding of the issue and the likely consequences of our actions, or at least some grasp of the range of potential consequences if we are unable to be certain.

This chapter reviews the latest scientific conclusions about recent climate change and its causes, and discusses the implications of different levels and timing of emissions reductions. Climate science issues relating to adaptation to climate change are also discussed. Most of this chapter is grounded in the science described in detail in the volume “The Physical Science Basis” in the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC 2007), which is widely known as “AR4.”1 More recent work from the Met Office Hadley Centre is also discussed.

HUMAN-CAUSED CLIMATE CHANGE: THE EVIDENCE

A vast body of evidence demonstrates that the world is becoming warmer and that this is not a natural phenomenon—beyond reasonable doubt, humans are to blame. By gathering data from a wide range of sources, from weather stations to tree rings, from ice cores to computer models, we can clearly see that the climate has already moved out of its previous natural state. This forms the bedrock of evidence that the human species is already influencing its own environment and can now choose whether to continue to increase this influence or reduce it.