Cracking up: The climate change challenge facing the insurance industry

3 Dicembre 2006 · Nuovi rischi / Nuevos riesgos

Good corporate governance requires companies to assess and mitigate risks from climate change. Now institutional investors are pressing for action, even outside the ‘Kyoto arena’.

The Carbon Disclosure Project (CDP), a co-ordinating secretariat for institutional investor collaboration on climate change. In May 2002, CDP wrote to the 500 largest companies in the world as measured by market capitalisation (the FT500) asking them to identify the business implications of their exposure to climate-related risks, and explain what they were doing to address these risks. The letter was sent on behalf of 35 institutional investors, including pension funds, fund managers and insurance companies who jointly represented assets in excess of $4.5 trillion.

CDP estimated that the discounted present value of potential carbon liabilities within a single emissions-intensive manufacturing firm could represent 40 per cent of its entire market capitalisation, under certain plausible scenarios. Companies with strong risk management policies – early emissions management, GHG trading, efficiency gains and technology development – will gain competitive advantage.

The fragility of the global equity markets makes the cost of carbon more pertinent. The market will not want earnings revisions, hidden costs and other liability scares due to weather events and GHG regulatory developments, or the increased fuel and electricity costs arising from regulation and carbon taxation. Measures to limit GHG emissions will reward efficiency leaders and place pressure on management, while higher energy prices will soak up cash and not all firms will be able to pass on increased costs to customers.

The context for action

The CDP research showed that many institutional investors recognise that corporate competitiveness and profitability can be influenced by climate change. Weather-related factors are already affecting earnings for some companies. A new emphasis on governance and disclosure, and increasing institutional investor activism will place more pressure on companies to respond to climate change issues, as will potential GHG liabilities.

Investors failing to take account of climate change and carbon finance may be exposed to significant risks and serious investment repercussions.

Research suggests the effects could run into the billions of dollars for high risk companies. What is more, it takes several years for companies to put effective risk management strategies and operating systems in place, so immediate action is favoured.

More than half the FT 500 companies have already recognised climate change as a serious issue and are developing strategies to reduce greenhouse gas emissions. For example:

– Japanese firms Mitsubishi and Mitsui have both taken a financial stake in emissions trading firms, the former with Natsource, the latter with CO2e.com.

– TotalFinaElf, Shell, BP, BG, Centrica, Norsk Hydro, Statoil, Imperial Oil, Conoco have all made attempts to quantify their GHG emissions profiles and many have set aggressive targets for the future.

-Norsk Hydro, Statoil, Shell, BG, BP and TotalFinaElf are all involved in emissions trading as a means of meeting emissions targets at optimal efficiency.

– Rail companies have begun to market their services on the strength of their low carbon characteristics.

– Banks are starting to explicitly address climate risk in credit quality assessments and equity valuation. Hypovereinsbank considers climate change in its general environmental risk audit in its credit risk assessment.

– Credit Suisse considers climate change factors as part of its risk assessment process in project finance, and in credit transactions in general.

– Swiss Re’s ‘Greenhouse Gas Risk Solutions’ develops and offers financial services and products supporting GHG reductions.

Meanwhile, companies see opportunities to create top line revenue growth from products and services predicated on a low carbon future.

The impacts of climate

Risks from the direct impact of climate change will affect companies vulnerable to intense and frequent storm events, temperature and precipitation changes, sea level rise, drought and other climate-related extremes. Not all sectors will suffer: certain climate trends will bring economic benefits, but extreme weather events are already having a conspicuous impact on sector economics and atmospheric scientists indicate that there is little reason to believe in a permanent return to ‘normal’ weather.

Worldwide economic losses due to natural disasters appear to be doubling every 10 years, and have reached almost $1 trillion over the past 15 years. Although damage trends are very closely linked with the growth of economic activity in high-risk areas, the effects of climate change will be to exacerbate these losses.

Other effects will likely include higher food prices, depleted energy resources, exacerbated by increase air-conditioning load, physical assets made more vulnerable, to fire and flood, and shifting weather patterns that will disrupt tourist economies. Impacts may be indirect: reports are emerging that the US semiconductor industry is at risk from potential disruptions to crucial components from Taiwan, where weather-induced water shortages are jeopardising chip manufacture.

Regulating emissions

Emissions regulations are a reality regardless of Kyoto ‘entering into force’ and will relate not just to carbon-intensive companies, but also companies with higher fuel and energy costs, and companies involved with fossil fuels. These shifts may result in counterintuitive outcomes; for example, an energy-intensive manufacturing company may see a net benefit to its bottom line if demand for its products picks up as part of the mitigation effort.

Virtually all industrial companies operating in OECD countries will have direct or indirect exposure to GHG emissions regulation.

The key factors influencing corporate financial risk from climate change and GHG mitigation are:

– Poor overall strategic awareness, leading to erosion of competitive advantage and general market underperformance.

– GHG emissions intensity, which increases the overall company compliance burden.

– Energy intensity, which increases vulnerability to fuel and electricity price rises.

– Geographic split, which determines a company’s weighted average country carbon reduction target, its exposure to weather extremes, and its ability to capitalise on financial incentives in clean power.

– Marginal abatement cost and the ability to purchase emissions credits, which determines the direct capital implications of required emissions reductions.

– The mix of products and services, which affects the extent to which the underlying business model is influenced by low carbon substitutes or weather extremes.

– Vulnerability to reputational damage, which affects the extent to which a company is affected by popular sentiment in support of positive action to address climate change.

Because of regional differences in approach to GHG management and natural variations in climate conditions the geographic distribution of a firm’s operations and markets is a critical determinant of equity carbon risk.

Investors heavily exposed to GHG-intensive sectors in regions aggressively pursuing emissions reductions will face greater risks than those with more carbon-diversified portfolios.

For example, beginning in 2005, European companies will have to pay 240 ($45) per ton of CO2 emitted until 2007 and a 2100 ($113) penalty, starting from 2008, if their GHG emissions exceed their allowance. Given the time it takes to develop and implement a company-wide emissions management programme – estimated between one to two years – firms that have not yet embarked on this process could face sizeable financial penalties.

Regional Kyoto policies could drive investment out of Annex 1 (OECD) countries. This would render certain emerging markets’ companies more cost-competitive. Investment capital may also be preferentially channelled towards high-return energy efficiency projects in emerging markets.

While non-Annex 1 companies may have an advantage in the short-term, the EU, for example, may in due course, have a powerful case to restrict imports or to impose a carbon levy under GATT rules. Furthermore, the proactive stance taken by several European countries does not seem to have rendered them less competitive. Companies in the UK – a region that has pursued a relatively aggressive regulatory agenda – considered to be taking positive, proactive measures to manage climate change risks have returned an average of 10.82 per cent to shareholders over the past 5 years, compared to FTSE 350 performance, non-capitalisation weighted, of 10.35 per cent and an MSCI World Index drop of 19 per cent.

The financial relevance of climate change depends more on the sophistication of company risk management than the prevailing regulatory environment.

From oil to clean technologies

IPCC predictions suggest that, if projected oil consumption forecasts are correct, weather-related disruptions to the equity markets will become more pronounced. Climate change will lead to more extreme weather events, significantly impacting coastal areas, the reliability of water sources, and the predictability of growing seasons. These are destabilising factors for developed and developing economies alike. Pressures to reduce fossil fuel dependency will continue to increase globally.

Meanwhile, global political leaders will increasingly turn their attention to measures that promote alternative, technology-led energy forms. Even outside the Kyoto agreement, President Bush used the need to reduce the US’ dependency on imported oil to call over $1 billion in support for hydrogen fuel cell development.

At the same time, energy efficiency and energy hedging will become more of an imperative. Fuel price volatility will increase and because energy expenses can be 20 per cent or more of overall operating costs in some industrial companies, even a small increase in primary energy prices can have a material impact where profit margins are already squeezed. Therefore, large industrial energy consumers will seek ways to minimise their oil dependency by becoming more energy efficient and by using alternative energy technologies and back-up power supply solutions.

The shift away from oil dependency offers substantial investment opportunities in ‘new’ energy option. The World Energy Council reports that the global market for renewable energy is likely to be $234 billion to $625 billion by 2010 and $1,900 billion by 2020.

The CDP data reveals that certain corporations are pro-actively embracing clean energy solutions – even without firm regulatory underpinning. Clean energy applications are driving new business opportunities, cost management and competitive advantage for corporations across all sectors.

Trading in greenhouse gases offers essential risk hedging and price realisation functions. However, CDPW estimated that it takes roughly one – two years for a large GHG-intensive firm to progress through the emissions assessment and mitigation process. Companies acting sooner to secure emissions reductions via the trading markets can expect to pay less for emissions reductions.

Corporate governance

In addition to direct emissions regulations, there are indications that large emitters – particularly those in the US – could face multi -billion dollar lawsuits akin to those associated with asbestos, tobacco and high-fat fast food. On 31 January, 2003, attorney generals in Maine, Massachusetts and Connecticut announced they would sue the Environmental Protection Agency to make it regulate carbon dioxide. The officials argue that there is no longer any doubt that carbon dioxide emissions are responsible for global warming, and that failure to regulate carbon dioxide violates the Clean Air Act.

City-level lawsuits from Oakland, California and Boulder, Colorado regarding US contributions to global warming may also be viewed as legal reference points for future international trade sanctions against the US over its non-participation in Kyoto.

An aspect of carbon finance that has received little attention is the implications for company directors and executives, pension fund trustees, money managers, actuaries, and pension consultants.

Shareholder activism on climate change is on the rise. In the US, shareholder activists filed 19 climate change resolutions in the 2002 proxy season.

The five largest carbon dioxide emitters among US electric power companies faced global-warming and other pollution-related shareholder resolutions. The actions were announced by a coalition of shareholders that included the State of Connecticut Retirement Plans and Trust Fund.

What is particularly noteworthy here is the changing nature of shareholder activism. Traditionally, the most active proxy filers have been umbrella organisations such as the Interfaith Centre for Corporate Responsibility, other faith or issues-based groups, and socially responsible investors. Over the last few years, however some of the US’ most powerful institutional investors – including CalPERS and TIAA-CREF – are becoming increasingly activist on environmental and social issues.

This accelerating convergence of the corporate governance/fiduciary agenda with the drive towards greater corporate responsibility on environmental and social issues will place additional pressure on fund managers, trustees and company officers to understand carbon risks, and to report on them where prudent to do so.

HOUSING INDUSTRY ASSESSES EFFECTS

As property manager at the Association of British Insurers, Jane Milne aims to predict the type of claims that members of the ABI will receive in future years. At a recent meeting for UK housing and construction organisations she explained what the likely effect of climate change would be.

She says that worldwide economic losses due to natural disasters – such as last year’s flooding across Europe – are doubling every 10 years and the UN Environment Programme has estimated that by the end of the decade they will be running at $150 billion. She describes some of the potential effects.

The biggest risk is likely to be from coastal flooding, she says, pointing out that 4.7 per cent of the UK’s housing was in coastal areas and so were many buildings, like power stations, that are important to the economy.

She points out how building use has changed: warehouses, where losses due to flooding could be minimised, have been converted to cafes, shops and houses that are economically more vulnerable. In addition to ensuring that buildings designed in those areas were proofed against wind, wave and salt spray, more drastic measures such as an unoccupied ground floor level may be required.

Milne says that in past years the greatest number of claims were for wind damage: “and there are 15 million chimneys waiting to fall,” she says.

More winter storms are predicted, along with a change in storm tracks that would shift French storms north to the UK. Wind speeds would increase by 5-8 per cent “but it is gust speed that really causes the damage. We can’t predict that,” she says, “but the impact is not linear: twice the speed causes four times the damage.” She says the design and number of roofs was the significant factor, so an increase in the number of apartment blocks over individual houses would reduce damage rates. “It doesn’t matter how strict building codes are, if the property owner doesn’t maintain it,” she said. She predicts that there would be a shift in management practices with more effort made to inspect and maintain roofs.

When it came to inland flooding, Milne said API was working on predictions of a 10-20 per cent increase in peak river flows, more in Scotland and the Northwest, and she said that could halve the effectiveness of flood defences. More thunderstorms and summer storms would lead to more flash flooding and that was less predictable than winter floods.

On the other hand, drier, hotter summers could halve soil moisture and cause more subsidence. “Then we need to think about foundation systems and about what is cosmetic and what is structural,”Milne says. For example, brick facias were attractive but if they crack due to movement that may allow rain to penetrate.

Some of these issues are being examined in a CIRIA project due to report in December. Funded by the DTI’s Partners in Innovation Programme, the NHBC, The Housing Corporation, RICS and CIRIA, the project will try to address the generally low knowledge among construction professionals about the effect of climate change. It will provide clients, designers and contractors with past examples of where various technical risks associated with climate change have been assessed and managed. It will also provide practical guidance to help manage the technical risk associated with different types of climate change-related impacts on a range of construction projects.

INSURANCE AGAINST CLIMATE CHANGE

Late in 2002, Swiss Re announced that it would withdraw cover against climate change liability claims if adequate risk management policies had not been developed. Jacques E. Dubois, chairman, president and chief executive of Swiss Re America Holding Corp, urged US businesses in a mid-2002 meeting businesses to begin committing to the reduction of greenhouse gas emissions, rather than waiting until regulatory terms are imposed. “Business should not delay in showing that it can both lessen its carbon footprint and positively influence government, stakeholders and the business community,” he said. The message was reinforced by Adrienne Atwell, head of sustainability at Swiss Re Americas Division, who said in June this year that corporations and financial institutions should develop sustainability management programmes, because “those who avoid these issues risk falling behind on economic, and potentially, reputational grounds.”

Swiss RE T currently participates in the UN Environmental Programme Climate Change Working Group and in mid 2002 produced its own discussion document on the issue, “Opportunities and risks of climate change”.

The company argues that insurance companies have unique experience in dealing with risk, so they can be decisive in dealing with climate change.

– It can identify risks, especially those that are not yet the subject of public debate. For example, it can point out that apparently harmless climatic anomalies, such as a “particularly warm” summer, can have far-reaching consequences.

– The industry can contribute towards ensuring that identified risks are actually perceived by those affected. This means making concrete linkages, the aim being to show where and how climate changes affect individual interests.

– The insurance industry provides decisive assistance in analysing identified risks. How do weather-related damage and losses occur? What influences their extent and probability of occurrence? How can they be qualitatively described, or even better, quantified?

– It can assist in reducing climate risks by supporting a practicable approach to climate protection in line with the principle of sustainability.

– It is the task of the insurance industry to facilitate insurance for weather risks despite climate change and to continue providing cover which is both adequate and affordable.

Swiss Re notes that, for its own protection and in the interests of the insured, the insurance industry is also called upon to foresee the indirect consequences of climate changes at an early stage so as to adapt itself, its products and those insured to the development in time and be able to provide the insurance cover required.

Source Power Economics
Author Janet Wood (janet@earthed.info, or website www.earthed.info)
Publication Date 26.08.2003
Document Type News articles
Issue/Topic Energy & Climate
Risk
Company BG Group plc. BP p.l.c. ConocoPhillips Mitsubishi Corporation Mitsui & Co., Ltd. Norsk Hydro ASA Royal Dutch/Shell Group of Companies Statoil Swiss Re

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