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In the 1999 motion picture ‘Analyze this’, a psychiatrist is reluctant to accept a mafia boss as his patient, but is then forced to accept and analyze him. I think the same applies to investors and climate change: investors are reluctant to analyze carbon exposures, but in the end they will also have to do it, says Willem Schramade, Sustainability and Valuation Specialist within Robeco’s Global Equity team.
Fossil fuel divestment is too simple an answer - as is ignoring the problem altogether. To make better decisions we need deeper analysis and serious attempts to value carbon exposures.
Climate change and falling carbon intensity
The COP21 conference is an important event that aims to keep climate change in check. With the planet currently on a path of well over two degrees global warming, crucial ecosystem services will likely be lost. The result would be warfare, collapsing states, and massive refugee flows. Clearly, such a scenario should be avoided. Fortunately, it can be avoided if we succeed in growing with less and cleaner energy, which requires a combination of technological improvements and pricing of externalities like greenhouse gas emissions (by means of taxes, caps or prices on carbon). In fact, according to a recent Citi report (Energy Darwinism II) the cost of action is lower than the cost of inaction, as the lower costs of fuels will offset the investments that need to be made. Still, COP21 faces a collective action challenge in that the bill needs to be split over the major emitting countries.
Even if COP21 succeeds, big question marks remain on the timeline and the interaction of technologies and regulation. Therefore, investment implications are far from clear. Yes, energy companies will be hurt and solutions providers will benefit. But by how much? When? And how are gains and losses going to be distributed?
Investors: too much intuition, too little analysis
Unfortunately, investors on both sides of the fossil fuel debate spectrum tend to take an intuitive approach that fails to value carbon exposures. The fossil fuel divestment movement simply excludes fossil fuels, which means it does not price carbon exposures. And traditional energy analysts tend not to put carbon prices into their models. They say that the energy transition is too unclear and likely too far out to be able to calculate anything about it. I think that is too easy and lazy. Carbon exposures can and should be valued and priced.
Analysts can devise scenarios, use shadow carbon prices, do sense checking on demand forecasts, while taking into account the future energy intensity of the economy. What if the carbon price goes to USD 40 or even USD 100? Who is going to be hit and in what way? For an oil company, what does a certain carbon price mean for its cost base, for the price of oil and its cost curve? What happens to the volumes and prices of derivate products like oil-based chemicals?
And what about the ripple effects further down the value chain, in industries like packaging, textiles, etc.? How will it hit companies’ profit and loss accounts? What’s already priced in? Which companies are best repositioning their business models? I’d love to see more work like that! So please, analysts, do your scenarios and calculations. Ask companies about their shadow carbon prices and other critical assumptions. To make better investment decisions, we need more openness and discussion on assumptions, scenarios and implications. Analyze this!