Price of taking responsibility
Environmental considerations are set to play an increasingly significant role in investment policy following two major new developments earlier this year.
The Kyoto Protocol became a legally binding treaty in February. It aims to slow down global warming by demanding cuts in greenhouse gas emissions by an average of 5.2% relative to a 1990 baseline over the period 2008-2012. Much of the difficulty surrounding its ratification was due to the perceived impact this would have on the participating economies which, broadly speaking, are those of the OECD – with the notable and much-publicised exception of the United States.
This in turn raises the issue of the affected companies on the one hand, those that do not have to deal with this additional cost burden on the other, and consequent implications for their shareholders.
Also of potential concern to investors is the Emissions Trading Scheme (ETS), an EU initiative that follows on from the Kyoto Protocol. The scheme is based on set limits for emissions of carbon dioxide – generally known simply as carbon emissions and fines are imposed on companies which exceed the limits.
In the first phase of the plan the fine is E40/tonne and in the second phase from 2008 to 2012 it will be E100/tonne. The first phase applies only to carbon emissions, while the second phase will convert all greenhouse gases to a carbon dioxide equivalent.
Companies may buy carbon certificates, which were originally set at E6 per tonne but which, because of overproduction of carbon are now at E23 per tonne, having peaked at around E30 per tonne as a result of the increase in demand for the certificates due to the drought in southern Europe and subsequent shortage of hydro-electricity.
Either way, the Kyoto protocol results in additional costs for the power utilities. The question for those at the coal face - the utilities - is how far can these costs be passed on to the end user?
“Utilities will treat it as an additional input to the cost of power,” says Neil Murray, investment manager for corporate bonds at the Scottish Widows Investment Partnership. “They will simply pass on the price to their customers.”
Fortunately, the utilities market has remained stable since the implementation of the treaty. “Governments allowed their utilities generous allowances within the framework of the protocol,” says Murray; “the price of the carbon certificates has increased at a reasonable rate and the utilities have accepted the new system without needing to be prompted. As a result of this stability, utilities will be able pass on the new costs that come into effect in 2008 as far as need be.”
He adds: “If this should become uneconomic the utilities will build new plant.”
Rory Sullivan, a director of responsible investments at Insight Investment sees significant pressures ahead. “While governments granted generous permits in the first phase they are likely to tighten up considerably in the second phase,” he says. “The issue of how far governments will allow electricity prices to rise has become a major political question.”
For industrial companies that are heavily reliant on energy, one issue is how far they have been hedging their energy costs and, like the utilities, how far they can pass on their higher energy costs once the hedging contracts run out.
It is true that energy is just one cost in the production process. It will be those companies that are the most energy dependent which will bear the greatest competitive pressure, both in terms of direct energy costs and costs incurred to improve energy efficiency.
Further problems arise because there are countries that are affected by the Kyoto Protocol and ETS and those that are not. “For utilities it does not matter because it is difficult to transport power,” says Murray. “But companies that are exporting to countries where the cost of power is lower are at a competitive disadvantage.”
The countries that have signed the treaty account for 55% of greenhouse gas emissions. So the potential for competitive disadvantage and subsequent loss of earnings and profitability is significant.
So how far are institutional investors taking this issue into account? “It is on their minds,” says Murray. “But it is one of many risk factors which they have to consider.”
The degree to which these factors can be considered is dependent on analyst research into the matter. “Most analysis in this field has been done on the utilities,” says Sullivan. “However, very little has been done on the companies which have been impacted.”
As the climate change issue rises up the political agenda the investment community has its work cut out.