Climate Change Mitigation Engagement A Rational Strategy for Universal Owners

Craig Mackenzie, Head of Sustainability

November, 2010

The Universal Ownership concept

The problem of externalities– Companies (and consumers) maximize profit by passing on costs to society (e.g. pollution)

By definition, for most investors externalities are financially beneficial (if socially costly)– they benefit from the increased earnings of companies, but don’t bear the social costs

But for Universal investors its different

– they own the whole economy, so they bear a proportion of the social costs associated with externalities

The time-horizon dimension– many environmental externalities give rise to social costs in the future: universal owners

with long-term time horizons will be most severely affected.

Pension funds are the classic Universal Owners– but also applies to life insurance funds, charitable foundations, and sovereign wealth

funds.

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Universal owners bear the costs externalised by companies and consumers

The external cost of carbon

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“…“…analyses that take into account the full ranges of analyses that take into account the full ranges of both impacts and possible outcomes…suggest that both impacts and possible outcomes…suggest that BAU climate change will reduce welfare by an amount BAU climate change will reduce welfare by an amount equivalent to a reduction in consumption per head of equivalent to a reduction in consumption per head of between 5 and 20%.” between 5 and 20%.”

Stern Review on the Economics of Climate ChangeStern Review on the Economics of Climate Change

The long-term social cost of carbon emissions could be very high

The practical costs of climate change

Health warning - the extent of costs is uncertain– Don’t know how fast temperatures will rise– Don’t know to what extent rising temperatures will trigger secondary consequences e.g.

more extreme weather events, rising sea-levels, changing precipitation– Don’t know whether non-linear feedbacks may accelerate and amplify affects, perhaps

catastrophically

Kinds of cost– Damage to real estate due to flooding, higher costs of flood prevention– Permanent loss of real estate due to rising sea levels– Higher costs of water supply – Lost agricultural production due to drought, loss of agricultural land due to desertification– Higher cost of heat-waves, forest fires– Risk of insurance industry collapse– Increased costs of disease– Higher energy costs due to increased demand for cooling

4Source: Any back-up or source information should be detailed here.

Costs are uncertain, but likely to be very high and will affect the whole economy

Implications for Universal Owners

Consequences for investors– Lower capital growth, smaller dividends, higher costs of real estate ownership – Loss of capital, real estate destruction, company bankruptcy

= Significantly lower portfolio returns

As recent banking crisis showed, a few hedge funds may profit by shorting e.g. damaged real estate and vulnerable insurance companies etc.

But a 5-20% fall in global GDP will have such widespread effects that Universal owners will not be able to escape them

The costs of climate change could undermine long-term investors capacity to meet their liabilities

This changes the burden of proof for ESG – For many action on ESG is a optional extra, to placate a minority of bothersome

stakeholders – If the above argument is correct, it makes action on climate change a fiduciary

obligation for Universal Owners

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Is action on climate change a fiduciary obligation for Universal Owners?

How should Universal Owners respond?

UOs cannot position their investment portfolio to avoid the consequences of severe climate change…

…the fundamental solution is to attempt to mitigate the risk of serious climate change

So what can Universal Owners do?

Four tests for a Universal Owner climate change mitigation strategy

– Scale: reduces emissions and at sufficient scale to avoid >2°C (450ppm stabilisation)

– Additional: goes beyond what is already happening

– Timely: starts reducing emissions quickly – 5-10 year window

– Capacity: action by investors is within their power and can realistically deliver intended result

Strategy options

1. Lobbying government to introduce systematic carbon policy (e.g. Cancun)

2. Allocating capital to fund low carbon technology and low carbon infrastructure ($1tn per year required by 2025 – according to IEA)

3. Engagement to drive large-scale investment in energy efficiency by companies

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Action must be at scale, additional, timely, and within investors power to act

Why energy efficiency is important

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Source: International Energy Agency (2010) World Energy Outlook

Source: McKinsey & Company (2009), Pathways to a Low-Carbon EconomyVersion 2 of the Global Greenhouse Gas Abatement Cost Curve

Barriers to energy efficiency

Why would profit maximising companies ignore opportunities to increase profits?

Barriers to action on energy efficiency

1. Fragmentation of opportunities

2. Lack of awareness of opportunities

3. Agency issues – the landlord-tenant split

4. Energy inefficiency ingrained in culture and procedures

5. Failure to make capital available to operational managers (even with RoI at 30%+)

6. Higher hurdle-rates for energy efficiency projects than for commercial projects

7. Harder to measure energy costs avoided

8. Poorly implemented technologies fail to deliver expected outcomes

9. Lack of priority given by senior management decision-makers

Common feature: most of these barriers are behavioural

With more senior management attention, and information about best practice, many could be overcome

Institutional investors are good at getting senior management attention, and encouraging adoption of best practice

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Universal Owners Energy Efficiency Engagement Program

Towards a Universal Owner Energy Efficiency Engagement Program

Develop a global scale collaborative engagement program to drive operational energy efficiency, as well as product-use efficiency, carbon efficient supply chains

Engagement to ask companies to implement specific profit-positive abatement technologies and techniques

Engagement to ask companies to take generic actions to improve energy efficiency– Setting carbon targets– Calculate their own abatement cost curve to identify cost effective opportunities– Establish management system to identify and overcome barriers – Monitoring and reporting progress to shareholders

Via the usual engagement mechanisms (meetings, collaboration, proxy resolutions, integration)

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Summary of key features

Universal owners face substantial risks from severe climate change

They have a strong incentive to encourage carbon abatement, and possibly a fiduciary obligation to do so,

UOs should support public policy, and allocate capital to low carbon transition

The energy efficiency engagement strategy is also attractive

Scale– Profit positive abatement of 5 Gt CO2e per annum is possible

Timeliness– Energy efficiency abatement can start now, and deliver these reductions soon, giving

governments more time to regulate

Additionally– Without action to overcome them, barriers to action on energy efficiency will remain

Capacity– Energy efficiency measures are profit-positive: they add value for current shareholders.

Active owners can ask for them without conflict– As CDP has shown, collective action by investors can drive significant action on carbon by

very large numbers of companies

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Important information

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Issued by: Scottish Widows Investment Partnership Limited, Company No. 794936. Registered Office in the United Kingdom at 10 Fleet Place, London, EC4M 7RH. Tel: 0131 655 8500. Scottish Widows Investment Partnership Limited is authorised and regulated by the Financial Services Authority and is entered on their register under number 193707 (www.fsa.gov.uk/register).

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