Investors should use a “Climate Change Exposure Grade” in their investment thesis

By Anonymous

In the absence of a true price for greenhouse gases, there is a more indirect, slower and more painful path toward addressing climate change which could be accelerated by leveraging the power of investors to change a corporation’s path by introducing a “Climate Change Exposure Grade” for every public company.

Companies currently deploy sustainability indexes and various forms of corporate social responsibility indicators under the cover of maximizing profits: Companies hope to increase revenues and margins by differentiating their products as “green” or to lower operational costs. While there are other justifications for sustainability initiatives (attracting human capital; mitigating future liabilities), I believe investors focus on these two reasons as they are more easily measured in terms of dollars and cents. Thus, in the absence of a carbon price, a company’s sustainability efforts are focused on the short-term benefits of increasing margins and not on reducing the production of underpriced negative externalities like greenhouse gas emissions.

Meanwhile, however, greenhouse gas emissions have led to climate change and there are tangible consequences for individuals, companies and countries. Some of these consequences can be witnessed by the increasing frequency of extreme weather events, droughts and floods. Many other future consequences are less predictable as weather and ocean patterns continue to change. Investors and their companies are exposed to these changes in a variety of ways: the markets for their products will change, their supply chain is interrupted, and the profitability of long-term investments disappears as the external environment changes drastically.

Under these circumstances, it makes sense for investors to add some kind of measure for the corporation’s climate change exposure when evaluating the likely return on investment. For example, a company whose supply chain has less exposure to droughts in the mid-west compared to a competitor should trade at a more favorable P/E multiple. A “Climate Change Exposure Grade” for a company could be created from inputs such as yields on catastrophe bonds, weather pattern changes and a company’s major markets. If this exposure score were independently determined by an “Climate Change Exposure Rating Agency”, financial investors would incorporate such information directly into their investment decision. In response, companies would incorporate climate change into their planning decisions, withdraw from exposed locations and advertise their efforts to adapt and mitigate exposure to climate change.

These actions in turn will create powerful signals to the affected communities as employment opportunities and capital investments diminish. Hopefully, this would cause local lawmakers to think more holistically about climate change and increase the motivation for climate change mitigation. This process is much less efficient than a carbon tax as developed economies have more means to adapt to climate change exposure and exposed emerging economies will be subject to less investment. However, in the absence of a carbon tax or some other clear price on climate change, the “Climate Change Exposure Grade” would accelerate the inevitable transition toward lowering greenhouse gas emissions.

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About macomberjohnd

HBS Finance faculty interested in sustainability in the built environment including devices, structures, townships, and cities.

One Response to “Investors should use a “Climate Change Exposure Grade” in their investment thesis”

  1. Interesting idea. I can understand the appeal of putting a rating on companies for a risk factor like exposure to climate change but I think implementation would be very difficult. Exposure to climate change is much more difficult to assess across industries and geographies than credit quality, which can be reasonably determined from a balance sheet. Companies that are in businesses related to natural resources and manufacturing would naturally be much more exposed to such risks but many are important contributors to the economy and to society, so discouraging investment is not necessarily warranted. If your system would be willing to make exceptions for such companies then the methodology starts to become more of an arbitrary rating and it is hard to see how that is much different from the many sustainability rankings that already exist. Global 100 is one example of such a ranking and many more exist at local levels.

    I also think that issuers who are likely to be shamed by the rating will simply opt not to pay for this rating. As is often the case for credit ratings, issuers only pay for ratings that they need in order to access capital and in this case such a rating would only be detrimental. If you plan to rate such companies without their cooperation it could be difficult to do accurately. If you do not think the issuers would pay for the ratings at all I wonder how this could be funded.

    I believe companies that take measures to become more sustainable deserve recognition and should be rewarded with lower cost capital by investors who seek to invest with companies that are mitigating this risk factor. Legislation like a carbon tax would be a definitive means of forcing businesses and society to change because it could be applied universally. Unfortunately I don’t see how a rating system could accomplish the same effect.

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