Investors, consumers and policy makers are paying increasing attention to environmental and social issues associated with business entities. This will impact on future corporate revenues, profits and investment returns. This article explores the climate change debate using "The Stern Review on the Economics of Climate Change", published by Cambridge University Press in 2007, as the core reference source. Understanding key aspects of the debate is a necessary first step to forecasting implications for investors.
Climate change policy responses depend critically on the science of climate change and whether there is a causal link between human activity induced greenhouse gas (GHG) emissions and global warming. A brief summary of the science is provided in chapter one of the Stern Review and NewScientist has published a special report, "Climate Change: A Guide for the Perplexed", which provides short summaries of the research associated with the 26 most common climate myths and misconceptions. This is available at http://environment.newscientist.com.
Assume for the moment that this causal link is established. That is, human activity is increasing the stock of GHGs in the atmosphere and the higher level of GHGs is causing global warming. The policy response might be to stabilise the level of GHGs in the atmosphere at some reasonable level by reducing annual GHG emissions to some target. Market forces on their own will not achieve this outcome because GHG emitters do not bear all the costs of increased GHG levels in the atmosphere. In economics, an externality is a cost or benefit resulting from an activity that is borne by parties not directly involved with that activity. Examples of externalities associated with global warming include: more frequent and extreme weather events such as hurricanes and typhoons, changes to global water patterns increasing the risk of droughts and floods, and melting of Greenland and west Antarctic ice sheets leading to rises in sea levels.
GHG emissions involve externalities that are more global and more intergenerational in nature than almost anything the world has dealt with previously. This is because current emitters in one country (such as a coal furnace) will impose climate change costs on people in other countries and future generations. GHGs remain in the atmosphere for extended periods of up to 100 years or more. Externalities such as pollution are more localised and limited in duration. This makes it easier for policy makers to develop and enforce solutions. Responses to climate change will require global policy and global governance; not an easy task. Because emitters do not bear these externality costs, there is no economic incentive for them to reduce their level of GHG emissions. Externalities cause a market failure in the sense that market mechanisms on their own cannot be relied on to produce the optimal levels of supply and demand.
It should be clear the economic argument for a policy response depends critically on the science that links human activity-induced GHG emissions to the climate change effects referred to above. If the science is invalid, there may be no externality and the costs incurred in reducing GHG emissions will be spent unnecessarily. Climate science is not my field of expertise, but there appears limited argument against the following statements: certain gases (GHGs) absorb and re-emit infrared radiation from the earth's surface, causing warming, the stock of GHGs now in the atmosphere is about 30 per cent higher than in pre-industrial times and higher than any time in the past 650,000 years, and the world's climate, defined as the average weather patterns over 30-year periods, has been warmer in the last part of the 20th century than at any time in the past 1000 years.
The climate change debate appears to centre on two issues: first, whether human activities or natural sources are causing the stock of GHGs in the atmosphere to rise. Natural emissions and absorptions of carbon dioxide amount to around 770 gigatons a year, while human activity and disturbances to the land, such as deforestation, currently results in around 30 gigatons per year. The second issue is whether the reason for global warming is increased levels of GHGs in the atmosphere or other factors, such as solar activity, oscillations in the Earth's orbit and other natural global weather cycles.
The complexity and long-run nature of climate change systems mean there will always be some debate on cause and effect and uncertainty around climate predictions. Beyond the uncertainties of the science, there are also significant uncertainties associated with the link between economic growth and GHG emissions, the costs of stabilising the level of GHGs in the atmosphere and if, when and how all these changes should be implemented.
Investors in companies that are carbon emitters will bear the direct costs of carbon taxes and the costs of changes in technology that result from new climate change policies. They will also be affected by the changes in demand for carbon intensive products and services caused by these policy changes. However, whether or not there are policy responses, changes in consumer behaviour and investor sentiment around these environmental issues will have an impact on energy prices and the future rates of return of entities that produce or use energy. Understanding the climate change debate, predicting policy responses, forecasting changes in technology, costs and consumer behaviour will all make this an important area for investors for many years to come.
