Seeking good positive returns.
Come rain or shine.
Sydney’s hottest day since 1939 – temperatures hit 47°C. Freezing weather grips cities across North America – Omaha, Nebraska sees new record low of -28°C. Typhoon Mangkhut devastates the Philippines and Southern China. US East Coast battered by Hurricane Florence.
Once again, extreme weather made headlines in 2018. In the UK, while we didn’t reach the highs of Sydney or the lows of Omaha, there were extremes by historical standards. Take St James’s Park, a short walk from Ruffer’s office in London. On 19 March 2018, there was snow on the ground. On 19 April, the temperature hit 29.1°C, the highest in the UK in April for nearly 70 years.
Weather patterns are changing. The world’s rainforests are being destroyed. Our atmosphere and oceans are increasingly polluted. One way of understanding these interconnected events is that they are a consequence of the depletion of the world’s natural capital. This is fast becoming an important concept for investors.
A tragedy of the commons – and of the horizon
Natural capital is an evolving concept and one that can be defined in many ways. In essence, it is the world’s stock of natural assets – including air, water, soil and all living things – that combine to yield a flow of benefits to people.
Human life is possible because of natural assets and the benefits we derive from them. These include the food we eat, the water we drink and the air we breathe. As well as other vital processes for human survival – such as climate regulation, flood defences and carbon storage.
Consider the rainforest. It is not just a resource of wood but also a carbon sink. It plays a central role in regulating our climate.
These natural assets are difficult to protect and even harder to value. As often happens with shared assets, they have been exploited and used wastefully for years, with the consequence that the world’s natural capital is being depleted.
Using a concept from economics, this is a tragedy of the commons. A tragedy where individuals act independently and according to their own self-interest. Yet their individual behaviour is contrary to the common good because it depletes or damages a shared resource. Originally, this concept used the example of unregulated grazing of livestock on common land. In the modern context, it can be applied to any shared resource, such as rivers, oceans and the atmosphere.
Today, we face not only a tragedy of the commons but what Mark Carney, Governor of The Bank of England, has called a “tragedy of the horizon”. As a lot of the damage to these shared assets is cumulative and persistent, current generations are imposing costs on futures ones.
The planet’s balance sheet
The world’s natural capital is made up of lots of diverse assets. There are many ways they can be damaged and the number of companies, industries and sectors causing the damage is vast.
As investors, we are stewards of our clients’ assets and so we must consider all potential risks.
Imagine that the costs of damaging the world’s natural capital currently sit on a theoretical planetary balance sheet. What if some or all of these costs were reallocated to the financial balance sheets of individual companies?
Water pollution is a good example. A mining company damages natural capital by releasing chemicals into waterways. If the company was made to pay for this damage, its costs would increase substantially and profitability would fall. Similarly, some businesses within industries such as agriculture or tourism have negatively impacted biodiversity – how might these businesses be made to pay for this damage?
Calculating the value of the world’s natural capital – and the costs of the damage to it – is not straightforward. But progress is being made, and the estimated costs are high.
For example, The Lancet Commission on pollution and health estimated the annual cost of pollution to the global economy to be $4.6 trillion. This is equivalent to around 6% of global economic output.
Will polluters pay?
The area that should be of considerable concern to investors is greenhouse gas emissions.
The atmosphere is a shared resource that’s being damaged by individuals and companies around the world. The problem is hard to solve, because greenhouse gas levels build up over time; the gases remain in the atmosphere for decades; and the effects can be felt thousands of miles from where the gases were emitted.
For greenhouse gas emissions to move from an environmental issue (which some companies still ignore) to a financial issue, a meaningful price for carbon is needed.
The report of the High-Level Commission on Carbon Prices analysed what would be needed to achieve the goals of the Paris Agreement on limiting global warming. The Commission concluded the price of a tonne of carbon needs to rise to at least $40 to $80 by 2020, and to between $50 and $100 by 2030. That compares with prices of below $20 per tonne in Europe for most of 2018. A number of options are available to achieve a meaningful price on carbon, including a carbon tax or an emissions trading scheme.
A company’s greenhouse gas emissions can be measured (and this is easier than, say, measuring damage to biodiversity). The available data is impressive. Coverage is broad, allowing for comparisons between companies, and over time.
With new perspectives and data comes the opportunity to hold companies accountable for the damage they are causing to natural assets. Paying compensation for emissions could substantially raise operating costs, reducing the profitability and financial returns of whole industries. Companies that don’t comply with new regulation might also lose their right to operate.
There is now a strong case for all investors to consider natural capital issues as, ultimately, every company depends on natural assets.
A collaborative approach
At Ruffer, we want to understand how the companies we invest in are managing natural capital issues, particularly the risk of a meaningful price on carbon.
We seek to understand how a company governs these risks at the management and board levels. To evaluate a company’s strategy accurately, we need data on greenhouse gas emissions. And we need detailed disclosures, including information about whether the company uses an internal price of carbon (and, if so, how this is used in its scenario analysis).
To encourage companies to disclose this information, and to improve corporate governance, we collaborate with other investors who share our concerns. A number of initiatives have been launched recently, the largest of which is Climate Action 100+. Ruffer was a founding investor signatory in December 2017.
More broadly, to preserve and protect the world’s natural capital, investors need to develop valuation techniques and methods that allow companies to quantify their impact on natural capital, and the extent to which they depend on natural assets. There have been some encouraging early steps here. But there are still many issues in the structure and consistency of the metrics that are being used. Only when these metrics can be linked to traditional valuation measures will it be possible for investors to evaluate fully a company’s impact and dependence on natural capital.
For investors, natural capital is no longer purely an environmental concern. It is also a financial one that should not be ignored.
Social pressure is changing the debate – and the regulatory response – as environmental issues become harder for governments to ignore.
The changes will affect entire sectors, bringing investors both opportunities and risks, as new companies emerge, new regulations are applied, and as new technologies and industries develop.
A deep understanding of natural capital issues will leave investors well placed to make good investment decisions.