Tyndall Briefing Note No.

7 JUNE 2003

The Carbon Disclosure Project
Dr Andrew Dlugolecki

them on behalf of others, their interests are affected. There are four key climate-change-related effects linked to shareholder value: • Extreme weather events, such as severe droughts or floods -disrupting core markets/supplies/operations/reserves or damaging assets • Regulatory action to limit emissions impacting significant carbon emitters -delaying projects or increasing operating costs and capital expenditure • Consumer reaction to corporate reputation on climate change -affecting sales and diverting management attention • Climate-responsive technologies, goods and services superseding those of today - a factor in credit-rating, stock-market valuation, and viability of markets Recent reports from the United Nations Environment Programme Finance Initiatives (UNEPFI), Universities Superannuation Schemes (USS) and the Coalition for Environmentally Responsible Economies (CERES) have identified several barriers to action on global warming by the financial sector. A key one was the lack of awareness about the financial implications of climate change, which is often seen as long term and non-critical by comparison with other business problems. Assembling data about the issue is therefore a high priority, and this is what CDP set out to rectify so successfully. Clearly the trend towards active shareholder engagement and corporate disclosure in the face of recent scandals has assisted the task. CDP- The Method and Process The CDP letter and questionnaire that were sent to the Chairmen of the Global FT500 are the backbone of the project. The team spent four months refining them to ensure that the tone and content would maximize the number of investor participants, result in a high level of corporate responses, and generate truly valuable information for tackling climate change. Over 45 experts were consulted over this period. Over the course of 2001/2002 CDP invited five leading consultancies, with climate change specialists, to be ‘on call’ should firms require assistance in answering the questionnaire. To maximise the response rate the team and supporting investors followed up non-respondent corporations persistently, reminding them that nondisclosure would be reported. In early 2001,CDP engaged Innovest Strategic Value Advisors to
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Introduction
The Carbon Disclosure Project (CDP) aims to create a focus between institutional shareholders and corporate businesses on the specific issue of the risks and opportunities presented by climate change. CDP is the international secretariat for this collaborative initiative whose members control assets in excess of $4.5 trillion. The management team of four is led by Tessa Tennant, who pioneered the first socially responsible investment (SRI) fund in the UK in 1988, and is supported by an Advisory Board of senior professionals from financial and stakeholder circles in the USA and Europe, including the author of this article. The CDP team scoured the world for top investment institutions to support the venture. By the end of March 2002, 35 institutions controlling over $4.5 trillion of assets had signed up, including Abbey National, Allianz Dresdner, Aviva, Connecticut RPTF, Co-operative Insurance Society, Credit Suisse, Henderson, ING, Jupiter, Legal & General, Merrill Lynch, Munich Re, Rabobank, Societe Generale, Storebrand, Swiss Re, and UBS. On 31st May 2002, CDP wrote to the Chair of the Board of the 500 largest companies in the world as measured by market capitalisation (the FT500). It asked them to complete a seven-point questionnaire to identify the business implications of their exposure to climate change, and what they are doing to address these risks (or, for some, opportunities). On February 17th 2003, the results of this exercise were announced, and they are now available for public inspection. Climate Change and the Capital Markets In January 2001, the UN Intergovernmental Panel on Climate Change (IPCC) issued its Third Assessment Report. This confirmed that the greenhouse gases from economic development are altering the Earth's climate so much that it will pose dangerous changes to our natural environment. CDP believes that shareholders, as the owners of major contributors to climate change (industrial firms), are uniquely positioned to do something about the problem of greenhouse gas emissions. Whether they directly own the shares, or manage
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analyse the raw data and report on the findings. The Innovest report and raw data were made publicly available at www.cdproject.net in February 2003. CDP now intends to ensure full exploitation of the corporate data by all stakeholders (investors, corporations, governments, scientists, and NGOs), and is already planning the next round of data collection, to start in third quarter 2003.

The results The seven questions were generic, in that they were not varied to suit the peculiarities of each sector. In general therefore the survey focussed on in-house GHG emissions, and those which might be generated along the supply chain or by products during their use and disposal. These are issues which are of more concern to industrial companies, but of course they are important for investors in those companies also. (It was suggested that financial services companies should answer them as owners of financial assets, not simply in respect of their core operations, but none were able to do this). The response rate was very high for such a novel exercise carried out globally (see Figure 1). Just 29% of companies ignored the letter, while 15% declined to participate, giving a positive attitude in 56% of the FT500. The attitudes differed considerably between countries. The US response, which accounts for 238 of the FT500, was poorer, with 34% not responding, and 23.5% actually declining to answer. The rest of the world was much better, with 25% not responding, and only 7% giving a negative reply i.e. the positive attitude reached 68%. In Germany this reached 80%, with 16 companies out of 20 giving answers. The UK, with the third highest number of FT500 firms, achieved 97% and Australia 100%, while Russia, Mexico and Asia outside Japan were all very poor in responding (see Table 1). This clearly indicates where the attention to environmental issues is still inadequate in the corporate agenda. The quality of the responses was highly variable ranging from 8% of companies which did not work through the questionnaire, but simply replied in a short letter, or with the corporate environmental report, to others which provided detailed answers and supplementary documents and data. For that reason, it is not possible to simply summarise the results of the exercise, but several broad conclusions can be drawn. Overall Findings 1. Investors failing to take account of climate change and carbon finance issues in their asset allocation and equity valuations are exposed to potentially significant risks. • Regulatory risks relating to greenhouse gas (GHG) emissions are real

The Kyoto Protocol looks highly likely to enter into force during 2003. Emissions restrictions and trading schemes soon will be a reality in the UK, Japan, the EU, Canada and parts of the USA and Australia. Beginning in 2005, many European companies face financial penalties under EU regulations if their GHG emissions exceed their allowance. • Almost every sector is vulnerable to regulatory or weather impacts Regulatory pressures will be felt most powerfully in emissions-intensive sectors and the energy industry itself. However, CDP responses indicate that climate change will also have significant impacts on sectors as diverse as: telecommunications, electronics, forestry, agriculture, food production and retailing, tourism, transportation, real estate, banking, insurance and fund management. (See the examples of positive action later). There were numerous examples of unmanaged weather impacts on corporate performance during 2002 (eg Australian drought), and climate change will reinforce this problem. • At company level, impacts to shareholder value vary widely, in the same sector Companies differ widely in their degree of exposure to climate change as a business risk and in their ability to manage this risk. Such systematic differentials from the norm are known as " beta factors" in the investment world, and as these differentials in " carbon beta" become clearer to the financial markets, they will impact the valuations of both debt and equity securities. (See Figure 2). 2. The corporate world is ahead of investors in its perception of climate change as a real business issue. • There is a groundswell among FT500 for action on climate change More than 80% of respondents (ie half of FT 500 companies) have already recognized climate change as a serious issue and are developing strategies to reduce greenhouse gas emissions. Sector leaders such as Statoil and BP, DuPont, Hypovereinsbank, ING and Swiss Re have not only formulated sophisticated strategies, but are well on the way to executing them by eg investing in renewables and low carbon technologies.. • There is a significant “information deficit” for investors Very few of the financial service companies surveyed have systematic, portfolio-wide information concerning both the absolute and relative levels of company-specific risk arising from climate change. This is a significant concern for those like pension fund managers, who are expected to exercise diligent care of the assets entrusted to them others. Without proper information such fiduciaries cannot discharge their responsibilities. 3. Climate change as a factor in corporate performance will continue to increase in importance, and its influence will become pervasive.
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• Early movers will be rewarded Companies “ahead of the curve” are, in general, better positioned to achieve cost-effective risk management solutions, to adapt to unforeseen future developments and to exploit systematically any upside profit opportunities. Companies acting sooner to secure emissions reductions via the GHG trading markets can expect to pay less for emissions reductions because the price of such credits has tended to rise over time (see Figure 3). • Legal liabilities may result Precedents set by asbestos and tobacco litigation could lead to a spate of lawsuits against significant emitters of greenhouse gases that have not adopted best practice in due time. This could extend into the financial sector. In December the New York Times reported that Oakland, California and Boulder, Colorado had joined NGO's in lodging a suit against federal export credit agencies, for supporting fossil-fuel projects without due consideration of their impact on the climate, and on their own water supply. • Supply chains will be affected "Carbon costs" will alter the economics of the supply chain in commodity and manufacturing businesses. Trade problems may arise between emerging market producers not subject to GHG regulations and "Annex 1" nations that are. • Climate-driven risks will continue to grow Strengthening evidence about the reality of climate change, compounded by further regulatory action by governments at all levels, can only raise the stakes for shareholders, who are now less inclined to leave major strategic decisions to executive management in the light of recent failures in governance. Examples of positive action by FT500 companies outside insurance • Japanese firms Mitsubishi and Mitsui have both taken a financial stake in emissions trading firms, the former with Natsource, the latter with CO2e.com. These companies are keen to serve the anticipated carbon offset needs of customers in the steel and electric utilities industries. • In the integrated oil and gas sector, most firms report considerable success in reducing emissions to date. Many have set aggressive targets for the future, and are involved in emissions trading in order to meet emissions targets at optimal efficiency. Yet, in July the World Resource Institute reported that of 17 companies studied, only three -- British Petroleum, Conoco and Phillips Petroleum – mentioned in their annual reports that climate policies and regulations could affect future business operations. • In the food industry, GHG targets have been set by Unilever (annual 3% CO2 reduction), Diageo (8% reduction between 2001-2004), and others. Danone, Nestle and Unilever have joined together to form the Sustainable Agriculture Initiative (SAI) that involves the testing and development of sustainable agriculture practices, including the consumption of natural resources and energy. • Electric utilities not preparing to trade GHG emissions credits are in a shrinking minority in the
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global power industry. Of the 25 FT500 electric utilities, 19 are quantifying their GHG inventories, 14 have emissions reduction programs in place and 7 are at an advanced stage of emissions trading. • Deutsche Telekom, NTT DoCoMo, BT, Vodafone and others are pursuing growing market opportunities in mobile communications that allow for greater efficiency in the management of remote vehicle fleets; new machine-to-machine communications technologies; reduced vehicle transport arising from flexi-working, teleconferencing, and the streamlining of overall efficiency via telecoms logistics networks. •Marks & Spencer has identified that the most beneficial action it can take is to reduce washing temperatures for its clothing products, which will save 0.25% of all UK domestic electricity use by 2004. • In the banking sector, firms like Hypovereinsbank and Credit Suisse are starting to explicitly address climate risk in credit quality assessments and equity valuation. The market for renewable energy is attracting finance - at y/e 2001, Hypovereinsbank had over €1 billion on its loan books for renewable energy sources. A cautionary note comes from UBS, which developed a product called " Alternative Climate" in 2000, aimed at the new GHG markets, but was forced to shelve it in 2002, owing to lack of demand. Other banks (BNP Paribas, ING Bank, and Rabobank ) see the potential for new business in partnership with public bodies and other industries, and are developing new financial products for coping with climate change. However, some banks seem ignorant. In the case of Credit Lyonnais, for example, which is highly dependent on weather- and carbon-sensitive sectors, a shortfall of 10% in debt servicing from such clients (eg due to tougher emissions targets) could be disastrous. • Equity Office Properties Trust has invested capital in becoming the energy efficiency leader in the Real Estate industry. The company is now a leader in Energy Star labelled buildings and has established On Site Energy Providers as a wholly-owned subsidiary, which extends the group’s energy efficiency efforts via demand side management programs and use of efficient distributed generation systems. The Insurance Industry - a Detailed Review of One Sector The Innovest analysis of the insurance sector contained in the report is somewhat misleading, because it does not identify that many FT500 insurance firms did not respond, particularly from the USA, but also including Generali and Zurich Financial Services. Conversely, it omitted to record that Prudential plc did reply. Also many of the replies from European insurers are not yet available for public review. Last, the survey asked insurers to respond on behalf of the assets which they owned, rather than for those which they managed on behalf of others, which would mean a vastly greater portfolio. The underwriting issues for the insurance sector are well-established thanks to the research carried out
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over many years, mainly by Munich Re and Swiss Re. Solvency and liquidity threats are becoming greater for P/C insurers and reinsurers due to the potential for large weather-related losses. New and existing markets may become unviable as climate change increases regional exposures. There may be some new opportunities in the insurance of GHG offset and clean energy, or alternative risk transfer (ART) through weather derivatives, catastrophe bonds, and GHG emissions trading guarantees. On the other hand, executive and director liability could prove an avenue for litigation against corporate GHG emitters. Swiss Re has reviewed its procedures for assessing the risk involved in offering Directors' and Officers' (D&O) Liability insurance to stop this loophole. Such senior people would be in the firing line if shareholders of an FT500 company sued the board for ignoring the implications of carbon risks. Conversely, since these individuals are in positions of authority, they also are able to initiate early action on the issue. Involvement in equity markets is a second exposure to climate change for insurers, and is in fact the main concern for life insurers and fund managers. Most of the respondents see the adoption of SRI principles as a key tool for ensuring that this risk is managed properly. Indeed, Aviva stated that, due to its own strategies for managing climate change, it felt its own shares would be a natural selection for such fund managers who are constructing climate-proof portfolios. Legal & General has begun to consider key factors like energy efficiency within its investment portfolio. Allianz has created a dedicated sustainability study centre and is making use of a €200 million line of credit, which may be extended to fund renewables technologies. Swiss Re also runs a CHF 90 million Eco-portfolio, which in part provides venture capital to renewable energy start-up companies. In general, the respondents are fully aware of the need to manage their own GHG emissions, and believe that it is consistent with cost-reduction. Apart from strategic decisions on the design and management of buildings, and installation of energy-efficient equipment and lighting, companies cite employee education as a key influence - Swiss Re had a reduction of 30% in energy use in its London offices from the latter factor alone. Business travel is another key area- Munich Re stated that by re-organising its client management it made substantial savings in travel costs. Many insurers believe that further significant reductions in their own emissions can only be achieved through sourcing their electricity from renewable energy, rather than from actual reductions in final energy usage. There was no discussion of the effect in trends in homeworking or call-centres, which could also be significant. The question of how to measure emissions received some attention; some preferred to monitor the ratio of emissions per employee or unit of floor area, since total emissions can be affected by corporate growth. (Interestingly, UBS favours the total
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method, since it plans to reduce the amount of floor space per employee!) Most financial companies , including insurers, did not feel that the question on supply chain emissions was appropriate for them, and rejected the idea that they might track them in future, for several reasons. They said it would duplicate the reporting of such emissions, distracted attention from the real climate change issues, in their sector, and would probably be impractical given the fragmentary nature of their suppliers. Turning to new revenue-generating financial solutions that can cover the risks of GHG reduction projects, trading etc., Swiss Re’s ‘Greenhouse Gas Risk Solutions’ group has given the firm undoubted brand leadership on the issue. Munich Re is also exploring opportunities to generate revenue on the insurance side of emissions trading (eg surety bonds, business interruption extensions, emissions accounting). Elsewhere, Aviva is undertaking trials on a “Pay-As-You-Drive” motor insurance premium which links the distance and frequency of travel to the insurance premium paid, and Legal & General notes opportunities for similar premium discounts for low CO2 vehicles. Emissions trading per se is unlikely to represent a major business opportunity for the insurance industry, because its internal emissions are relatively light. Prudential plc had considered entering the UK emissions trading scheme, but the regulations were too restrictive. Swiss Re has scheduled a study for 2003 on implementing an internal CO2 trading scheme. Several other firms continue to monitor developments in the EU and UK GHG markets, including Legal & General, Aviva and Munich Re. Using the data Innovest recommend that investors should monitor the following key factors because they measure corporate financial risk from climate change: • Poor overall strategic awareness leading to erosion of competitive advantage and general market underperformance, which may be inferred from a lack of willingness to respond positively to the CDP survey, or from a naïve or thin reply • GHG emissions intensity which increases the overall company compliance burden • Energy intensity which increases vulnerability to fuel and electricity price rises • Geographic split which determines a company’s liability for carbon reduction targets, its exposure to weather extremes, and its ability to capitalise on financial incentives in clean power • Marginal abatement cost and the ability to purchase emissions credits which determines the direct capital implications of required emissions reductions • Mix of products and services which affects the extent to which the underlying business model is influenced by low carbon substitutes or weather extremes
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Vulnerability to reputational damage where a company may be affected by popular sentiment in support of positive action to address climate change

evaluations? Investors could play a catalytic role in bringing about these necessary steps. Dr A F Dlugolecki, Visiting Research Fellow , Climate Research Unit, University of East Anglia ( contact: andlug@hotmail.com) Footnote This article is based on the report," Carbon Finance and the Global Equity Markets" prepared by Innovest Strategic Value Advisors for the Carbon Disclosure Project, London, February 2003. The full report and survey replies are available at the www.cdproject.net site. References CERES (2002) Value at Risk: Climate Change and the Future of Governance ( Boston, Massachussets, USA: Coalition for Environmentally Responsible Economies) Mansley, M. and A. Dlugolecki (2001) Climate Change-A Risk Management Challenge for Institutional Investors. (London, UK: Universities Superannuation Schemes Ltd. Discussion Paper No 1) UNEPFI (2002a) Climate Change and the Financial Services Industry: Module 1 Threats and Opportunities (Geneva, Switzerland: United Nations Environment Programme) UNEPFI (2002b) Climate Change and the Financial Services Industry: Module 2 A Blueprint for Action (Geneva, Switzerland: United Nations Environment Programme)

The database should become a major reference point going forward. Speaking to the New York Times, Bozena Jankowska, the head of socially responsible investing at Allianz Dresdner Asset Management, said: "The consensus is that climate change has become sufficiently material to the investment world that we need to find a new way to understand the risks it poses to our clients and their money." CDP provides the basis for this work. However, CDP restricts itself to simply collecting and reporting the data, which is of course a major project, but there are many related issues which are critical to ensuring that the data leads to real and efficient change. For example who will rationalise the proliferation of a patchwork of GHG regulations around the world that makes it difficult for companies to standardise procedures, services and products? For many industries, business planning requires a longterm view of markets and technologies; the recent call by Premier Tony Blair for the reduction of emissions by 60% in 2050 provides the necessary perspective which has been lacking from the Kyoto Protocol- will other politicians follow? Will regulatory bodies like the SEC and FSA support the need for greater uniformity and transparency in the reporting of corporate environmental issues? And, will investment analysts start to use information such as the CDP database when they prepare

Figure 1 Responses to CDP survey Source: Innovest Stratregic Value Advisors, from p5 of Innovest report

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Figure 2 Examples of sensitivity to climate change Source: Innovest Strategic Value Advisors from p16 of Innovest report

Figure 3 Trends in the price of carbon Source: Natsource, from p29 of Innovest report

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Country USA Rest of world Of which: Canada Mexico Japan Rest of Asia Russia UK Germany Other Europe Australia Misc All

Number of companies 238 262 19 6 50 21 4 38.5 20 90.5 8 5 500

% no response 34 25 21 83 28 62 100 0 10 20 0 80 29

% decline to participate 23.5 7 10.5 0 8 10 0 2.5 10 9 0 0 15

% that participated 42.5 68 68.5 17 64 28 0 97.5 80 71 100 20 56

Table 1 National variations in corporate responses (Note some companies are registered in two countries, counted here as 0.5 in each)

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June 2003