Assume that in coming years companies around the world will be forced to dramatically reduce their carbon dioxide emissions. What does this mean for investors?
Goldman Sachs says a company’s ability to manage its carbon footprint will emerge as an important determinant of its competitive position and long-term valuation. This is thrust of a recently released report that presents a framework for analyzing how global efforts to combat global warming will influence company performance. (Thanks to Chris Lindley for this link.)
The main driver of Goldman’s analysis is the rising cost to emit carbon dioxide. The framework relies on an OECD projection that puts the cost per ton of carbon dioxide at $60 by 2030 and as high as $150 by 2050. These are the costs the OECD believes will be necessary to motivate companies to reduce their emissions sufficiently to stabilize atmospheric carbon concentrations at 450 parts per million.
Carbon-intensive industries will naturally be most affected by these rising costs. Indeed, according to the Goldman Sachs analysis, “In more carbon intensive sectors, effectively reducing emissions will be the key to sustaining competitive advantage as the value of carbon emissions escalate.”
Goldman Sachs believes that carbon efficiency will eventually have a big influence on company profitability. “Our analysis implies that a value of US$60/t placed on all direct carbon emissions would result in ~20% of the cash flow of carbon intensive industries moving from less- to more- carbon efficient companies,” the report says.
It goes on to say that companies with lower carbon footprints and management teams that are focused at reducing carbon emissions will fare better than companies that are less effective at managing their carbon exposure. The firm has developed a “climate change management score” they use to rank firms’ performance in this area. The score is based on 10 to 12 indicators in four categories: leadership/transparency; management of own operations; supply chain management; and product development; and draws on data from public reports, Carbon Disclosure Project filings, corporate sustainability reporting and other public disclosures. Using this scoring system, the report identifies “climate change leaders” in a variety of sectors. The implication is that over time, climate change leadership will become an an attribute that is attractive to investors because it’s predictive of financial performance. (It’s worth noting, with appropriate irony, that a study released earlier this year by the Interfaith Center on Corporate Responsibility assigned Goldman Sachs the worst “climate risk profile” of the nine financial services companies evaluated.)
Goldman’s analysis is solid. But how useful is it for making investment decisions? Looking at global power utilities, Goldman found only a weak relationship between carbon efficiency and valuation multiples: “…while the relationship has strengthened, it remains relatively weak compared to the potential impact higher carbon emission penalties will have on sector profitability,” says the report.
With company valuations still influenced mostly by short-term considerations, it may be a while before Goldman’s climate change management investment framework becomes influential in investment decisions. But it is a great piece of thought-provoking work.