Global Climate Change: Uncovering Hidden Investment Risk and Opportunity

Abstract

Superior environmental performance within an industry sector consistently correlates well with superior ®nancial performance, whether measured as ROI, ROE or total stock market return. One reason for this is that environmental performance is a strong, empirically demonstrable proxy for the quality of corporate management, which, in turn, is a key determinant of relative ®nancial performance. In other words, well managed companies, almost by de®nition, also manage the environmental aspects of their business well. The Innovest EcoValue '21 rating methodology was established to measure environmental performance and translate it into ®nancial terms, measuring over 50 different aspects of environmental risk, opportunity and strategy. Our model enables investment advisors to improve portfolio risk-return characteristics by identifying industrial companies with hidden eco-ef®ciency value potential. Experience to date shows that using the model to screen out poor environmental performers while favoring top performers can generate outperformance premiums of 240 to 290 basis points in an enhanced diversi®ed portfolio. In sectors with large environmental impacts, such as the electric power industry, the environmental performance premium can range up to 1500 or more basis points. This premium has been growing. Continued increases in national and international regulations, risk disclosure requirements and market demands for more environmentally responsible corporate policies will cause it to grow further. Innovest has rated the environmental performance of over 800 companies worldwide. In this paper, attention is focused on the petroleum and U.S. electric utilities sectors, as exemplars of high impact industries where the environment can be used as a powerful competitive weapon. Given the resource-intensive, high-emission nature of these industries, environmental expenditures already have a large impact on corporate pro®tability. Several factors are converging to increase this impact and make the distinction between top and bottom environmental performers even more pronounced. Global climate change has emerged as one of the most important of these factors.