studie climate and finance

8/7/2019 Studie Climate and Finance

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Foreword 3

Executive Summary 5

Introduction 10

1 The Direct Cost of Climate Change 111.1 The Global Perspective 111.2 The European Perspective 13

2 The Economic Implications of Climate Change Policies 162.1 Mitigation Policy 162.2 Effects on the Corporate Sector 172.3 Effects on the Consumer Sector 20

3 The Necessary Path 223.1 Avoiding Dangerous Climate Change 223.2 What is Good Policy? 23

4 Financial Services: New Risks, New Opportunities 254.1 Insurance 25

4.1.1 Adapting to Climate Change 254.1.2 Insurance Solutions to Tackle Climate Change Business Risks European Examples 274.1.3 Insurers Risks and Opportunities in Mitigating Climate Change 294.1.4 Recommendations 324.2 The Banking Sector 324.2.1 Climate Change-Related Risks 324.2.2 New Opportunities 344.2.3 Recommendations 374.3 Asset Management 374.3.1 Institutional Investors 384.3.2 Consultants and Actuaries 394.3.3 Fund Managers 40

4.3.4 Financial Analysts 424.3.5 Companies 434.3.6 Recommendations 44

5 Financing Low-Carbon Energy 45

6 Recommendations 48

Endnotes 50

Bibliography 53

Boxes, Tables and Figures 56

Acknowledgement 57

CONTENTS

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Executive Summary

1. Climate change is real

Climates have always been changing. But thistime there is one big difference: the changes areprincipally man-made. The issue has becomeurgent because the pace of change is accelerating.This report identifies actions for key stakehold-ers: Allianz Group, its clients, co-financiers andpolicymakers.

Europe is not only warming 40 percent fasterthan the world as a whole, but has already sus-

tained severe damage from climate change. Stormsin 1999 and floods in 2002 each cost 13 billioneuros, while a heat wave in 2003 cost 10 billioneuros. Although no precise estimate of all futurecosts can be made,a European Commission paperputs the future cost of all the potential cumulativeglobal damage at 74 trillion euros at todays valueif effective action is not taken.

Climate change will have a multitude of effectson human society and on nature if we fail to takeclear actions to slow it down. While milder win-ters may seem an attractive proposition for Euro-peans, it is a prospect that deceives. Climatechange will lead to increased heat stress, a rise ininsect-borne diseases, and increases in rates of skin cancer and food poisoning. Globally, climatechange already results in about 160,000 deaths a

year, and this is likely to rise sharply because of increasing shortages of food and water.

The extraordinary heat wave in 2003 caused

27,000 deaths in Europe and disrupted agricul-ture, inland shipping, and electricity production.Huge swathes of forests covering a total of 5 per-cent of Portugals surface area were destroyed in aloss put at one billion euros.

By the end of this century such a summercould be routine. Mediterranean agriculturemight be in a state of collapse. Everywhere inEurope rainfall will be more intense. The numberof major floods in Europe has already risen fromone per year to 15 in recent decades. In the UK,the annual cost of flooding this century will riseto as much as 30 billion euros. Businesses areincreasingly reporting reduced profitability be-cause of unusual weather. Many European Unionholiday destinations will suffer in a region

where travel and tourism generate about 4 per-cent of GDP.

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EXECUTIVE SUMMARY


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2. Climate change policies arechanging the economics

Governments are starting to introduce policies totackle the causes and combat the effects of green-house gas emissions (GHG), and these policies willalter the economics of entire industries. They willaffect company share prices, both positively andnegatively. Examples from industry show thatproactive strategies tackling CO 2 emissions reapeconomic benefits. And climate change might notbe the only reason for taking such steps. Otherbenefits of climate change policy might includereducing dependence on energy imports, achiev-ing more reliable energy price levels, ensuringclean air, and creating jobs. The growth of carbonmarkets associated with emissions entitlementsoffers revenue opportunities for developing coun-tries and more efficient companies, and willneed a range of services from the financial sector.International emissions trading could be worth

between 50 and 800 billion euros in 2025.Climate change policies will have an effect on

a number of industry sectors. The most sensitivesectors are either energy-intensive, such as cement,aviation, metals or energy industries such as oiland gas, coal, power utilities; or provide energy-consuming products such as automobiles.

The driving force behind much of the currentcarbon market activity is the EU Emission Trad-ing Scheme (ETS). Some of the early warnings of huge effects in certain sectors seem unlikely now,but the current market price has climbed to over20 euros per tonne of CO 2 (May 30) which is notnegligible.

There has been a steady flow of researchreports looking into the issue of carbon con-straints on corporate earnings since 2002. They demonstrate that there are clear differences in thepresent value of corporate earnings, across a rangeof possible future climate policy scenarios. Thismeans that managements and investors cannotassume that there will be time to react to policy

when it is approaching implementation.A WWF study found that certain electricity

companies could face costs of as much as 9 per-

cent of gross earnings, though costs may bepassed on, while low-cost producers can extractlarger margins. A Dresdner Kleinwort Wasser-stein (DrKW) study concluded that 8 out of 18cement companies were overvalued by up to13 percent.

3. Financial sectors need for

consistent, long-term policy frameworks

To combat the negative effects of climate changeconsensus exists that the global average tempera-ture should not increase by more than 2 degreesCelsius and rather stay below this threshold.This will imply a cut in annual GHG emissionsof 60 to 80 percent by 2050 globally, from thecurrent level of almost 7 billion tonnes of carbonto under 2.5 billion. In line with these targets,

individual EU member states have already announced national greenhouse gas reductiongoals that support a path of deep and consistentreductions. For example, France proposes a 75 per-cent reduction by 2050, the UK a 60 percent cut by 2050, and Germany is considering a 40 percentcut by 2020. However, specific actions are rarely defined beyond a horizon of 2012, the conclusionof the first Kyoto commitment period.

Early action is needed to provide greater cer-tainty for business, long-term investment andtechnological change. Inconsistent policies or nopolicies at all simply deter investment. Amongthe inconsistencies: the EU subsidized fossil fuelsby 24 billion euros in 2004 compared to 5.3 bil-lion euros for renewable energy sources; andinternational transport fuel is tax-exempt. Thebest strategy would involve a mix of actions onenergy efficiency, including conservation meas-ures, renewable energy and switching to low CO 2fuel and gases. Perhaps half of the potential growthin emissions could be saved by greater energy efficiency.

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4. New risks and new demands forfinancial services companies

The financial services industry needs to adapt itsinternal processes and policies and its productsand services to meet the challenges its clients faceas well as to safeguard its own viability. To enablefinancial services companies to play a responsiblerole in mitigating climate change they require areliable, transparent and international co-ordinat-ed policy framework as well as long term, appro-priated CO 2-reduction goals. That gives certainty for investment decisions and provides businessopportunities for clients.

In order to adapt their own operations to thenew challenge,financialservices companies shouldinclude climate change risk in their internal gov-ernance procedures, in line with the existingfinancial corporate risk identification, controllingand reporting structures and best practice inreporting requirements.

INSURANCE

Climate change and climate policy affect insurersthrough the risks they accept from clients. Sinceclimate experts predict changes in the intensity and distribution of extreme weather events (espe-cially water-related and storms), and because of the resultant risk of catastrophic property claims,insurers are likely to regard climate change as athreat rather than an opportunity. The high num-ber of tropical storms worldwide pushed insured

weather losses in 2004 to a record 32 billioneuros. While the incidence of tropical storms isnot conclusively linked to climate change, theirincreased frequency is part of a pattern of higheractivity.

Projections for the UK from the Association of British Insurers suggest that by 2050 the annualcost of weather claims will double to 3.3 billioneuros, while an extreme year might cost 20 billioneuros. In Germany the total exposure to flooddamage in one event might be 15 billion euros.Climate change is increasing the potential forproperty damage at a rate of between 2 and 4 per-cent a year. Because insurance pricing relies on

historical data, this could lead to an underpricingof weather risks by as much as 30 percent due tothe time lag between the historic data that is usedto set prices, and the future period in whichclaims will occur. In Allianzs global industrialinsurance business for example, around 35 to40 percent of insured losses are already due tonatural catastrophes mainly floods and storms so this could materially affect the overall prof-itability of insurers. Other effects are expected toinclude claims for loss of sales, heat stress amongclients or staff, damage to vehicles, travel delays,and pollution from floods.

But climate change will also bring moredemand for conventional risk transfer and openopportunities in new areas such as emissionreduction projects.

Insurers Agenda for Action: Gather information on future climate risks and

thereby better predict and underwrite climate-

associated risks. Control their exposure to natural catastrophes

and other climate-related risks by developingadequate risk assessment tools such as floodzoning and establishing expertise for naturalcatastrophes.

Upgrade risk assessment methodologies suchas identifying potential new liabilities fromcarbon emission or using environmental duediligence screening of a company.

Develop risk management expertise regardinglow carbon technologies jointly with industrialclients to develop new products supportive of low carbon technology.

BANKING

Banks play an important role in climate-relatedfinancing and investment, credit risk manage-ment, and the development of new climate riskhedging products. On the downside, they facecredit risks because policies to cut emissions cancreate costs for carbon intensive sectors and com-panies. Price volatility in carbon markets (CO 2,oil, gas, coal) and climate-related commoditiesleads to uncertainty in financial projections. For

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example, the price of CO 2 varied between 5 and20 euros per tonne in the two years to June 2005.But climate change also creates opportunities.According to the World Energy Council, therenewable energy market could be worth 1.4 tril-lion euros by 2020. The global carbon market in2010 could be worth up to 200 billion euros, esti-mates Point Carbon. Exploiting the Kyoto Mecha-nisms could enhance project returns by up to 15percentage points e.g. in methane reduction proj-ects. Weather derivatives offer potential to banks:the total notional value of this market rose to 3.5billion euros in 2003/04. Emission trading createsnew relationships between corporates: cross-bor-der, cross-commodity, cross-product, and that inan increasingly international context. Significantnew investments will be required internationally in high value added technologies for both largeand small scale aspects for each project. A key challenge here is to marry long-term investmenthorizons with short-term regulatory change.

Banks Agenda for Action:Banks taking leadership on climate change issues

will therefore need to Review and optimize their own carbon risk

management and (further) develop assessmenttools applied to carbon risks and carbon riskreduction strategies (e.g. by using carbon relat-ed economic analysis for sectors or companiesand/or by developing climate change relatedrisk matrixes).

Define clear risk requirements for clientsregarding carbon risk reduction and marketstrategies (e.g. by discussing rating require-ments with clients).

Foster the development of carbon risk hedgingproducts e.g. derivatives.

Facilitate finance for public programmes that fos-ter the introduction of low carbon technologies.

ASSET MANAGEMENT

Climate change is one of the most financially sig-nificant environmental issues facing investorstoday. It distinguishes itself in the fact that it hasimplications for a number of sectors that areexposed to policy-driven strategies to mitigateclimate change. Therefore, understanding to

what extent and how climate change will impactor enhance the value of investments is crucial if shareholder value is to remain protected. Althoughthere is increasing evidence to suggest that cli-mate change considerations are starting to per-meate into investor thinking, it is an issue that as

yet still lacks incorporation into mainstreaminvestment considerations. Barriers exist in thelack of understanding of the implications anduncertainty around climate change policy andregulation which remain complex.

Furthermore, the availability of comparableand consistent data on companies emissions lev-els, as well as tools to assess risks and opportuni-

ties remain limited. Looking at the asset manage-ment chain of responsibility institutionalinvestors, consultants, fund managers, financialanalysts and companies each face differentchallenges. But what is clear is that each one of them can take specific action, primarily to devel-op understanding and respective tools regardingthe financial implications of climate change.

Specifically, fund managers and financial analysts should: Evaluate their client portfolios for climate

change risks and opportunities in order to beable to respond to changes in climate changepolicy and legislation.

Engage with company management to under-stand how climate change is impacting theirbusiness and what strategies they are employ-ing to minimize its risks or maximize opportu-nities from it; educate clients about the benefitsand processes being used to incorporate extra-financial issues in the management of theirassets.

Request and reward external research providerse.g. brokers to produce consistent, quality, long-

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term research, which incorporates extra-finan-cial issues such as climate change and integratesuch issues into their mainstream analysis andinvestment decisions also by utilizing the helpof their in-house or external SRI expertise.

5. Financing low-carbon energy

The solution to climate change is essentially toconvert the worlds economies to low-carbon tech-nologies, through both alternative energies andmore efficient energy conversion. Low-carbonenergies can be a contribution to the mitigationof GHG emissions and a business opportunity forproject developers and investors.

The future outlook for the low-carbon energy market is promising. According to the Interna-tional Energy Agency investment in cleaner ener-gy at present is USD 20 billion a year, mainly to

solar and wind power, expected to grow to USD100 billion globally within 10 years. Investmentin renewables and clean energy technology rose150 percent between the years 2000 to 2004,across a wide range of applications (efficiency,

windpower, fuel cells, etc.).The growing market opens increasing oppor-

tunities for financial services providers.However, renewable energy technologies, given

their innovative character, often face a number of additional barriers compared to other projects,e.g. technical problems or higher upfront costs.Therefore it is necessary to develop specificexpertise and financial involvement in low-car-bon energies and to diversify the risks of suchenergy projects.

6. Adressing climate change is5. crucial for the financial sector

Climate change will increase costs for the financialsector if no action is taken. Banks and investors inparticular need a clear regulatory framework onclimate policy which they can adapt and basetheir investment and lending decisions on, whileinsurers face the prospect of heavy losses.

Integrated financial organisations need to beaware that climate change could result in a com-pounding of risk across the entire business spec-trum, diluting some of the benefits of diversi-fication. For example, an insurer is exposed toproperty losses from extreme events, but so too isa property investor, and also a banker providingservices to the property management sector. Fur-thermore, if the insurer seeks to reduce his risk by

withdrawing cover, other stakeholders (investors,bankers etc.) are left with greater, uninsured risks.

Therefore, integrated financial organizations

need to develop pro-active strategies to managethe increasing risks due to climate change.

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10 Climate Change

Introduction

Human-induced climate change has rapidly be-come an important factor for the financial sectorin its insurance, banking and investment activi-ties. For centuries the financial sector has beeninvolved in the management of climate variabil-ity through its provision of credit for seasonalcycles of agriculture, selection of suitable invest-ment opportunities, and insurance against natu-ral disasters, and has gained an invaluable fundof experience in that area. However, now thechanges are not random, and the rate of change isaccelerating. The details of the future climate are

still unclear, and in fact they depend critically upon the way we manage our business and socialaffairs and use the land. It is clear that planningfor the future properly, means anticipating differ-ent weather patterns and different economicstructures from todays. The risks faced by clients

will be different, and the returns on their presentand future investments will change from the cus-tomary ones. The challenges will spring from anumber of directions physical changes in theenvironment, regulatory moves to limit green-house gas emissions, legal challenges to inade-quate governance, reputational fallout from thecorporate position on climate change, and com-petitive pressures as production costs shift andproducts are substituted in response to the neweconomics of a carbon-constrained world.

In matters that affect them and their clients,financial companies have a duty also to join thedebate to ensure that the outcome is efficient.Because of their involvement in every strand of the economy, and their dependence in the long-term on sustainable economic development, inte-grated global financial companies like Allianzneed to take a broad, objective view. This is par-

ticularly valuable, since their views ought toreflect the best outcome for society as a whole.

The position as assessed by this report is thatthere is already enough information to see thatbusiness as usual is not an option the undeni-able costs of prevention are less than the potentialdamage that could result. Nor is there time to wait

while knowledge about the climate changeprocess is improved, and energy technologies arerefined early reductions in greenhouse gas emis-sions avoid the need for much sharper cuts later.The main sections of the report discuss these

points in more detail. Section 1 The Direct Cost of Climate Change assesses the evidence about theeconomic costs of climate change. Section 2 TheEconomic Implications of Climate Change Poli-cies considers the business effects of policies andmeasures intended to reduce the growth in green-house gases. Section 3 The Necessary Path thendiscusses what the best option for climate changepolicy is in the light of the costs and benefits of sustainable development. In section 4 FinancialServices: New Risks, New Opportunities we lookat the implications of climate impacts and poli-cies for the financial sector in its three mainbranches: insurance, banking and asset manage-ment. Section 5 Financing Low-Carbon Energy gives a more specific discussion of the concreteoptions to facilitate market penetration for sus-tainable technological solutions. Finally, section 6Recommendations identifies the key messages,and action points for the principal stakeholdersincluding Allianz Group, its clients, and policy-makers. Naturally, the specific mix of actionsneeds to be seen in the context of each financialmarket, but there are strong common elementsthroughout.

INTRODUCTION


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1The Direct Cost

of Climate ChangeClimate change will touch almost every aspect of life. Here is an assessment of financial impacts first, globally; with some emphasis on two key impact areas health and water; and, secondly,relating to Europe.

1.1 The Global Perspective

Climate change will alter weather patterns and make the sea rise. The overwhelming scientific consensus is not only that the change will be con-

siderable, but also that change has already takenplace because of greenhouse gas emissions. Themost recent comprehensive global perspective isthe 2001 IPCC Report 1, which warned that cli-mate change could reach dangerous levels thiscentury. The next IPCC report is due in 2007, butalready it seems clear that, in the light of recentresearch, the risk will be revised upwards fromthe 2001 assessment (see Section 4 Financial Ser-

vices: New Risks, New Opportunities).Climate change will increase the unreliability

of water supplies both in quantity and quality. It will decrease agricultural yields in the tropics. It will cause a rise in sea levels and thus threaten todisplace tens of millions of people from coastalsettlements. It will cause extreme temperature

stress and cause shifts in the location of some dis-eases. And it will result in insurance losses fromextreme events.

Putting a cost on climate change presents mas-sive problems. Climate changes impacts are wide-ranging, cannot be modelled in detail, and tryingto place a value on damage in the distant futureposes problems that border on the philosophical. 2

In spite of these difficulties, an EU Commissionpaper puts the potential cumulative global dam-age at 74 trillion euros at todays value if action isnot taken to prevent climate change. This amount

is equivalent to a cost of 80140 euros per tonnefor CO2, compared to the current market levelof around 19 euros per tonne. More important,aggregating costs and benefits is misleading be-cause gains for some are taken to cancel out loss-es for others. 3 Tropical countries may be particu-larly exposed. Coral decay caused by temperaturerises and acidification could cost over 200 millioneuros a year in the Caribbean. The cost of Hurri-cane Ivan that hit Grenada in 2004 amounted totwice the countrys GDP. 4 The adverse outlook for

water, crops and sea-level rise in developing coun-tries mean that more people will be harmed by climate change than benefit from it.

In the short term, the rich north would benefitbecause of warmer winters while the poor would

1 THE DIRECT COST OF CLIMATE CHANGE

Table 1Macro-Economic Effectof Climate ChangeSource: IPCC, 2001

Country type Temperature rise Effect

Developing Any Generally net economic loss,increasing as temperature rises

Developed Up to 2 degrees Celsius Net economic gain

From 2 to 3 degrees Celsius Mixed or neutral

Over 3 degrees Celsius Net loss


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12 Climate Change

become poorer. But even the wealthier nations would eventually have difficulties if climatechange were to gather momentum, as shown inshown in Table 1. Even short term, problems indeveloping countries might destabilize the worldeconomy. There are two reasons. First, an increas-ing proportion of industrial and service activity islocated there, so that disruption would affect the

whole supply chain. This has not yet been fac-tored into the projections. Second, an increase ininequality could trigger criminal and civil disor-der on a large scale.

These considerations are underlined by thepossibility that climate change may acceleratedue to chain-reaction effects as certain thresholdsin the climate system are exceeded (see Box 1),leading to influxes of climate refugees.

The cost of natural disasters can be cripplingfor developing nations. The World Bank has inad-

vertently become the worlds third largest rein-surer after Munich Re and Swiss Re because it

has to divert so much of its development fundsinto disaster relief. Rich countries are vulnerabletoo, but they have the resources to cope. Japan forexample has two million people living belowhigh-water level, and assets of 400 billion euros inthat zone. Climate change will double that expo-sure by 2100.

Among the concerns that Japan needs to deal with are heat waves. Each increase of 1 degreeCelsius in air temperature reduces the efficiency of nuclear power plant by between 1 and 2 per-cent but at the same time increases demand by 5000 megawatts (MW). 5

Water shortages are set to increase even in astable climate simply because of economic devel-opment. Industry is greedy for water. 5 billionpeople will have inadequate access to drinkable

water by 2025. Consumption is also increasing incountries where populations are growing and be-coming wealthier. Climate change will worsen thisin Central Asia, the Mediterranean region, south-


Climate change projections depict agradual increase in temperature andprecipitation. However, prehistoricdatashows that at least eight times in thepast 11,000 years there has been anabrupt onset of a radical new state. 6

Ice-cores show that the average tem-perature in Greenland shifted by 10 degrees Celsius in 5 years, andthat annual snowfall halved within3 years. One of the key triggersappears to be the failure of the Gulf Stream or thermohaline current (THC).Shutdown of THC could result incatastrophic changes in ice cover or

vegetation, dramatic shifts in the water cycle, and a sharp drop in tem-perature for the North Atlantic andall those regions which border the

Atlantic (East Coast USA and Canada,Western Europe).

A study commissioned by the Pen-tagon 7 concluded that disruption andconflict will be endemic features of life if abrupt climate change occurs,and that many countries needs willexceed their carrying capacity withconsequent large population move-ments. Contrary to the Hollywoodblockbuster The Day after Tomorrow,the possibility of this event occurringbefore 2100 is very small, 8 and gener-al planetary warming would cushionthe effect to some extent. 9 However,there are already signs of change inthe North Atlantic: weaker currents, 10

and changing temperature. 11

It is more likely that climatechange could accelerate due to naturalfeedback mechanisms, such as the dis-appearance of tropical rainforests, thethawing of tundra, and the shrinkingof ice-cover; all of which would speedup global warming by increasingthe level of greenhouse gases, or theabsorption of heat by oceans. Already the official UK climate models at theHadley Centre are indicating suchpossibilities in some of their projec-tions. 12 The changes would compoundthemselves, because natural systems(e.g. forests and rivers) might start tofail due to the high rate of change, andthe risk of unstable weather patterns

would also be much higher.

Rapid Climate ChangeBox 1


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ern Africa and Australia by 2025, adding another500 million to the water-deprived. Around the

world, the land surface hit by drought has risenfrom 15 percent to 30 percent in 30 years. 13 Many reservoirs in Australia are at only half capacity. A2002 drought there cut farm output by 30 per-cent, lowered GDP by 1.6 percent, and cut 70,000jobs.14 In Africa, the Maghreb faces a rainfalldecline of up to 40 percent by the 2050s. This inturn carries the risk that refugees will be drivenaway by drought and start heading for the EU. 15

In places like Peru, California and India, the lossof glacier water will cause problems for hydro-power, agriculture, and consumers, and lead to anultimate conflict over resources. 16 In southernAfrica, as much as 8 percent of GDP could be lostbecause of hydropower shortages.

Paradoxically, the flood risk will increase evenin drought-prone regions because climate changeconcentrates precipitation. Warm air can carry greater amounts of moisture than cold air. When

it rains, the run-off will be faster because of sun-baked surfaces. Rapid urbanization of low-lyingcoastal areas means not only an increase in popu-lation densities but also increasing levels of assetsbeing placed at risk. The risk of urban flooding

will increase due to outdated drainage and otherinfrastructure deficits. Individual country studiessuch as in Egypt, Poland, and Vietnam have esti-mated that the costs of rising sea levels will be inthe tens of billions of euros. Although scienceremains unable to provide definitive informationabout future storms, it is notable that 2004 was arecord year for both hurricanes in the USA andtyphoons in Japan. 17 The storms lasted longerthan usual and reached further north than nor-mal. In addition, Brazil was struck by its first-everhurricane-like storm.

Temperature increases of up to around 2.5 de-grees Celsius can have positive effects on foodproduction. For example, milder winters prolonggrowing seasons in higher latitudes. 18 The effectis less in the tropics because of the existing hightemperatures.

Overall, the effects of climate change onhuman health will be adverse, particularly for the

poor because of their vulnerability to floodingand to heat stress combined with greater humid-ity and air pollution. Diseases like malaria willspread. Climate change already causes about160,000 deaths a year because of hunger, poor

water quality, respiratory problems, and drown-ing. This will be greatly worsened by shortages of food and persisting difficulties in obtaining clean

water. 19

1.2 The European Perspective

The facts make it clear that action needs to be taken urgently. A European Environment Agency report in 2004 said Europe is warming 40 percentfaster than the world as a whole. 20 Across Europethe negative effects will be greatest in the southand east. 21 Hot summers will double in frequency by 2020 (in Spain, they will occur five times as

often) and increase tenfold by 2080. Cold winters will halve in frequency by 2020 and be non-exis-tent by 2080. Summers will be drier in southernEurope and winters will be wetter in northernEurope.

Severe damage is already evident. Storms in1999 cost 13 billion euros, floods in 2002 13 bil-lion euros, and a heat wave in 2003 10 billioneuros. A total of 14 climate-related incidents since1987 have cost over 75 billion euros, while theannual cost of climate disasters in the EU regionhas doubled to 8 billion euros in 20 years. 22 By 2070 rivers in southern Europe will be carryinghalf the water they do now while those in thenorth will be carrying half as much again. Even inregions that become drier, rainfall will be moreconcentrated. The risks of flooding will rise. Ananalysis of catastrophe damages suggests that a1 percent increase in precipitation is associated

with losses of up to 2.8 percent. 23 Already thenumber of major floods in Europe has risen fromone per year between 1900 and 1974 to 15 a yearbetween 1993 and 2001. 24

In the UK, floods cost 1.5 billion euros a year.By 2070, this could be twenty times as much.



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towards either wet or dry months, but the cur-rent decade has been hit by severe flooding. Asector which is clearly exposed to extreme condi-tions is the insurance industry, but this is amelio-rated by the fact that, outside the UK, the risk isoften borne formally or informally by the state orby the victims themselves.

Conclusions

1. Potential losses from climate warming areincalculable in detail, but a European Commis-sion paper estimates a global figure of 74 tril-lion euros if effective action is not taken.

2. Rises in sea level will threaten to displaceentire coastal communities and destroy theirassets with severe disruptionto adjacent regionsand the finance sector.

3. Poor countries will be the first to be hit by climate change, but this will set off a reactionin the supply chain that will eventually affect

wealthier countries.4. Widespread drought and shortages of water

will lead to problems for agriculture, hydropower and, ultimately, to a conflict overresources.

5. In Europe, where warming is happening fasterthan elsewhere, flooding is already costinghuge amounts, with worse to come.

6. Health systems will need to come to terms with increases in certain diseases such as skincancer as climates warm.

7. Insurance companies were the first financialsector companies affected by the impacts of climate change. Today the impacts extend toliterally all branches of the sector.

Table 2

Number of AbnormalWeather Months perDecade in UKExpected level is12 per decade.Threshold for abnormal isthe 10-percent level. Datafrom the Hadley Centrewebsite. 2000s proratedto observed period.

Type/decade 1960s 70s 80s 90s 2000s

Hot 10 17 18 34 33

Cold 15 17 18 13 10

Wet 14 11 19 15 26

Dry 10 15 10 15 12


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2The Economic Implicationsof Climate Change Policies

The problems of climate change have their ori- gins in the greenhouse gases created from economic activity. 34 Because these emissions wereonce considered as harmless by-products, theirside-effects were not included in the cost of pro-duction. Even as economic progress was givingmillions of people higher standards of living,climate change remained a nebulous concept that

would take place sometime in the future and nota visible, immediate issue.

This means that deliberate intervention is needed

to alter behavior patterns.35

In 1992, the countriesof the world met under the auspices of the UnitedNations and agreed on the United Nations Frame-

work Convention on Climate Change (UNFCCC).The key aim of this is to avoid dangerous climatechange while permitting economic development.The primary objective is to reduce emissionsfrom economic activity, and the second is tolessen the impact of unavoidable climatic changes.Under the UNFCCC, strategies to control green-house gas emissions and limit damage from cli-matic extremes are known as policies and meas-ures respectively for mitigation and adaptation .Mitigation policies draw the most attention, be-cause they affect the whole economy and oftenfeature unfamiliar regulations. Adaptation isdirected only at vulnerable activities, and may simply be an extension of current measures. Thekey instrument is the Kyoto Protocol (see Box 2).

2.1 Mitigation Policy

Mitigating the effects of climate change is not as expensive as many people think. Often there are significant, immediate benefits such as clean air and new jobs.

Carbon emissions could be cut by between 20 per-cent and 40 percent by 2020 using current tech-nology, estimates the Intergovernmental Panel onClimate Change. It says half that reduction wouldcost nothing extra while the rest would be subject

to a modest cost of around ten euros per tonneof CO2.36

Efficient lighting can cut lighting bills by be-tween 50 and 75 percent with a payback in one tothree years. 37 BP claims to have saved 500 millioneuros over three years by introducing voluntary internal carbon constraints, encouraging its work-force and management to seek both greater effi-ciency and new sources of revenue from by-prod-ucts.38 Similar stories come from other membersof The Climate Group, an association of compa-nies, cities and regional administrations devotedto spreading good practice in the area of climatechange.

But climate change might not be the only rea-son for taking such steps. Other reasons might bereducing dependence on energy imports, achiev-ing more reliable energy price levels, ensuringclean air, or creating jobs (45,000 new jobs werecreated in wind power industry in seven years). 39

Another benefit of mitigation is the incentiveto innovate. The development of wind-poweredelectricity is a prime example. Ultimately, sup-plies of conventional gas and oil need to bereplaced anyway. Similarly, the growth of carbon

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markets associated with emissions entitlementsoffers revenue opportunities for developingcountries and more efficient companies, and willneed a range of services from the finance sector.International emissions trading could be worthbetween 50 and 800 billion euros in 2025. 40

Policy is only beginning to take into accountclimate change as an economic factor. Policy innovations include price guarantees for renew-able energy, quotas for non-fossil fuels, energy-efficiency standards, compulsory and voluntary limits on emissions, and emissions tradingschemes (cap-and-trade schemes, see Box 3).

The EU has in fact a wide range of policy ini-tiatives in place or in prospect to fight climatechange, and will have to develop further ones.

Outside the EU, various sub-federal initiativesare being implemented, notably in the UnitedStates, Canada, and Australia.

2.2 Effects on the Corporate Sector

Carbon constraints will mean different things for different sectors. Studies show, for example, that the effects on corporate earnings for the motor industry worldwide would vary considerably.Earnings for some manufacturers would increase while others would decline.

Other reports indicate that earnings globally inthe oil and gas industries would be neutral insome cases and down in others, and that the vari-ation would be less than in the motor industry.The gas sector stands to benefit from changes.Metals and mining especially aluminum andsteel would be vulnerable. Electricity and waterutilities would generally be able to minimizefinancial impacts by passing costs on to the con-sumer, although one study did suggest that coal-based utilities were in some cases unprepared

while some utilities were not always in a position

to pass on costs. The option of passing on thosecosts depends on the price sensitivity of demand,


The 1997 Kyoto Protocol was the firstsubstantive agreement to mitigateglobal warming under the UnitedNations Framework Convention onClimate Change (UNFCCC). Annex 1(38 developed countries) agreed toreduce their emissions of six green-house gases by a total of 5.2 percentbetween 20082012 from 1990 levels.The six gases include carbon dioxide(CO2), methane, nitrous oxide, andthree fluorocarbons. Other countriesagreed to adopt positive measures, but

without any binding targets. A shareof the Annex 1 obligations to reducethe emissions can be achieved viathree flexible mechanisms: Interna-

tional Emissions Trading (IET), JointImplementation (JI) and the CleanDevelopment Mechanism (CDM).Under IET, industrialized countriescan trade part of their emissionsbudget known as Assigned AmountUnits (AAUs). In principle, this trad-ing regime applies to nation states,although the participation of compa-nies is not explicitly excluded. JI andCDM are project-based mechanisms,since new emission certificates aregenerated via specific emission re-duction projects. Under JI, an indus-trialized country invests in an emis-sion reduction project in anotherindustrialized country and receives

credits for achieved emission reduc-tions so called Emissions ReductionUnits (ERUs). Under the CDM, anindustrialized country invests in aproject in a developing country andobtains credits for emission reductionscalled Certified Emissions ReductionUnit (CERs). The Kyoto Protocolentered into force on February 16,2005, but was somewhat diminishedin impact by the non-ratification of key parties, including the United Statesand Australia.

In addition to the Articles on miti-gation, there are also important oneson adaptation, particularly for devel-oping nations, and awareness-raising.

The Kyoto Protocol

Box 2


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as well as market regulation and market ineffi-ciencies. Even more challenging for utilities is tomake investment decisions to replace or upgradeexisting infrastructure today while at the sametime accommodating the long-term outlook of decreasing future emission allocations.

The driving force behind much of the currentcarbon market activity is the EU ETS (see Box 3).Although it started on January 1, 2005, it is stillevolving as emissions allocations had not all beenapproved by that date. Some of the early warningsof huge effects in certain sectors seem unlikely

18 Climate Change


now, but the current market price has climbed toover 20 euros per tonne of CO 2 (May 30) which isnot negligible. The International Energy Agency believes the effect of the EU ETS on internationalcompetitiveness of whole economies is marginal,as eligible companies receive free entitlementsfor most of their emissions. Nevertheless, sensi-tive sectors are the energy-intensive industries(cement, metals), or those which produce energy (oil and gas, coal, power utilities). Rising powerprices combined with rising oil and CO 2 pricesare likely to negatively impact energy intensiveindustries located in Europe,in particular when therate of growth in Chinese demand is slowing.

There has been a steady flow of researchreports looking into the issue of carbon con-straints on corporate earnings since 2002. Natu-rally the earlier findings were somewhat specula-tive, because the status of the Kyoto Protocol wasuncertain, and the EU ETS was not well-defined.The fact that the studies come from different

sources (banks, investment brokers, policy ana-lysts, energy industry institutes etc) and arebroadly in agreement means that one can usethem to frame strategies.

In some cases the analysis is simply qualita-tive, but it may still be useful given the greatuncertainties in policy implementation, and thefact that climate change is only one influence oncorporate performance.

Most of the results below relate to the EU ETSspecifically. However the first three are broader,and contain an important general message. They demonstrate that there are non-trivial systematicdifferences in the present value of corporate earn-ings, across a range of possible future climate pol-icy scenarios. This means that managements andinvestors cannot assume that there will be time toreact to policy when it is approaching implemen-tation, because there are strategic structural fac-tors such as access to resources and technology, orcustomer mix, which take longer to shift. A sec-ond point that recurs is that some sectors faceseveral environmental challenges, and that tack-ling greenhouse gas emissions may interact withsome of those other problems.

The EU ETS is a so-called cap-and-trade scheme regulatingindustrial CO 2 emissions in theEU 25. The scheme started in Jan-uary 2005. The first phase runsfrom 20052007, the secondphase runs from 20082012,coinciding with the first KyotoProtocol commitment period.About half of EU CO 2 emissionsare covered by the scheme. It istargetted at large individual ener-gy-using installations in definedeconomic sectors: mainly ener-gy production, metals, construc-

tion materials, and paper. As amarket-based mechanism theETS ensures emissions are re-duced most cost-efficiently, thecap giving effective control overtotal emission amounts.

Each EU country has to devel-op a National Allocation Plan(NAP) outlining the total numberof emissions allowances (EUAs)allocated (free of charge) to the

individual installations coveredby the scheme. According to theEuropean Commission, the allo-cation of allowances should bein line with the member statesKyoto commitments. At the endof each year, each site must sur-render sufficient allowances tocover their CO 2 emissions forthat year. Failure to do so willresult in fines 40 euros pertonne of CO 2 in the first period,and 100 euros in 20082012. Inaddition, the deficit must becompensated for in the follow-

ing year.Companies can meet their

targets by implementing meas-ures to reduce CO 2 emissions orby buying surplus allowancesfrom other firms i.e. trading. Theso-called linking directivefrom2004 allows emissions creditsfrom JI/CDM projects under theKyoto Protocol to be used withinthe EU ETS.

EU Emissions TradingScheme (EU ETS)

Box 3


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Climate Change 19

A study of the general effect of climate policy on the automobile industry across the world by The World Resources Institute (WRI) concludedthat the effect of carbon constraints on the corpo-rate earnings of individual companies rangedfrom an increase of 9 percent to a decline of 10percent, reflecting factors such as the likely com-pliance costs to match potential emissions con-trols on vehicles and the manufacturers customermix. Most interestingly, the study examined arange of scenarios and concluded that a company such as Toyota which had a strong R&D programon technologies that might replace the internalcombustion engine would have a distinct advan-tage in every scenario. 41

A second study in the same general, non-EUseries by WRI looked at the oil and gas sectorglobally,again using a scenario approach to issuessuch as the Kyoto Protocol and found systematicdifferences, but over a smaller range, from mar-ginally positive to a decline of 5 percent in earn-

ings.42

Curiously, Exxon Mobil, which has cam-paigned against early action on climate change,

was not as vulnerable to mitigation policy assome other petrocarbon companies.

ABN/AMRO carried out a multi-sector study, which identified metals and mining as the mostaffected industry, particularly aluminum andsteel.43 On the other hand gas (the cleanest fossilfuel, and an easy substitute for coal) and platinum(for fuel cells) will benefit. The analysts felt thatelectricity and water companies would be rela-tively unaffected because costs could be passedon to customers. Car manufacturers might facepotential brand issues (along the lines of the cam-paign what car would Jesus drive?). Cementcompanies in Annex 1 countries might be forcedto focus on special-purpose products because of external competition. The study named individ-ual companies in each sector as winners or losersbut the selection was different from other ana-lysts and not quantified. 44

Turning now specifically to EU ETS, in an early study of the power sector DrKW rightly felt thatemissions regulation was inevitable. If a toughallocation of permits was adopted the effect on

wholesale electricity prices might be as much as a70 percent increase. Initially, it looked as if theNational Allocation Plans (NAPs) would be tooloose, but then they were tightened by the Euro-pean Commission. In fact, DrKW had already foreseen two years ago consistently high pricesfor CO2 of above 15 euros per tonne. UBS adopt-ed a four-scenario approach to look at company prospects. It found that coal-based utilities (suchas RWE) faced an uncertain future, with a spreadof 70 percent in valuations. By contrast, theBritish utility SSE was stable with positive upsidein all four scenarios, because it would receive a

windfall benefit (free emission allowances). Thesector would become less commodity-like withpremiums for green electricity, and merger andacquisition activity might be stimulated. Theeffects would ripple along the value chain to fuelsuppliers, and heavy consumers. 45 Power compa-nies do have a range of options to respond withthe exact choice of which would depend on the

carbon price, and factors like vertical integration,availability and use of renewables, and diversifica-tion intentions. 46 WWF commissioned a study of utilities which found that companies in phase 1 of the ETS were unprepared. Some could be affectedby up to 10 percent of earnings because it was notalways able to pass on costs. Accepting the consid-erable uncertainty on NAPs, companies could stillplan responses such as switching from coal to gas.Wholesale electricity prices in the UK might riseby over 5 percent, the report said, but this nowseems unlikely. 47 Other environmental issuesthat interact with climate change here are acidrain, water quality (outflow from cooling), andlandscape aesthetics.

The effect of emissions trading on the energy sector should soon be clearly visible as an impor-tant factor in investment decisions regarding gen-eration assets, i.e. technology and fuel choice.

Cement currently accounts for 5 percent of global CO2 emissions. These emissions are grow-ing at 4 percent per year. CO 2 emission reductionsin this sector can be achieved by a number of strategies. However, to achieve deeper long-termcuts new ways to reduce the CO 2 impact of the



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20 Climate Change


cement sector will have to be developed. Uncer-tainty over the allocation of emissions permitsdoes not provide the necessary incentives for theindustry. 48 Other construction materials (such asglass and clay) have strong local pricing power,

which enables energy costs to be absorbed, orcannot be transported long distances. A DrKWstudy of the impact of EU ETS reduced targetshare prices on eight out of 18 companies in thecement sector by up to 13 percent and alteredinvestment recommendations on several. 49 Thisis broadly confirmed by McKinsey, whose expertsnote that while on average the effect may not begreat, the impacts will vary greatly between com-panies depending on individual circumstances,and also what other mitigation measures are inhand in firms primary areas. 50

Some energy-intensivesectors likethe aviationsector are not within the ambit of the EU ETS sofar. However, the sector is growing so rapidly, atabout 5 percent per year, and its impact is so large

(possibly 10 billion euros in terms of climatedamage) that it cannot be ignored by policy mak-ers much longer. Potentially 15 percent of totalhuman-induced climate change may be due to theaviation sector by 2050. 51 Both a fuel tax solutionand the inclusion of the aviation sector in emis-sions trading are currently being discussed onthe political level the airlines themselves (e.g.Lufthansa and British Airways) prefer emissionstrading. 52 Due to the large impact of the sector onclimate change, climate policy regulations for thesector could have considerable consequences forthe cost calculations of the airlines. DrKW esti-mates that corporate profits could be reduced by 1015 percent by an EU-wide fuel tax. 53

The related sector of travel and tourism gen-erates about 4 percent of GDP in the EU, and,mainly because of sun, sea and sand tourism,accounts for about 0.75 percent of global green-house gas emissions from Northern to SouthernEurope. 54 As shown in section 2 The EconomicImplications of Climate Change Policies, thisindustry is vulnerable to direct climate impacts,so it faces a doubled exposure to climate change if the cost of travel rises because of higher energy

prices. It has been ignored in investment studies,probably because its market capitalization issmall. But the social impacts could be very large it is a high employment sector, and also rankshigh in consumer awareness.

Finally Nikko and Citigroup note a number of opportunities in power technology as climatechange policies begin to show effect. Energy effi-ciency technologies as well as renewable energies

will likely provide increased opportunities forfinanciers.

2.3 Effects on the Consumer Sector

Consumers will be affected by emissions regulations indirectly through the cost of goods and services 55 , and also through increasing emphasis onenergy efficiency in household and transport use.

In the EU, the price effect of industrial sector reg-ulation will generally be small, at least until thesecond phase of the Emissions Trading Scheme.The effect on high-street prices will be minimal;many non-energy factors in production process

will be little affected. Although the impact is like-ly to be greater between 2008 and 2012, when theKyoto Protocol targets have to be met, govern-ments are likely to be careful about taking directaction that might hit the consumer sector such asintroducing steep increases in energy prices orraising taxes.

Increasing emphasis will be placed on energy efficiency, and the setting of energy performancestandards for all major types of equipment(cars, domestic appliances) as well as real estate(see Box 4). Though the capital cost of moreefficient equipment may be higher, the whole-life cost may be less once energy savings andreduced maintenance are allowed. Voluntary standards run the risk that consumers will opt forcheaper equipment, ignoring the savings thatcome later.

Once consumer hardware becomes generally more energy efficient, policies leading to energy


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Climate Change 21


price increases will gain more widespread accept-ance. The value of older equipment and property

will decline in relative terms as their running costsincrease. For consumer goods which are quickly

replaced, it would be ideal if this entire processcould take place within the time frame of theKyoto Protocol that is, by 2012. For property, thesituation is more complicated because demo-graphic trends and ownership patterns vary markedly across the EU, as does the replacementrate of domestic property stock. (Currently only about 0.1 percent of the UK housing stock isdemolished every year).

A key element in getting consumers to play apart in emissions reduction is education. Oneconsequence of higher efficiency is the reboundeffect. Instead of accepting the savings fromreduced consumption, consumers change theirbehavior to raise consumption back to previouslevels. They increase home heating or drive far-ther or faster. Consumers need to learn to beenergy-wise, to monitor consumption and to con-sider whole-life costs. For people with less dispos-able income such as the elderly or single parents,even small cost increases from climate policy may be burdensome, and policymakers will need toconsider this.

Conclusions

1. Managements and investors should not assumethey will have time to react to policy when it

is approaching implementation. Proactive en-gagement with policymakers to plan ahead forbusiness changes is required.

2. Climate change mitigation measures are ofteninexpensive, and the savings and side benefitsmay accrue quickly.

3. Governments need to bring in unambiguouspolicies so investors are not deterred. Compa-nies need clear signals and directions from pol-icymakers about future climate change relatedregulations.

4. Carbon constraints will have different effectson the earnings of companies, both from sec-tor to sector and within sectors.

5. Some measures to combat climate change willhave significant side-benefits as well, such as re-ducing reliance on imports,stable energy prices,cleaner air, employment and innovation.

European Member States will have to imple-ment the Energy Performance of BuildingsDirective (EPBD) by January 4, 2006 at thelatest. It is intended to bring about a majoruplift in the efficiency of energy consumptionin building stock, which accounts for 40 per-cent of EU final energy demand. There arefour key measures: introduction of a soundmethodology to calculate energy performance;

application of minimum standards to newbuildings and larger old buildings at the timeof major renovation; certification of buildingsperformance when built, sold, or rented; andregular inspection of heating and cooling sys-tems. Only industrial and historic buildingsare excluded, and any buildings frequented by the public will have to display a certificate of energy efficiency.

EU Energy Performanceof Buildings Directive

Box 4


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22 Climate Change

3The Necessary Path

Since the last report of the International Panel onClimate Change in 2001 much new evidence hasarrived showing that the risk of climate change isconsiderably worse than previously thought. Thesensitivity of the climate system has been under-estimated (see Box 5). New factors like acidifi-cation of the ocean have been identified 56. Thedisappearance of polar icecaps 57, 58 and tropicalforests 59 is almost inevitable, unless we act soon.

3.1 Avoiding Dangerous ClimateChange

Climate has to be measured in many ways for anaccurate picture, but the key statistic is the average temperature. The Earths temperature takes a longtime to respond to changes in the atmosphere,because the land and water are so massive. Wait-ing until the temperature has stabilized is there-fore not an option, because damaging impactsmay arrive before equilibrium is reached. Thealternative is to select a level of greenhouse gases

in the atmosphere that seems likely to just avoidcausing a dangerous equilibrium temperatureand aim to remain below that. Atmospheric levelsof concentration in gas are measured in parts permillion by volume of carbon dioxide equivalentor ppmv cde. There is growing international con-sensus that global average temperature shouldnot increase by more than 2 degrees Celsius andrather stay below this.

3 THE NECESSARY PATH

Box 5

Recent observations of the atmos-phere show that pollution has beendimming the suns radiation and soslowing down the pace of climatechange, perhaps by as much as half.Unfortunately, it also has seriousimmediate effects on plant growth,human health, and rainfall, so it can-not be allowed to continue. If it is elim-

inated it will effectively double therate of global warming. 60, 61 A secondsource of concern is that because of their huge size, very few variationscan be tested on climate change com-puter models (General CirculationModels, or GCMs). The standard pro-jection given for climate change is atemperature range by 2100 of 1.4 to

5.8 degrees Celsius. A recent novelexperiment took advantage of thespare capacity on domestic personalcomputers to try out thousands of plausible variations and found thatthe range was extended at the top endto 11.9 degrees Celsius, which wouldbe catastrophic. 62

The High Sensitivity of the Climate System


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Climate Change 23

Because of these factors the European Heads of State stated that the global average temperatureincrease should not exceed 2 degrees Celsius. 63

Earlier, the European Environment Ministers 64

stated that this temperature stabilization wouldmean require staying well below a GHG level of 550 ppmv cde, which is double the natural levelof CO2. This implies a cut in annual GHG emis-sions of 60 to 80 percent by 2050 globally, from thecurrent level of almost 7 billion tonnes of carbon tounder 2.5 billion. In line with these targets, indi-

vidual member states have already announcednational greenhouse gas reduction targets thatsupport a path of deep and consistent reductions.For example, France is aiming at a 75 percentreduction by 2050, UK a 60 percent cut by 2050,and Germany 40 percent by 2020. However, themost recent evidence on climate change process-es reduces the safe level of GHGs by about a quar-ter. Therefore, to limit the rise in temperature tounder 2 degrees Celsius with high confidence

means aiming for 450 ppmv cde, not 550.65

By 2004 the GHG level was already over 400ppmv cde and rising at 2 ppmv each year 66. It isclear that urgent action is needed to address thedivergence between what we are doing and what

we need to do and that using less energy, or usingcarbon-light technologies will be needed to com-pensate for this. In fact, because we are not main-taining a stable level of emissions but increasingthem, it will require double the effort to achievea safe concentration of greenhouse gases in theatmosphere. Therefore deeper and faster reduc-tions of greenhouse gases will be necessary. Forgovernments, waiting for more scientific certain-ty does not appear to be sound. 67 Delaying actionby 20 years could mean reducing emissions very rapidly later (three to seven times faster to meetthe same target). On the other hand, early actionovercomes the inertia of the climate and socio-economic systems, and provides greater certainty to business for long-term investment and techno-logical change.To take an analogy fromphysics, thestatic friction that prevents movement is muchgreater than the kinetic friction that opposes amoving body.

3.2 What is Good Policy?

A key issue is finding policies that work. Because there are many barriers to change (such as the long-life of capital stock, fear of risk, problems of scale, transition from laboratory to marketplace),to inspire confidence and innovation policies must be loud, long and legal. 68 That is, they mustbe unambiguous, well-signalled in advance, andenforced reliably. Cinergy, a major coal-depend-ent utility in the USA, has publicly called foremissions regulation by the federal government,because there is a proliferation of sub-federalinitiatives, but more importantly because invest-ing in cleaner technology is expensive and cannotbe justified economically without a change inoperating regulations. 69

At present, businesses are faced with mixedsignals on energy technology. EU-15 subsidizedfossil fuels by 24 billion euros in 2004, comparedto 5.3 billion for renewables. International trans-

port fuel is tax-exempt, yet air transport is thefastest-growing source of emissions.

Absence of policy is in fact worse than unfa- vorable policy, since the risk of policy changedeters any investment. Long-term policy plan-ning can have a strong payback in economicterms. Providing 10 years warning of a fiscal taxcan reduce the cost by one-third as efficientprocesses can be implemented beforehand. Costs

will be lower if new technology is introduced aspart of the business cycle. Much of EU powercapacity needs to be replaced within the next20 years (at a cost of 1.2 trillion euros), whichraises serious issues for those countries and com-panies in particular that currently operate onthe basis of a fossil-fuel heavy generation port-folio or electricity sector. If the restructuring canbe accomplished with low-carbon technology,new plants will not have to be retired early. Devel-oping countries like China and India are expand-ing rapidly, with huge investments in new infra-structure and buildings. Both situations offer agolden chance to introduce climate-friendly solu-tions in the course of economic expansion orreplacement.



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Creating new energy technologies can be costly and risky. Generally this means that it does notsuit investors requirements. The private sectoroperates on a short duration-high risk to longduration-low risk front. Unfortunately, this is thereverse of technological development, where thelonger the gestation, the higher the risk. Thismeans that governments need to provide supportfor lengthy programs to reduce the risk profile.Yet globally, government energy R&D has fallenfrom a peak of over 10 billion euros in 1980 tounder 6 billion in 2001, and most of the spending

was concentrated on nuclear power. Some coun-tries also heavily subsidize fossil fuels at theexpense of funds available for new technologies.Policy changes are creating a perception of greater risk for investors in the energy sector dueto increased uncertainty about fossil fuel eco-nomics. This can be countered to some extent by reducing the uncertainty in renewables, but insuch a dynamic situation it seems inevitable that

investors will have less appetite to participate inthe energy sector until policies have crystallizedand new business models have emerged andstabilized.

A second area of concern for the private sectoris the so-called valley of death for innovators. Toget from pure research to the marketplace, inno-

vations have to pass through a number of stages,from basic R&D to demonstration, to niche mar-ket and then full commercial production. Govern-ments are often prepared to support the initialphases of innovation, but are reluctant to pick

winners that is, to support manufacturers inthe wind-up to full-scale production and market-ing, between the demonstration to niche marketphases of development. Since this is a cash-burnsituation, when the costs are still high and therevenue is insignificant, it is unattractive forinvestors. Nevertheless major American institu-tional investors have announced a target of investing 400 million euros into clean technology including renewable energy in the near future,and have set up the organizational structuresto achieve this with external advisors. Allianzsprivate equity arm Allianz Capital Partners has

entered renewable technologies. So far, Allianzhas bought the wind power gearbox manufactur-er Hansen Transmissions for 132 million euros.More major investments will follow.

A crucial issue is how climate change will betackled internationally. There are many possibili-ties. The finance sector would like to know now

what goals for emissions will be set for after 2012, when the first Kyoto Protocol commitment periodends and what instruments will be used toachieve them. Financial companies see emissionstrading systems as having great potential in emis-sions reduction efficiency with a range of busi-ness opportunities. This requires transparency and reliability in rules and regulation, based on aclear downward path for reduction targets toachieve the required CO 2 target levels.

The sector would also like to see developingcountries involved in a way that utilizes marketmechanisms such as emissions trading.

Conclusions

1. To avoid dangerous climate change, very largecuts in greenhouse gas emissions are required,of the order of 60 to 80 percent by 2050.

2. This means a big shift in energy policy now.Governments need to bring in unambiguouslong-term policies so investors are not deterredby the increased riskiness of energy projects.

3. Climate change mitigation measures are notalways expensive, and the gains are not alwaysonly in the long-term.

4. Carbon constraints will have different effectson the earnings of companies, both from sec-tor to sector and within sectors.

5. Some measures to combat climate changemight be introduced for other reasons as well,such as reducing reliance on energy imports orto avoid energy price volatility.


24 Climate Change


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Climate Change 25

4Financial Services: New

Risks, New OpportunitiesClimate change is creating new risks but alsonew opportunities for all sectors of society fromchanging weather conditions to greenhouse gasabatement measures. The financial services in-dustry needs to adapt its internal processes, poli-cies, products and services to meet the challengesits clients face as well as to safeguard its own

viability. This survey looks at each of the threebranches of financial services insurance, bank-ing, and asset management as well as issues thataffect institutions in all three.

4.1 Insurance

Climate change and climate policy affect insurers through the risks they accept from clients. Sinceclimate experts predict changes in the intensity and distribution of extreme weather events (espe-cially water-related and storms), and because of the resulting risk of catastrophic property claims,insurers are likely to regard climate change as athreat rather than an opportunity.

Insurers need to adapt to climate change by assessing how changing weather patterns willinfluence their clients exposure. They must adapttheir risk assessment and review their underwrit-ing (pricing, contract conditions and risk accept-ance procedures) with a view to their specificrisk exposure (line of business, geography, etc.),and business opportunities as well as the typeof customer (private, commercial, industrial) they are focussed on (see Table 3).

Beyond this core business activity, mitigationoffers some interesting new opportunities forinsurance. In some cases, insurers may be able to

assist clients that are involved in renewable ener-gyor energy efficiency technologies.In thisway theinsurance industry can offset its short-term risksarising from polluting and inefficient technolo-gies and also decrease its long-term risk arisingfrom extreme events.

4.1.1 Adapting to Climate Change

IMPACT ON INSURANCE

Adapting to climate change is a huge challenge

for insurance. Insured weather losses from prop-erty damage in 2004 hit a record 32 billion eurosbecause of severe storms in Japan and USA. 70

Such storms, their frequency, location, timing andintensity are a strong indication of climatechange. Their occurrence is also part of a strongupward trend in catastrophe costs in other loca-tions like Europe 71 and Australia. 72 A study by theAssociation of British insurers has found thatclimate change is increasing the potential of prop-erty damage at a rate of 2 to 4 percent a year.Since insurance pricing relies on historical data,this could lead to an underpricing of weatherrisks by as much as 30 percent. 73 In Allianzs global industrial insurance busi-

ness, for example, around 35 to 40 percent of insured losses are due to natural catastrophes.More than three quarters of these losses arefrom storms and floods, so the overall effect of ignoring a trend would be serious. Potentially,climate change will make storms worse becausea warmer atmosphere will contain more energy and transport more rain.Here, research in co-operation with modelling

centers is necessary to better identify regional

4 FINANCIAL SERVICES: NEW RISKS, NEW OPPORTUNITIES


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26 Climate Change

impacts of climate change. On balance, climatechange in Europe may prolong human lifebecause of milder winters, but it could also bringincreased burdens for health insurers and pen-sion funds. Other effects are expected to includeclaims for loss of sales, heat stress to clients orstaff, damage to vehicles, travel delays, and pollu-tion as a result of floods.

How insurers react to trends or scientific evi-dence varies greatly between the lines of insur-ance. For industrial and large commercial clients,contracts are renewed every year and the port-folio can be totally altered, taking into account

the number of contracts in regions particularly exposed to risk of climate change. Trend assess-ments can help to investigate the vulnerability of different industrial sectors. However, extremeevents occur in bursts, so that there are quietperiods that lead to a form of inertia and scien-tists are reluctant to commit themselves on indi-

vidual events, so market and regulatory forcesmay be the decisive factors. Finally, to be able toreact at all, insurers need to survive the firstonslaught several insurers in Florida did notsurvive Hurricane Andrew.


Table 3Important Climate

Change-Related Risksand Opportunities

for InsurersAdapted from ABI 2004

Insurance class/ Risks Opportunitiesline of business (from climate impacts, (from proactive policy or

policy implementation, climate impacts)or policy failure)

Property Unprecedented accumulation More demand for insurance andof extreme events threaten alternative risk transfer

solvency/liquidity

Risk differentials can be priced Getting cover may become harder Insurance of Kyoto projects Lack of capital/reinsurance Administration of disaster recovery Inaccurate risk pricing Prototype equipment can be Misinformed response from insured

public sector More costly repair-work

Casualty Unexpected claims for duty of care Cover for professional services to Product failures in new conditions carbon markets Disruption to transport Green transport products such

(extreme events) as low-mileage motor policies

Life/health/ Episodic impacts on human health More demand for health coversavings Underestimating human life Growing wealth in developing

expectancy due to warmer winter markets due to technologyin northern hemisphere transfer

Reduced disposable incomedue to disasters

Other under- Increased losses from business Alternative risk transferwriting interruption, e.g. due to failure (catastrophe bonds etc.)

of public utilities R&D risks for low carbon Disruption to leisure events technology Increased losses in agro-business Consulting/advisory services Novel technology in energy sector Insurance for emissions trading

Trade risks for technology exports Carbon becomes an insurable

asset


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Climate Change 27

For private and small commercial clients (massmarkets), however, policies are not regularly reviewed. In fact, these policies generate the bulkof claims, for example during the Elbe flood of summer 2002 in central Europe. Changing thestrategy in mass markets is much more difficultcompared to industrial clients, due to regulatory and other pressure, which leaves insurance com-panies with a substantial climate related residualrisk in mass markets.

4.1.2 Insurance Solutions to TackleClimate Change BusinessRisks European Examples

Insurance practices vary greatly across Europe.The following pages give an overview of how theissue is being tackled in Allianzs major Europeanmarkets. In Britain , where much analysis has been carried

out, cover against weather perils is wide-spread.Projections suggest that climate change will dou-ble the annual cost of British weather claims to3.3 billion euros by 2050, while an extreme yearmight cost 20 billion euros. Research suggeststhat the underlying weather risk is rising at 2 to4 percent a year, which could lead to an under-estimate in pricing of as much as 30 percentbecause of the time lag between the historic dataused to set prices and future claims. 74 A particu-lar issue in the UK is flood insurance. The indus-try is introducing a competitive risk-based pric-ingstructuretoreplacetheolduniformtariff. Thisrequires cutting-edge analysis with geographicalinformation systems and catastrophe models. Norwich Union has developed its own risk

maps by using aerial surveys and is now sell-ing them to other insurers. As a result it wasfound that 10 percent of property to a total

value of 300 billion euros is at an immediaterisk of flooding.

The industry is also working with the gov-ernment and other stakeholders to control therisk through land-use planning, infrastruc-ture design, and funding for maintenance.

In Ireland , which has a similar insurance sys-tem to the UK, insurers are hampered by theabsence of a public post-code for real estate.Allianz Ireland has therefore geo-coded thebulk of its risks itself in order to apply a risk-related underwriting approach. An importantresource for carrying this out has been the 15-man internal risk survey force, which provideslocal knowledge about flood hazards for exam-ple. The government has just released its firstassessment of future climate impacts in Ire-land, 75 and this will help insurers to improvetheir planning.

In much of Germany flood insurance is avail-able for private and industrial customers.Allianz and other insurers supported the devel-opment of a zoning system based on the calcu-lation of probability of flooding using geologicaldata to allow risk-adequate priced insurance.Research commissioned by Allianz and otherGerman insurers indicated that the total expo-

sure to flood damage in one event might be15 billion euros. 76 This reflects the fact thatflood defences in some regions are rather weak(only good against a 30-year flood in formerEast Germany, for example).

The Czech Republic was hit hard by floods inboth 1997 and 2002. Unlike in 1997, little rein-surance cover was available in 2002 because of low reinsurance capacity after the World TradeCenter attack in 2001 and the concurrent stock-market crash. It was clear that risk manage-ment was worth investing money in. At the sametime public geo-data was obtained to constructrisk maps by combining internal insurancedata and public data (see Figure 1). By workingdirectly on model development itself, Allianzhas side-stepped the black-box syndromeassociated with proprietary models previously used. These models allow individual propertiesto be underwritten more precisely. Howeverhistorical data is not sufficient and it is impos-sible to check the programmed logic of propri-etary models which makes it difficult to assesshow effectively they will cope with novel cir-cumstances. The company is now exploring the



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28 Climate Change

potential costs of various flood scenarios by applying its data to hydrological models.

Geological and hydrometeorological hazardsgenerate important economic losses and socialdamages in Spain . The country is especially sen-

sitive to the impact that desertification couldhave in certain areas of Spain, such as the centerand the south, and the possible consequencesof a sea level rise in the coastal zones.Overall, floods produce the most importantlosses, having reached in the last decades anannual average of losses of around 0.1 percentof the gross domestic product.Projections made by the Geological Survey of Spain estimate losses due to floods will total25.7 billion euros over the next 30 years.In this context, it is remarkable that the SpanishConsortio 77 coverage has provided a reliable pro-tection against these climatic events in the past.Last year the Consortio introduced importantmodifications, giving much wider coverage inorder to insure all major climatic event scenarios.

In Italy Allianzs Italian subsidiary RAS adoptsa territorial area approach to implementingunderwriting rules and principles. The publicly available data on flood hazards is still notadequate for a thorough risk assessment, soinsurers are cautious in this area. Improve-ments in river banks, beds and maintenanceprogrammes in general are under way, but due

to failure in the past in enforcing regulationson land development, property in certain areasremains exposed. Insurance cover for climatechange related events is mostly restricted to thecommercial lines sectors. The price-driven

small and medium enterprise market tends togenerate an adverse risk selection. As a con-sequence, the offer of coverage and the devel-opment of a diversified weather risk portfolioare limited. Storm and atmospheric eventscoverage, however, is widespread. Apart fromflood events recorded in the north of Italy in1994 and 2000, the market was hit last winterby heavy snow falls. The peak loss was 2.5 mil-lion euros, due to a collapsed roof, which high-lighted the importance of building codes andthe quality of construction.

Elsewhere in Europe, the public sector oftenprefers to operate a solidarity system of cross-subsidy for weather risks, through disaster relief or public insurance. For example, in France ,there is a well-established public cat-nat rein-surance system which uses the private sectorfor administration. However, one aspect thatcauses some problem is that a disaster has to bedeclared by the local prefect to trigger the cov-er which can lead to anomalies. After severedroughts in the period 19892002 which causedthree billion euro worth of damage to build-ings, a double trigger method was established,


Figure 1Geographical Informa-

tion Systems and FloodRisk Czech RepublicSource: V Bohdanecky,

Allianz


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Climate Change 29

2. The Mega Cat program reinsures the topnatural peril scenarios of Allianz Group upto return periods of more than 1,000 years.Both tools make extensive use of the goodgeographical diversification of the differentAllianz entities. Depending on the scenario,these two covers provide NatCat protectionof more than 1.5 billion euros, so that evenmore intense events due to climate changeshould be covered.

The regulatory boundaries of insurance makesome risk transfer solutions complicated. 80 Forexample, new risk transfer tools like weatherderivatives are not regulated as insurance prod-ucts, and there is a basic presumption that catas-trophe risk can be accounted for on a one-yearbasis, although it is closer to the multi-year natureof life and pensions business.

4.1.3 Insurers Risks and

4.1.3 Opportunities in MitigatingClimate Change

New technologies are ultimately more efficientand represent better risks. Therefore there is anatural interest for insurance companies to


based on water table and soil typology to givean objective way of defining drought-hit areas.Yet, this method has its limitations; as it wasnot able to cope with the drought of 2003 whichcaused over one billion euros of damage in a sin-gle year. It was not preceded by a dry winter,

which was a criterion to provide coverage. Themethodology is therefore being reassessed. 78

The expected increases in losses from climatechange as described above will result in greaterdemands for public and private insurance mecha-nisms to provide compensation to victims, par-ticularly in flood-prone areas such as coasts,river catchments, and steep valleys. 79 This willbe counter-productive unless appropriate atten-tion is given to risk management, which is wherethe insurance industry could play a valuable role.Insurers need to focus their attention on solvency management by assessing their exposure to catas-trophe scenarios and arranging reinsurance. For example, Allianz Group set up two big

catastrophe (Cat) programs to optimize itsuse of reinsurance and to increase the groupprotection against worst case natural perils:1. Super Cat covers medium-sized events in

Europe and Australia up to return periods of 250 years by pooling the potential losses of the Allianz entities.

Supplementary to any compensation for lostassets, insurance policies can provide financialresources to cover costs incurred for clearanceand demolition, expenses involved in damagelimitation, outgoings for decontamination andremoval of soil, and professional disposal. If a commercial client of Allianz in Germany decides to include the eco-package in its prop-erty insurance, any additional costs involvedin order to upgrade facilities and protect the

environment as a result of replacing lost ordamaged items covered by the insurance willbe proportionately reimbursed. For example,the owner of a building that has burnt downcan replace the original single glazing withenergy-saving multiple-pane insulation glaz-ing when the structure is rebuilt. The addi-tional costs incurred will be reimbursed upto an agreed limit under the terms of theeco-package.

Upgrading Technology

to Protect the Environment

Box 6


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benchmark new technologies and thereby steertechnical innovation to effective implementationthrough risk-assessment techniques as well asconsider concessionary conditions for environ-mentally-friendly technologies.

Thus GHG mitigation provides some interestingnew opportunities for the insurance industry. Itcan influence and leverage the emergence of newtechnologies in several ways. One area is property and engineering insurance. Usually after aninsurance loss in an old industrial plant, theinsurer only has to pay for the installation of thetechnology that had been in use at the time of loss. Yet, if an upgrade of old facilities is possible,insurance could support this technological inno-

vation, although it is a more expensive option.Allianz is applying this possibility in many casestoday (see Box 6).

However, as with every profit-risk ratio, every new technology also has unrecognized or unfa-miliar risks for example offshore wind parkinstallations will entail cable laying, high stresscomponents, and salt corrosion, all of which can

potentially increase the risk of such an installa-tion. Absence of insurance is a powerful blockerto finance for projects in this area some expertsbelieve the volume of projects might rise by 300 percent if insurance cover were available. 81

This rise is expected despite the fact that insur-ance cover would make up as much as 11 percentof operating costs of offshore wind parks. 82

Allianz has paid 33 million euros in the lastten years in claims related to on-shore windturbines. This led the company to initiate closecollaboration between wind turbine producers,energy suppliers and certifiers to improve thetechnology and maintenance practices so thatinsurance could become available later.

In the field of geothermal energy, Munich Rehas similarly played a major role in developinginsurance cover for exploration risk.

Loss of revenue for renewable energy produc-ers is another potential field for new covers, forexample, for wind generators if the wind speedis too high or too low.


30 Climate Change

Various researches have been con-ducted by the financial sector to devel-op insurance instruments for thegreenhouse gas market as a whole andCDM projects in particular. There isobvious demand from project devel-opers, investors and buyers of CERsfor risk-mitigating tools for CDM pro-jects. Austrian Garant Insurance,French Global Sustainable Develop-ment Project (GSDP) and Swiss ReGreenhouse Gas Risk Solutions aretrying to meet this demand with the

launch of the first carbon delivery guarantee insurance. A carbon deliv-ery guarantee is an insurance product

where the re-insurer/insurer acts asguarantor for future CER delivery, andfinancial compensation is paid in caseCERs are not delivered according toagreed terms and conditions. The car-bon delivery guarantee is shaped tomeet the CER buyers demand for riskmitigation. One of the first carbondelivery guarantees was applied toCERs generated by a reduction project

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