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"Environmental Finance provides a thorough, objective discussion of the environmental risk issues facing financial institutions and how to effectively manage both the challenges and opportunities they present. A very current, informative and comprehensive reference."
-James R. Evans, Manager, Environmental Risk Management
RBC Financial Group
Today, environmentally irresponsible companies run the risk of hurting their bottom line as well as their image. As a result, environmental risk is reshaping the way insurance companies underwrite to corporate clients, banks lend, investors invest, and companies operate. Banks and insurance companies are also developing new environmental financial products to help their corporate customers protect their bottom line against changes in environmental legislation and the impact of adverse weather and climate change.
Environmental Finance: A Guide to Environmental Risk Assessment and Financial Products is one of the first books to explore this emerging field. This comprehensive reference opens with a discussion of the concepts and tools used by financial institutions to develop environmental policies and products, and then details how recent changes in the financial services sector have affected the capacity of companies to respond to the environmental challenge. From here you'll learn about innovative new products such as tradable pollution permits, weather derivatives, catastrophe bonds, and many other market-based solutions that are being created in response to every type of environmental problem-from hurricanes to asbestos.
The financial and social consequences of environmental risk will continue to grow. Learn how to hedge these risks and come out on top with Environmental Finance as your guide.
Environmental finance is a recently coined term, one that probably could not have appeared until the closing moments of the twentieth century. It encompasses all market-based instruments designed to deliver environmental quality and to transfer environmental risk. It signals a radical change of direction in the way that modern industrial society has approached environmental challenges in the past.
The modern environmental movement appeared in the second half of the nineteenth century in response to the ugliness and destruction of the industrial revolution. Throughout most of the twentieth century people assumed that there was an implicit trade-off between an attractive environment and economic growth, because this was the lesson they drew from the previous century. People had become wealthier through an industrialization process that blighted the landscape and poisoned the water, the air, and the ground. The lesson seemed obvious. If people in the twentieth century now wanted to restore a healthy and attractive environment they would have to pay for it. There is no logic whatever in this assumption. It is just a simple quid pro quo-if you want something you will have to pay for it. Hence, if you want a decentenvironment it will cost you something, maybe a lot more than many people want to pay.
Happily, the world is a more complicated and interesting place than this simple assumption implies. The accounting systems that grew up alongside the industrial revolution concentrated on the simplest financial indicators-revenues, costs, and the balance. If a company did not have to pay for its damage to the environment, then it did not show up on its balance sheet. Economists later dignified these omissions as "externalities"-or costs that the firm passed on to society at large.
If we-as citizens, as investors, or as businesses-are now really concerned about these environmental damages, then we should find ways to include them in the balance sheet. Once we make this adjustment the world appears in a more interesting light. If we really do value an attractive and healthy environment, then we will be prepared to pay for it. The converse of this deduction is even more interesting-the businesses that destroy environmental value should reflect that fact in their balance sheets and be valued accordingly. Can these simple observations be put to good use? We believe they can.
Environmental finance is a field of inquiry and activity that has grown up to address these challenges. If we truly wish to value environmental quality, then we should try to price its worth, in the business context. This is a very different ambition from that of "environmental economics" or even "ecological economics." These approaches have been developed to respond to the values of society at large. Environmental finance, on the other hand, approaches environmental problems from the internal perspective of the firm, acting in its own interest. Its interest will be framed by the personal ambitions, expectations, and values of the managers and owners of the firm, as well as by the regulatory system through which society obliges them to respond to the environmental challenge. Some firms also respond to the expectations of all the stakeholders in the enterprise, including employees and the local community. (See the section titled "Stakeholder Relationships" in the next chapter.)
How might a firm that wishes to achieve certain environmental standards chart its path? First, the firm must have a clear assessment of its situation in the biosphere now. (The biosphere is that part of the planet inhabited by living organisms.) Is it causing damage for which it might later have to pay? This is the simple compliance issue, which is driven by legislation. The more complex issue lies over the 20-year horizon. How will the biosphere have changed by then, and how might the firm be responding?
AN EMERGING FIELD
There are many examples of market-based solutions for environmental problems, and in the past 10 years the development of these solutions has begun to play a part in the evolution of the financial services sector. For people who develop and use these products the connections between them may not be obvious. For example, what has "carbon trading"-the trading of carbon dioxide emissions reduction credits-got to do with socially responsible investment? The answer is that both have evolved in response to environmental change. The concept of environmental change embraces all those changes to the physical environment that have happened as a result of the growing impact of humankind on the biosphere, including climate change and local environmental degradation. The development of financial products to respond to environmental challenges has reached a stage such that environmental finance can be recognized as an emerging field of research and practice.
A successful environmental financial product must satisfy two quite distinct criteria. First, it must establish its niche in the marketplace. Second, it must meet the environmental objectives (such as emissions reductions or risk transfer) that it was designed to address. In this book we will not only identify and analyze successful products, we will also do the same for products that might meet one of the criteria but not the other. For example, the establishment of carbon trading will be successful in an environmental sense only if it facilitates the genuine reduction of carbon dioxide emissions. The risk of failure is evaluated in Chapter 7. Regarding the other criterion, the trading of catastrophe options on the Chicago Board of Trade would certainly have been able to transfer risk from insurers to the capital markets had it been possible to establish a sufficiently large and liquid market. Their failure to reach that point is discussed in Chapter 5.
WHY IS IT HAPPENING AT THIS PARTICULAR TIME?
There is no question (optimists notwithstanding) that the biosphere is coming under increasing pressure. The source of pressure is twofold: increasing numbers of people and increasing intake of resources and production of wastes as people grow wealthier. (See Figure 1.1.) Observers have worried about the exhaustion of resources, such as minerals and fossil fuels, for more than a hundred years, but the fear has been dismissed by others who demonstrate that resource shortages raise prices and those higher prices bring in new discoveries and more efficient means of production. Indeed, the nonrenewable resource base does not appear to be a problem today. The resource problem lies with potentially renewable resources that could be managed sustainably, but which are abused. Key problem areas are freshwater, ocean fisheries, agricultural soils, forests, and loss of biodiversity. The other big problem is the wastes we produce, especially greenhouse gases, which are accumulating in the atmosphere and are expected to change the climate. This issue is discussed in detail in Chapter 7.
It is the climate change problem that has pushed environmental concerns to the fore. It is a very large-scale problem that threatens to disrupt the climate on which we all depend for the necessities of life. This is not an aesthetic issue, nor an animal rights issue; it is a survival issue. It has become clear that something must be done, even if there is considerable disagreement as to what that something is. It requires governments to make a series of difficult decisions, which is something governments do with reluctance. It requires governments around the world to act in concert for the common good.
Since the climate change and environmental pressure problems were acknowledged at the Earth Summit in Rio de Janeiro in 1992, governments have avoided taking any decisive action. Some have talked courageously about taking up the challenge, but action on the ground has been token at best. Meanwhile, greenhouse gases have continued to accumulate, just as predicted, and the climate has warmed, as expected. (See Figures 1.2, 1.3, and 1.4.)
Even in the heyday of strong central governments in the postwar period, national governments would not have been likely to take decisive action on climate change, because the problem is large and complex, and the benefits we might expect from decisive action lie beyond the political time horizon and even beyond the lifetimes of our children. It is even less likely that national decision makers will be decisive today when command-and-control and tax-and-spend styles of government are completely out of fashion.
By default, it falls to the private sector to look ahead and make appropriate plans to protect its own self-interest, although government is still essential to regulate and encourage the development of appropriate policy frameworks. It is interesting that-at this same time-much of the private sector is undergoing a process of globalization, whereby it is acquiring the capacity to make decisions on a global basis, influencing governments and companies around the world. Now the citizens of many countries, in the environmental domain as well as others, can affect shareholders' interests. The tension arising from the interplay between local and global interests is an important part of the backdrop to the themes explored in this book.
Global decision making-meaning decisions that can respond to conditions around the world in real time-has only recently become possible through the revolution in information technology (IT). To the public the IT revolution is mainly visible through the Internet, e-mail, cell phones, and handheld computers. Behind these novelties lies the more powerful world of global positioning systems (GPS), which can abstract terrestrial information from satellites, and of remote sensing and geographical information systems. Together these technologies provide the potential for a global information system that can be accessed in real time. This provides, for the first time, the possibility of a global level of awareness. While this level of support does not provide omniscience, it does provide a heightened sense of global environmental change, which is what we need to meet the challenge.
Nor is this global information capacity restricted to global companies and governments. It is also to some extent available to members of the public, and certainly to international nongovernmental organizations (NGOs), some of which have multimillion-dollar incomes. This global capacity for information exchange at low cost has increased the potential for global pressure to be brought on companies that fail to live up to the public's expectations. This pressure can be exerted through demonstrations, shareholder activism, product boycotts, and legal challenges. The global reach of the international company can be matched by a global capacity of the NGOs to mobilize public opinion. Although the link is difficult to prove, it is certainly no coincidence that many corporations have recently moved beyond "greenwash" (environmental whitewashing) to constructive environmental engagement. Several prominent companies have not only started publishing annual environmental reports on their activities, but they have also had them externally verified (Delphi and Ecologic 1997). This development is analyzed in Chapter 8.
Although government regulation and public opinion are essential driving forces, it has been corporate experience with environmental engagement that has accelerated the rate of acceptance of corporate environment responsibility and has recently provided conditions that are favorable to the development of environmental financial products. On the positive side we have the whole range of advice, from the cautious optimism of Financing Change (Schmidheiny and Zorraquin 1996), Sustainable Finance and Banking (Jeucken 2001), and Sustainable Banking (Bouma et al. 2001) to the infectious enthusiasm of Cool Companies (Romm 1999), Factor Four (von Weizsäcker et al. 1998), and Natural Capitalism (Hawken et al. 1999). Books such as these may have helped to reassure the skeptical decision maker that environment and economy are not a zero-sum game but are actually mutually reinforcing.
Even if the skeptic did not gain confidence from such reading, then he or she could not have failed to learn from the hard lessons of environmental neglect. Asbestos was the first environmentally related problem that entailed multibillion-dollar losses and the bankruptcy of several major corporations. It took 30 years to unfold, and the story is still not over. (See Chapter 5.) Concurrent with the asbestos drama was the unveiling of the lethal impact of industrial pollution and inadequate landfills, culminating in the heavy burden of the U.S. Superfund legislation, with which companies are still struggling. (See Chapters 4 and 5.) Some environmental concerns are still gathering momentum, such as lead paint, while others, such as toxic molds and genetically modified organisms (GMOs), have yet to make their impact felt.
There is no doubt that private-sector decision makers had been softened up by these environmental challenges, even before climate change claimed their attention. Timing was critical for this to happen. The Earth Summit met in June 1992, and the Framework Convention on Climate Change was adopted. Then Hurricane Andrew struck in August of the same year, inflicting record damage on the insurance industry. Already there had been speculation that global warming might produce more and bigger hurricanes (still an unresolved issue among scientists). Even the possibility that climate change might be responsible for this type of impact, on a more frequent basis, was enough to focus a number of minds on the fact that scientists did not know exactly what climate change might bring. Suddenly a very large question mark appeared over balance sheets all around the world. It was possible that the world had embarked on an era of alarming and irreversible change. As Peter Bernstein summarized the issue:
If global warming indeed lies ahead, a long string of hot years will not necessarily be followed by a long string of cold years.... If humans succeed in destroying the environment, floods may fail to follow droughts. (Bernstein 1996, 182)
There are risks in inaction, and there are risks associated with mitigation, because both the direct physical impacts of more extreme weather and the economic impacts of mitigative action-specifically, reducing the use of fossil fuels-could be very significant.
Some sectors, like insurance, focused on the first issue and decided that mitigative action was essential and urgent.
Excerpted from Environmental Finance by Sonia Labatt Rodney R. White Excerpted by permission.
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CHAPTER 1: THE EMERGING WORLD OF ENVIRONMENTAL FINANCE.
An Emerging Field.
Why Is It Happening at This Particular Time?
How Might Environmental Finance Prepare Us for the Challenges Ahead?
CHAPTER 2: CONCEPTS AND TOOLS FOR DEVELOPING ENVIRONMENTAL FINANCE.
Environmental Management and Shareholder Value Creation.
Environmental Management Systems.
Looking Ahead: Scenarios and Simulations.
Tools for Risk Transfer.
Trading Atmospheric Emission Reduction Credits.
CHAPTER 3: THE FINANCIAL SERVICES SECTOR.
Structure of the Global Market for Financial Capital.
Forces Reshaping Financial Service Industries.
Core Financial Services.
Response of the Financial Services Sector to Deregulation.
Financial Services' Approach to Environmental Issues.
CHAPTER 4: BANKING.
Direct Liability of Contaminated Land.
Environmental Products and Services.
Niche Markets and Microcredit.
Internal Environmental Management.
UNEP Financial Institutions Initiative.
Measurements and Reporting of Environmental Management.
Climate Change: Risks and Opportunities for the Banking Sector.
Sustainable Energy Funds.
The Price of Carbon.
CHAPTER 5: INSURANCE.
Angus Ross, Invited Author's Comment.
Contaminants in the Environment.
Climate Change and Extreme Weather Events.
Transferring Risk from the Insurance Industry to the Capital Markets.
Regional Variations in the Response of Insurance Companies to the Environmental Challenge.
CHAPTER 6: INVESTMENTS.
Evolution of Screening for Social and Environmental Responsibility.
The Relationship between Environmental and Financial Performance.
Performance of Environmentally Screened Funds.
Variation in Research Results.
Socially Responsible Investment Portfolio Performance Ratings.
Institutional Portfolio Managers.
Environmental Products in Fund Management.
Environmental Research and Rating Organizations.
CHAPTER 7: CLIMATE CHANGE AND FINANCIAL VULNERABILITY.
Accepting Climate Change as a Real Phenomenon.
Physical Impacts of Climate Change.
Vulnerability by Economic Sector.
Anticipating Human Response to Climate Change.
Critical Factors in Human Response to Climate Change.
CHAPTER 8: Environmental Reporting and Verification.
Trends in Environmental Reporting.
Main Types of Environmental Reporting.
Pollution Release and Transfer Registers.
Accounting Profession and Security Regulators.
Environmental Reporting from the Preparer's Perspective.
Environmental Reporting from the User's Perspective.
Progress in Environmental Reporting.
Alan Willis, Invited Author's Comment.
CHAPTER 9: Strategies for Managing Environmental Change.
Greenhouse Gas Emission Targets: Rationale, Types, and Methods.
Climate Change Programs.
New Weather-Related Products.
Trading Pollution Reduction Credits.
CHAPTER 10: THE WAY AHEAD.
Business and Environmental Change: What's New?
The New Paradigm.
Environmental Change: From Challenge to Opportunity.
The Environmental Learning Curve: Redefining Success.
UNEP Statement by Financial Institutions on the Environment and Sustainable Development.
List of Signatories to the UNEP Statement by Financial Institutions on the Environment and Sustainable Development.
UNEP Statement of Environmental Commitment by the Insurance Industry.
Status of the UNEP Statement of Environmental Commitment by the Insurance Industry.
The Annex 1 Countries.