Universal ownership: Why environmental externalities matter to institutional investors

Their portfolios are inevitably exposed to growing and widespread costs from environmental damage caused by companies. They can positively influence the way business is conducted in order to reduce externalities and minimise their overall exposure to these costs. Long-term economic wellbeing and the interests of beneficiaries are at stake. Institutional investors can, and should, act collectively to reduce financial risk from environmental impacts.

US$ 6.6 trillion

The estimated annual environmental costs from global human activity equating to 11% of global GDP in 2008.

US$ 2.15 trillion

The cost of environmental damage caused by the world’s 3,000 largest publicly-listed companies in 2008.

>50%

The proportion of company earnings that could be at risk from environmental costs in an equity portfolio weighted according to the MSCI All Country World Index.

Business use of environmental goods and services generates environmental damage that carries significant costs

• These are largely external to financial accounts. Without adequate information about environmental externalities, markets have failed to account accurately for the dependence of businesses on ecosystem services such as a stable climate and access to freshwater.

Environmental costs are becoming increasingly financially material

• Annual environmental costs from global human activity amounted to US$ 6.6 trillion in 2008, equivalent to 11% of GDP. Under a “business-as-usual” scenario, annual global environmental costs are projected to reach US$ 28.6 trillion, equivalent to 18% of GDP in 2050.

Reducing greenhouse gas (GHG) emissions, water use and air pollution would have the greatest effect on reducing environmental costs

• GHG emissions and resulting climate change impacts account for a large and growing share of environmental costs – rising from 69% (US$ 4.5 trillion) to 73% of externalities between 2008 and 2050. The expected rise in costs for escalating GHG emissions and climate change impacts results in projected external costs of US$ 21 trillion in 2050. Water abstraction and air pollution are the other main contributors to environmental costs.

Medium- to large-sized publicly listed companies cause over one-third (35%) of global externalities annually

• The largest 3,000 public companies caused over US$ 2.15 trillion of global environmental costs in 2008, which equates to nearly 7% of their combined revenues. Other actors in the global economy, such as small and private companies, governments, other organisations and individuals contribute the remaining US$ 4.45 trillion of external costs.

Five sectors account for around 60% of all externalities from the largest 3,000 listed companies

• Reducing GHG emissions in the Electricity, Oil & Gas Producers, Industrial Metals & Mining and Construction & Materials sectors would have the greatest effect on reducing carbon costs. Reducing water use from the Food Producers and Electricity sectors could also lower environmental costs significantly.

Most large, diversified equity funds invest in many companies with significant environmental impacts that undermine the environment’s ability to support the economy

• In a hypothetical equity portfolio weighted according to the MSCI All Country World Index, externalities could equate to more than half of the companies’ combined earnings before interest, taxation, depreciation and amortisation (EBITDA), weighted according to Index constituents.

External costs caused by companies can reduce returns to investors

• Environmental costs can affect portfolio values by reducing future cash flows for companies held in portfolios and lowering future dividends. For a diversified investor, environmental costs are unavoidable as they come back into the portfolio as insurance premiums, taxes, inflated input prices and the physical cost associated with disasters. One company’s externalities can damage the profitability of other portfolio companies, adversely affecting other investments, and hence overall market return.

The costs of addressing environmental damage after it has occurred are usually higher than the costs of preventing pollution or using resources in a more sustainable way

• It is in the interests of Universal Owners such as large institutional investors – with stakes in an economy-wide cross-section of publicly traded securities as well as property and other non-listed asset classes – to reduce externalities. It is in the financial interest of fund beneficiaries that Universal Owners address the environmental impacts of investments to reduce exposure to externalities and protect long-term returns.