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The Implications of Climate Risk for Fiduciaries and Fund Managers: What Investors Need to Know

March 30, 2005

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Good morning. Thanks for being here today on this second day of an extremely important set of meetings. Yesterday was a remarkably inspiring day. Inspiring because it showed us the promise of an economy of the future - a springboard for hundreds of new businesses and tens of thousands of jobs and inspiring because it provides hope that we can, with smart entrepreneurial sense, build our way out of the scientific dilemma posed by the enormity of global warming.

But none of this would be possible without the profound leadership of the conveners of this conference, CalPERS and CalSTRS, their visionary boards and their bold staff who have led on important issues - issues of governance and issues of fiduciary duty - and who have brought others along to make change that in all instances benefit their pensioners. Treasurer Angelides, Controller Westly, to the PERs and STRs boards - your leadership is exactly what is needed to tackle this enormous global warming challenge.

Today, we are here to examine the serious financial questions posed by climate change. To learn how serious the risks are (and for that matter, what the risks are) and we have a leading scientist, Dan Kayen, and a leading business leader, Peter Schwartz, to help answer that question. As to whether these risks can create economic and investment risk, we have Matthew Kiernan, Colin le Duc and Jon Naimon prepared to respond to this. And we will also ask and answer what role pension funds and other fiduciaries have in addressing climate risk with national leaders like Rob Feckner, Chris Ailman, Jeb Spaulding and Toni Symonds.

Two months ago, I had the privilege of attending the World Economic Forum in Davos, Switzerland - a gathering of global business leaders. At an early plenary session, participants were asked to choose the three key issues that the world must focus on, above all others. Twelve issues of enormous magnitude were described by eloquent experts - subjects like weapons of mass destruction, world poverty, unrest in the Middle East, HIV, education, etc? Global warming was in the top three. I must tell you that I did not see a lot of environmental activists in the room. Business leaders, not activists, chose this subject because it has emerged as a key strategic, business and governance issue for corporations and investors - a colossal problem with significant business risks and substantial opportunities.

Yesterday, we focused like a laser on the opportunities. This morning, I want to do three things.

I want to review the risks posed by climate change- -- physical risks, regulatory risks,litigation risk, and for some, even, reputational risk. I want to pose a question that, Ibelieve, every treasurer, fiduciary, chief investment officer, insurance executive and fund managershould consider. And I would like to conclude with four prudent actions that fiduciaries,trustees, and fund managers are beginning to take in order to reduce risk, protect their assets, and weather the likely storm ahead. Physical Impact We all know that climate change will cause direct physical impacts on our world, and place some sectors and businesses at risk from these impacts. The state of California, for example, faces significant challenges, especially as it relates to a key ingredient of our lives and our growth - water. Global warming is likely to give California more water at the wrong time and less water when it's really needed. All of this leads to more wildfires of the sort we have watched with horror, droughts, flooding, erosion, and disruption for agriculture and other water-dependent industries. The severity of recent wildfires in California, which have already led to tens of millions of dollars in property claims and impose huge anticipated relief costs on the California and national treasuries, can be traced in part to the large amount of dry timber from trees that had been killed by the voracious bark beetle. Investments in forestry or in high-end domestic or vacation real estate will be affected.

Consider the possible impact to this states' agricultural economy. California's Central Valley produces a huge percentage of America's fresh produce. Changing weather and water may put that at risk, with far reaching effects. Globally, the insurance firm Munich Re says that climate change will cost the water industry alone $47 billion in the next 50 years and nearly $1 trillion in the next 70 years.

And these impacts are only the tip of the iceberg as far as impacts we can expect to see around the globe. Risk assessors at the major reinsurers suggest that coastal real estate should be evaluated to assess the impact of sea level rise. There is a reason why many insurers are refusing to insure waterfront property at all. They're not just charging higher prices; they're flat refusing. The federal government is currently spending $8 billion to restore our national freshwater treasure in the Everglades, which preserve wildlife and drive the Southern Florida tourist economy. Yet, those millions of acres in the Everglades are, on average, less than three feet above sea level. We could easily lose that valuable acreage -- at substantial cost. Sea level rise has already claimed valuable oceanfront property on both coasts; it could put tremendous financial pressure on harbor cities like New York City, San Francisco, and Boston.

Hotter temperatures will worsen air pollution and cause deadly heat waves. Who can forget the horrendous heat wave several years ago that gripped Europe for nearly a month and led to the death of several thousand people in France. Dr. Paul Epstein of Harvard University has shown how high temperatures have pushed formerly tropical disease like West Nile virus further and further north. What happens to our national health care costs if malaria starts to spread across the United States?

Investors, have a right to expect a thorough, detailed analysis of the potential costs and opportunities for each of the major sectors that face substantial risks.

Beyond the substantial physical risks, some which realistically may be further out in the future, regulatory risks are here now.

Some parts of the world are changing their behaviors - through markets, taxes, regulations, and the courts. This adds new complexity to the financial picture.

Despite the opposition of the current Administration, the trend toward regulation of global warming pollutants is clear. The Kyoto Protocol is now in effect. The EU has put a price on carbon. Major industrial nations are acting. What are the implications of these decisions for those with European, emerging market, or other global equities?

Here at home in the U.S., major bills are being considered in Congress, 11 states have acted or are in the process of acting. Yet, businesses remain in limbo.

The regulatory environment is one of, at best, uncertainty. As John Coomber, CEO of Swiss Re often says, business leaders need certainty.

Electric utility companies, poised to invest in new power plant facilities costing hundreds of millions of dollars, are at risk of substantial stranded costs. This point was made loud and clear in a recent climate risk report prepared by the nation's largest electric power provider, American Electric Power.

To quote from the report: "The issue is not whether the U.S. government will regulate GHG emissions, but when and how ... Continued uncertainty over when and how carbon dioxide emissions will be regulated at the national level is the least optimal path forward."

Litigation Risks - As many of you know, eight attorneys general last year filed a massive tort-claim against the nation's largest electric utility companies. This suggests there will be more lawsuits to follow.

The question is no longer if global warming pollution will be regulated, but when, how, and by whom?

The likely increase in legislative, regulatory, trade, and legal measures to address global warming exposes all companies - particularly those with significant emissions - and all portfolios in which those companies are held to risks significant, material, and likely.

The electric utility sector and auto sector stand out as key areas of concern. Auto companies producing low-carbon vehicles and possessing superior carbon-reducing technologies should see market share increase and improved competitive advantages as governments - whether in California, Canada, the Northeast states, or China -- act. In contrast, companies that have more carbon-intensive vehicles and that are lagging behind in the race to develop lower-carbon technologies could suffer from lower sales, increased costs, and reduced profits.

Two years ago, Ceres looked at the link between climate risk and corporate governance. We began with a very straightforward list of 14 steps that a prudent, rational company might take, starting with the board and moving throughout the company, to discover their degree of exposure to climate risk and steps that could take to mitigate those risks. We then analyzed and interviewed 20 major carbon-emitting companies and asked how many of these common sense steps were in place. We discovered huge variability. Some companies, such as British Petroleum and Royal Dutch/Shell, were pursuing all 14 of these steps and had built the mitigation of climate risk deeply into their strategies and practices. Others, including ExxonMobil, were doing as few as four. This suggests that some businesses will be far, far better prepared than others to meet the challenges ahead.

Many companies and investors also recognize that positive and proactive measures to address global warming can also capture significant benefits for shareholders. Companies with clean technologies or approaches may seize new markets or market share.

The bottom line: carbon constraints will produce both winners and losers. Investors who fail to heed the warning signs emerging on their radar screens today, will face the perfect storm of global warming emerging tomorrow.

Mark Twain once said, "Everybody talks about the weather, but nobody does anything about it." Twain may have been right then, but he's wrong today. There is much being done about it.

Indeed, prudence suggests, perhaps even dictates, that those who are responsible for preserving the value of these businesses and investments analyze this risk and take steps to mitigate it. Trustees that address the seriousness of embedded climate risk, demonstrate they are following the reasonable expectations of good governance and the requirements of fiduciary duty.

So here are some questions that I would like to pose today.

The single most important question is this: Under what circumstances and to what degree will a portfolio be affected by climate risk?

Fiduciaries need to being asking and answering these questions. There is a huge army of brilliant people out there trained to assess risk. They routinely assess currency risk, political risk, interest rate risk, demographic risk, and operational risk - now they need to look at sectors and firms and analyze climate risk.

Some U.S. companies and investors, unfortunately, are still doing little to assess climate risk or to mitigate it. When a hurricane is forecast, we prepare for it. But most of Wall Street seems content to ignore climate risk and feels more comfortable, like the ostrich with its head in the sand, pretending that global warming will not affect their portfolios because the impacts are long term. But the data is piling up and the trends are clear, so much so that in 2005 it is no longer an option for any major investor or fiduciary to ignore the risks of global warming.

What is heartening is that many investors are moving forward slowly, judiciously and responsibly, despite limited financial information, resistance from Wall Street, etc.,

Treasurers, comptrollers, pension fund leaders, foundation presidents are beginning to act. In November 2003, Ceres, along with 15 pension fund leaders convened an all-day Institutional Investor Summit on Climate Risk at the United Nations in New York City. That historic meeting brought together 300 leaders of the investment community, 250 or so from the Wall Street money management firms, 50 or so from the largest public pension funds, to look at the issue of climate change, to understand the magnitude of it, to understand the broad financial risks that come with it and then TO ACT. And this past January, we convened another group of European investors (Toni Symonds was there) to build upon the U.S. based group of pension funds who were seeking more financial information from companies in order to assess their own risk.

And act they did. CalPERs, CalSTRs, the state treasurer from Connecticut, leaders of the City of New York and the state of New York retirement funds, and many others, launched an Investor Network on Climate Risk. Individually and collectively, they have acted.

They first called for more disclosure - not just through voluntary measures like the Carbon Disclosure Project, but also through mandatory measures. Fifteen pension fund leaders called on the SEC last year to clarify that climate risk is a material risk and must be included in a company's MD&A. Investors need adequate data to make responsible decisions.

Corporate Governance - These large investors also agreed to engage with major emitting companies through thoughtful dialogues, shareholder resolutions and by voting their proxies, as part of their corporate governance programs. Last year nearly three-dozen shareholder resolutions were filed with auto, electric power, oil and gas, manufacturing and real estate firms, asking the companies to assess their financial risk from climate change - regulatory, physical, etc. And more than a dozen of those resolutions resulted in discussions that yielded results. Cinergy, AEP, TXU and three other electric utility companies have agreed, in response to investors, to undertake comprehensive assessments of their financial and competitiveness risks. Some of the reports are already done. And, in each of those reports, the companies agreed that the risk was substantial, that this was a governance issue and that the regulatory environment made this particularly acute.

The Cinergy report, in response to investors, noted: "We share your position that management and the Board have a fiduciary duty to carefully assess and disclose to shareholders appropriate information on the company's environmental risk exposure."

After extensive negotiations with shareholders, six oil and gas companies - Anadarko Petroleum, Apache, ChevronTexaco and three others -- agreed in recent months to take far-reaching actions to disclose their potential financial exposure from climate change and develop strategies to improve their strategic positioning to reduce greenhouse gas emissions and promote clean energy. These results came about because large investors recognized the risk and took action.

Third, investors are also beginning to ask their investment advisors to develop their own analysis of climate risk and to raise the issue in sectors where there is material risk.

And, fourth, our network has convened a group to work with CalPERS and CalSTRS on the private equity front and to follow the course charted here in California.

In 15 months, because of the interest of investors concerned about the financial value of the companies in their portfolios, we have seen more than a dozen companies change their practices. We have seen a few Wall Street firms begin to develop some competency to assess this risk. We have seen the extraordinary progress here in California through the four-part Green Wave Initiative. And, no doubt, more is coming.

The issue is now on the agenda of the National Association of State Treasurers, Corporate Counsels, Corporate Board Directors. We will be discussing it at the upcoming Council of Institutional Investors meeting, and a group of foundation presidents will be discussing climate risk with their CFOs.

A recent McKinsey report said over the next 5 to 15 years the way a company manages its carbon exposure could create or destroy shareholder value

Now some will say that it is impossible to address climate risk. But I would remind you that when the world faced the threat of the Y2K problem, a problem with a smaller scope and much less substantiating data, the SEC became so alarmed about the potential risk to investors that they required every company to spell out their Y2K mitigation plans in their 10-K forms. According to CNN in November 1999, U.S. businesses and organizations directed at least $114 billion into fixing the Y2K problem in the two years before the millennium.

In closing, let me thank you for this opportunity to be here with such a distinguished group. I am extremely heartened that so many fiduciaries with solemn responsibilities to many millions of Americans, as guardians of huge assets over the long-term, are beginning act now in a prudent and thorough manner to address climate risk and related issues.

The change we are seeing is coming for many reasons. But to be sure, one of those reasons is the attention being paid to it by investors. To those in this room and to the many other investors and business leaders focused on this and acting, I offer my humble thanks.