The public demand for action linked to climate change is growing. In June 2015, the Dutch government was ordered by the Dutch court to cut carbon emissions to protect its citizens and future generations in the world's first climate liability suit. A few months later, the supreme court of India banned the registration of some diesel vehicles. More recently, the President and US government were being sued for failing to act rapidly to stop climate change ... by 21 kids! As stated by a CNN journalist, the future is suing the present.
What could decision-makers do to incorporate future generations into the decisions made today?
I argue in this paper for the use of 'green discounting', to take immediate and dramatic action to respond to climate change threats.
Discounting, and more generally accounting, governs the day-to-day activity of institutional investors and listed companies. Its influence is much more significant than taxes, and yet it attracts much less attention.
If you invest in a project, a company or a financial instrument, you have to discount the future cash flows to obtain their 'value' today and make your decision. The logic of discounting is powerful and combines a mix of risk, reward and time preference.
Discounting is king. But is it taking into account the interest of future generations?
Given the recent climate liability suits and the 'cash paradox' it seems that the answer is clearly no. The cash paradox illustrates the preference of the 'present' versus 'future generations'. The world has never been so awash with money, and yet we are still lacking green investments.
From now through 2030, the global economy will require $89 trillion in infrastructure investment across cities, energy and land-use systems, according to the World Bank. Meanwhile the volume of total financial assets is expected to rise by 50% to $900 trillion between 2010 and 2020, according to Bain & Company.
To illustrate the effect discounting, let's assume you are a financial officer in a large investment bank having to choose between two long-term energy investment projects operated by the same company.
Both projects are in the US and require $100 million of investment. The first project is linked to a coal plant (with a massive carbon footprint) and the second is a renewable energy project transforming used wood into heat (with a low carbon footprint). Other characteristics are exactly the same (duration, cash flows, etc.) and a positive $250 million cash flow is expected in 20 years for both investments.
To compute the net present value of both projects, you need to ascertain the discount rate. First, you use the interest rate for what is commonly viewed as the least risky investment possible – US government bonds (let's assume this is 2%). Then, because your projects are more risky, you add a 'credit spread' to penalise these investments (for example 1%). Eventually, you add a liquidity premium, as these investments are long term (fixed at 0.5%).
As a result, both projects have a positive net present value of $25.65 million. You are indifferent and could choose either project, as they are both profitable.
In the example above I assumed that both projects had the same funding cost. But in real life, green projects funding costs are higher and already penalised by low oil and CO2 prices.
What is missing in this picture?
If you are an economist or financial expert you would probably say 'nothing', despite the ongoing debate around the right level of discounting and the uncertainty around discount rate. But if you are sensitive to the climate, you would mention that climate damage is not taken into account in the discounting process.
To take into account the climate damage and carbon footprint of each project, I suggest adding a 2% climate premium for the coal project and a 0% premium for the renewables project. This would make the coal project lose money with a net present value of minus $14.3 million. You can see the huge impact on the value of future cash flows caused by this green climate premium.
The climate premium would depend on the carbon and environmental footprint of the project or company. It is the difference between the true value of an investment and its climate risk-free value.
Ideally, climate premiums should be market-based. However, such markets don't exist yet. It is one of the reasons that has led me, together with Professor Michael Mainelli, to argue in favour of the creation of a new asset class: environmental policy performance bonds - let's call them carbon dioxide (CO2) bonds. The coupons of CO2 bonds would be linked to CO2 reduction targets. The more a government reduces CO2 emissions, the less interest the government pays.
Issuing a CO2 bond would be a simple and effective way for governments to enhance their funding, provided they engage in reducing their CO2 emissions.
Contrary to green bonds with a fixed coupon, there is a clear incentive for the issuer to reduce CO2 by whatever means available, especially 'costless' ones such as adhering to CO2 reduction policies.
If such CO2 bonds were issued by governments, one could easily deduce climate premiums for each country and then build on this market to ascertain a premium for each company.
In the meantime, we could use carbon rankings produced by firms like ET Index. They provide public scoring of the world's largest companies based on greenhouse gas emissions disclosure. Relative carbon intensity is computed and ranged for top worldwide listed companies. ET Index ratings could be easily converted into an equivalent green premium until a market is created.
Tackling climate change is closely linked to the economic decisions made today by investors. If they are too present-oriented, they will over-invest in fossil fuels and under-invest in renewable energy. As a result, future generations will 'pay' and inherit a damaged planet.
Introducing climate premiums into discounting will help encourage the most energy efficient solutions.
Accounting and prudential regulators should lay the foundations for the integration of climate premiums in all listed companies' balance sheets. Decision makers must act now, as any shareholder in a bank or energy company could be tempted by legal climate cases.
More importantly, taking into account future generations thanks to a climate premium could help achieve a better capital allocation and, ultimately, save the planet.