The way investors value companies is changing, evolving into a model that takes into account not only sales, profits and dividends but also long-term environmental and social costs. Phrases like "going green", "eco-friendly" and "sustainable practices" are moving from fringe buzzwords to the forefront of the investor lexicon.
Let's examine the roots of this problem, and explore how the world is changing and how business will evolve to thrive in this new green environment.
The Disconnect Between Business and the Environment
With the rise of the Industrial Revolution, industry began pumping ever-increasing amounts of greenhouse gas into the air. Greenhouse gas (GHG) is actually a broad category that includes any gas that traps heat within the earth's atmosphere, thereby raising the planet's temperature. Water vapor, for example, is also a greenhouse gas, but for our purposes we will be talking about carbon dioxide (CO2), which represents 84% of the human-emitted GHG according to the Environmental Protection Agency.
Carbon dioxide enters the atmosphere naturally, and also through human activity. The burning of fossil fuels, wood and solid waste, and the manufacture of cement all add extra CO2 to the atmosphere. Public concern about the possible effects of GHG is growing; a March 2007 study by the Yale Center for Environmental Law and Policy found that 83% Americans surveyed cited global warming as a "serious" problem, up from 70% in 2004.
To be fair to the first captains of industry, the scientific facts and their implications were not available back in the 1800s. In that time, capitalism was the only rule of business, and it worked fantastically. America went from a little-known colony to a world powerhouse in less than 100 years, thanks to embracing - and soon innovating within - modern industry. (For more on the rise of capitalism, see Financial Capitalism Opens Doors To Personal Fortune.)
Just about everything a company does costs something. Raw materials, electricity, employees, buildings and land all have specific costs that are arrived at through the time-tested mechanisms of supply, demand and capitalism. There was no monetary cost for emitting greenhouse gases, so industry as a whole has had little reason to consider it, let alone worry about it. (To learn more, see Economics Basics: Demand and Supply.)
Investors cast their votes as well, handsomely rewarding companies that grew their profits, regardless of the methods used to achieve them. More and more, shareholders and Wall Street tended to focus on short-term results. They began to live in a world where the "what have you done for me lately?" mentality defined the success of a publicly-traded company.
Capitalism Becomes Earth-Friendly
However, as evidence about industry's environmental impact continues to emerge, it is becoming increasingly difficult for a company to assume that the environmental effects of its business will have no cost. For example, many global economic giants are in the process of creating strategies and regulations that will put a discrete cost on emitting GHG.
Alternative fuels and sustainable energy sources are getting a helping hand from governments via subsidies, tax breaks and social goodwill. This innovative space is also seeing massive inflows of institutional and venture capital, as worldwide funding grew more than 65% during 2006, according to a report from the United Nations Environment Program. (For more insight on how venture capital can lead the progressive charge, read Private Equity A Trendsetter For Stocks.)
Important Precedent Spurring Change
The U.S. Supreme Court ruled in 2007 that greenhouse gases can be treated as pollutants under the Clean Air Act. This ruling applied to "tailpipe emissions" from cars and trucks, but the precedent will allow the same reasoning to apply to industrial production of carbon emissions. The comments from the ruling suggest that any company or group wishing to appeal would have to scientifically prove that greenhouse gases do not cause global warming. It is unlikely that any company would risk the public relations disaster of even making that argument, regardless of whether it's a winning one.
Carbon Credit Trading
From gold to timber to uranium, every scarce resource on the planet has a cost. Corporate America is entering a new phase, one where the right to produce carbon emissions is also treated as a scarce resource. Once there is an explicit cost to produce environmental damage, it becomes more expensive to produce greenhouse gases, so products and services that contain a lot of carbon will become more expensive relative to lower-carbon goods.
In Europe, The European Union Emission Trading Scheme is a multinational effort by countries that have signed the Kyoto Protocol and pledged to reduce GHG through caps and emissions trading for carbon credits. Emissions trading has been going on in Europe since 2005, and global trading in carbon credits grew to $30 billion from $11 billion in just one year (2005 to 2006), according to the Harvard Business Review. (To learn more about the carbon credits and carbon trading, see What is the carbon trade?)
The Role of the Markets
One thing that all companies will have to start doing - if they haven't already - is figuring out what their total carbon emissions are across the board. Shareholders, governments and business partners will want to know, and those emissions may soon have either a cost or a tax of some kind.
Companies will soon discover that there are economic benefits to increasing their energy efficiency and lowering their GHG through increasing efficiencies in the supply chain, the value chain and manufacturing operations. The companies that show leadership here will be those that have strong corporate governance policies. Studies conducted by consulting group McKinsey on the S&P 500 have shown that these companies tend to outperform the broad market over extended time period. (To learn more, read For Companies, Green Is The New Black.)
Consumer choices and market demand will dictate most of what companies offer us. Each time a product like a hybrid car or low-energy light bulb gains a large market, it sends a message to CEOs, stock analysts, institutional investors and venture capital funds.
Winners and Losers
Losers - Heavy Industry & Energy
As one might expect, "heavy" industries like electricity generation, oil refining and forestry are the ones at the greatest risk of suffering initial cost increases. For example, coal-burning power plants with their billowing smokestacks are both an eyesore and a big producer of carbon emissions. But for the time being, we can't simply shut them all down - coal-based power is the source of over half the power consumed in the U.S. each year according to the U.S. Department of Energy. The percentage is even greater in developing nations such as China.
However, if the U.S. were to implement a cap-and-trade system (where companies are given an allocation of carbon and charged for any excess emissions), each extra ton of carbon emitted by a coal-fired plant would be a direct cost - and considering the average plant's output, the crunch on short-term profitability could be severe.
Toss up - Financial Firms
Financial institutions face a mixed bag, one with growth opportunities (by way of new markets and commodities to trade) and increased liabilities. Insurance companies could see higher profits from premiums paid by companies looking to insure against CO2 litigation, but property/casualty insurance could be hit hard in the extreme case that major sea level changes occur on coastal properties. There are already examples of large insurers offering financial incentives to companies that do their part to reduce emissions or even become "carbon neutral" (i.e. they produce no net emissions).
Winners - Green Innovators
Companies that prove to be efficient and sustainable enough to produce lower emissions than their allowable cap would be able to sell those extra credits for a monetary profit. Companies that are directly engaged in the production of alternative energy or other green-related businesses would get several benefits; in addition to excess carbon credits that could be sold (generating green energy would not count towards their allowance) they could receive subsidies and tax breaks that would increase their profitability, especially during the first few lean years when development costs run high and sales typically run low. (For more on investing in company's leading the green crusade, see Clean Or Green Technology Investing and Building Green For Your House And Wallet.)
In addition to being able to purchase carbon credits on the open market, companies that exceeded their caps could invest in projects that reduced greenhouse gases, such as planting trees, alternative energy/fuel production and carbon capture systems that push gases into the ground as opposed to releasing them in the air.
Some companies will be leading the charge (whether for image or substance) even doing things aren't immediately profitable in the short term; others will be happy to wait on the sidelines until they are forced to change, either through taxation or regulation. When the future inevitably becomes the here and now, companies who arrive late to the game not only risk higher than anticipated costs, they also risk falling behind their competitors in knowledge and shareholder image.
Perhaps most importantly, new industries will emerge, and new markets and commodities will be formed. Both society as a whole and the markets will determine the true long-term costs of environmental damage and sustainable economic systems.
To continue reading on this subject, see Go Green With Socially Responsible Investing.