According to a recent analysis by Trucost, the estimated cost of environmental damage caused by human activity reached $6.6 trillion in 2008, or 11 percent of the global Gross Domestic Product (GDP).
To put the loss in perspective, it was 20 percent larger than the $5.4 trillion loss in the value of pension funds in developed countries caused by the global financial crisis in 2007 and 2008.
The findings of Trucost are included in a new report from the Principles for Responsible Investment (PRI) and the UNEP Finance Initiative (UNEP FI), "Universal Ownership: Why environmental externalities matter to institutional investors." By 2050, the report continues (PDF), "global environmental costs are projected to reach $28.6 trillion, equivalent to 18 percent of GDP," in a business-as-usual scenario.
Furthermore, according to the report, "environmental costs are likely to be incurred earlier," because "values do not account for growing ecosystem sensitivity, increased natural capital scarcity and potential breaches of thresholds." On the other hand, if renewable and resource-efficient technologies are introduced on a global scale, the cost of environmental externalities could be reduced by 23 percent by 2050.
In a footnote, Trucost states, "Actual values are likely to be higher, since this study takes a global view that simplifies many economic and environmental complexities." Due to a lack of data, the report excludes most natural resources used, "as well as many environmental impacts including water pollution, most heavy metals, land use change and waste in non-OECD countries."
Citing a 2005 study entitled "A Tale of Two Market Failures: Technology and Environmental Policy (PDF)," the report asserts, "The costs of addressing environmental damage after it has occurred are usually higher than the costs of preventing pollution or using natural resources in a more sustainable way."
Focusing on the top 3,000 companies by market capitalization, Trucost found that they contributed $2.15 trillion to environmental costs in 2008. Trucost also found that the industry sectors most responsible for greenhouse gas (GHG) emissions -- by far the single largest contributing factor to environmental costs, equaling 7.5 percent of external costs -- were the electricity, oil and gas, industrial metals and mining, and construction and materials sectors.
To measure the potential impact on institutional investors of such costs, Trucost constructed a hypothetical fund in which $10 billion in assets were invested in the MSCI All Country World Index (ACWI), which consisted of 2,439 listed companies in 2008. "With US$10 billion invested in equities in the Index, an investor would be proportionally responsible for US$560 million of the externalities caused by the listed companies annually," Trucost found.
As the report notes, many institutional investors can be described as universal owners. Universal ownership can be described as holding a diverse and long-term portfolio which has the characteristic of representing the global economy at large. According to the report, the portfolios of universal owners "are inevitably exposed to growing and widespread costs from environmental damage caused by companies," as Trucost's hypothetical index indicates.
Because large institutional investors "need to own a broad cross-section of capital markets to maintain risk-adjusted returns," divesting many companies with considerable exposure to the risks associated with environmental externalities is not an option. Absent the option of divestiturev -- which, in any case, would do little, if anything, to pressure companies to change their environmental practices -- what can institutional investors do to protect their investment and encourage the transition to a global low-carbon economy?
First of all, as recommended in the 2009 UNEP FI report, "Fiduciary Responsibility: Legal and Practical Aspects of Integrating Environmental, Social and Governance Issue into Institutional Investment (Fiduciary II) (PDF)," asset owners should recognize that their fiduciary duty allows for, or even requires, a sustainable investment approach. Furthermore, according to Fiduciary II, "Advisors to institutional investors have a duty to proactively raise environmental, social, and governance (ESG) issues within the advice that they provide, and that a responsible investment option should be the default position."
Universal owners can also engage with laggards and the most influential companies in their portfolios through shareowner action. By doing so, the report states, "Investors can help to raise the bar across a sector and within supply chains."
However, engagement with individual companies, or even industry sectors, can be a relatively inefficient strategy when the impacts of climate change are likely to be devastating. For this reason, according to the report, "Investors could reduce risk and protect future fund returns by encouraging policy makers to implement measures that maintain natural capital and reduce pollution." Furthermore, because companies themselves require clear signals from policy makers to accurately assess the risks and opportunities for their business operations, investors and companies can work together to call for regulatory certainty.
Citing the influence of the Investor Network on Climate Risk (INCR) on the 2010 decision by the U.S. Securities and Exchange Commission (SEC) to publish interpretive guidance on reporting risks associated with climate change, the report recommends that investors work together through collaborative forums, because collaborations "backed by the value of combined assets have more impact."
Finally, investors can use resources such as The Economics of Ecosystems and Biodiversity (TEEB) initiative to help them determine their financial exposure to environmental risks. The TEEB study compares the costs of the loss of biodiversity to the costs of effective conservation and sustainable use, and states, "Making the value of our natural capital visible to economies and society creates an evidence base to pave the way for more targeted and cost-effective solutions."
This article originally appeared at SocialFunds.com and is reprinted with permission.
Image CC licensed by Flickr user Mikael Miettinen.