How to prevent the natural resources economic bubble

Policy Matters

How to prevent the natural resources economic bubble

Bubble image by Tyler Olson via Shutterstock.

When economic bubbles burst, the results can be devastating. Consider the recent housing bubble or the previous high-tech bubble. While the high-tech industry has recovered, millions of homeowners and former homeowners have not. Several years later, global markets today are still feeling the effects of the housing market implosion. Clearly, preventing economic bubbles is a worthwhile enterprise.

By definition, a bubble occurs when prices are inflated above their "real" value. For stocks and other investments, value is related to their anticipated future performance. If there is some risk that might prevent a company or investment from doing well in the future, that risk should be figured into the "real" value. When such risks are hidden, prices become inflated and a bubble grows.

In recent years, climate change and natural resources have begun moving into the realm of financial risk that companies need to understand and appropriately value. For traditional financial accounting, this represents a significant shift, but the foundation is sound: The risk of climate change is real and therefore should be factored into the "real" value of companies' stock and investment portfolios. The same is true of threatened natural resources, such as clean water. The risk of depleted natural resources is real. Hiding that risk will contribute to an economic bubble.

Because natural resources and climate touch of all of us, a bubble that encompasses them would be destructive in ways that are hard to imagine.

Organizations such as GreenBiz, The Investor Responsibility Research Center Institute (IRRC) and Ernst & Young have been working to both determine and track what companies should do and are doing to manage their risk.

The Global Reporting Initiative and integrated reporting are two of many proposed tools to help companies navigate the complexity and accurately value risks that, until recently, have been taken for granted.  

Admittedly, the proper valuation of natural resources -- and access to them -- is an extremely complex task. Recent advancement in scenario analysis programs and techniques have, possibly for the first time, made it possible to do so. Other information resources such as Aqueduct are also coming online to help companies and analysts see risks they may not have seen before.

Shareholders are beginning to pressure corporations to take action on the natural resources bubble. According to a report released recently by Ernst & Young, sustainability and climate-change-related shareholder resolutions are the second most common type of resolution so far in 2013, behind political spending.

Although still a limited few, some companies have seen the writing on the wall and begun to take serious action. One shining example of a company going out of its way to mitigate the natural resource bubble is Canadian Tire Corp.

"We've looked at what would happen in a carbon constrained economy." Canadian Tire CFO Marco Marrone said in an Ernst & Young report last year. "At a cost of $30 (CAN) per tonne, in many cases, the impact to the cost of goods sold could be in the low single-digit percentages. However, in some product categories, the cost of goods could be 30 percent to 40 percent higher. The modeling has allowed us to quantify carbon price risk in these categories and identify how we can take energy and carbon out of the equation."

Imagine if one of the big Wall Street banks had correctly assessed the risks of the housing bubble. When the bubble burst, the impact on their reputation and credibility would have been incredible, not to mention their likely capture of substantially increased market share. Canadian Tire is working hard to assure its stability in the face of climate change and all of the ecological and political instability that already has begun as a result. This is among the reasons that Canadian Tire is one of Canada's most trusted brands.

For all of the progress being made, the problem is that many companies still have a long way to go to appropriately mitigate this risk, and many others have yet to even acknowledge it. But it should no longer be excusable for a company not to be aggressively moving toward some version of integrated reporting, and as financial analysts begin to expect it, even the holdouts will have to acquiesce.

At the GreenBiz Forum in New York earlier this year, there was a consistent refrain from the C-Suite presenters that by and large, financial analysts don't ask about sustainability or risks associated with ensuring continued access to natural resources and other potential damages from climate change.  

We are facing a massive bubble driven by climate change and undervalued access to and use of natural resources. Despite some progress driven by the C-Suite and shareholders at some individual companies, the market is largely blind to it. Despite the complexity, if we are going to avoid the coming burst of a very big bubble, financial analysts need to step up to the plate and start asking these tough questions -- and they need to do it now.

Bubble image by Tyler Olson via Shutterstock.