Subprime Carbon: Preparing for the Dangers of Hidden Carbon Risk

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WRI is drawing lessons from the subprime mortgage crisis to prepare the financial community for another potentially paradigm-shifting market change: the advent of carbon regulation.

With the Wall Street financial meltdown on everyone’s mind, the dangers of hidden risks are a timely topic. At a minimum, there are two key lessons here with respect to climate change and carbon risk.

First, markets may operate in a way that routinely ignores or misprices an important risk. Many things can contribute to this, including short-term, deal-driven incentives, poor risk analysis by internal auditors and external agencies, and lack of government oversight. These problems can be exacerbated by financial sophistication that adds complex layers to financial products. Products such as mortgage-backed securities may have helped to fuel easy credit and an avenue to pass on bad debt.

When information is unclear or muddied, risk can get dangerously mispriced. And that’s also true with carbon assets. With future carbon-related legislation as a constant moving target, added to the complexity in compiling GHG inventories, no one knows exactly what the real carbon risks are today. Put simply, they are difficult to decode.

Second, new financial players who hold significant positions in diverse industries along complex supply chains create an environment in which market turmoil in one sector can ripple through to other, sometimes seemingly unrelated, sectors. Likewise, the introduction of a carbon price impacts costs, revenues, profitability, cash flow, and market share of companies. Certain businesses may be unable to perform under carbon price constraints.

In the forthcoming Issue Brief on “Subprime Carbon,” we look at how carbon risk creates significant credit risks across diverse industries, for businesses and investors alike. These risks include:

• Supply Chain Risks: Increased input costs and price pressures are likely to affect company cash flows and bottom lines.

• Product and Technology Risks: Operating efficiency and competitive advantage may be compromised as competitive products, technologies and processes that limit carbon emerge.

• Regulatory Risk: As policymakers set emissions cap, develop inventory methods and apply rules to different industries, companies face rising and uncertain compliance costs.

Here are some of the questions we consider and attempt to answer in our Issue Brief:

• Are financial markets and businesses doing something to mitigate these risks?

• Are businesses creating alternative strategies to respond to potential cost increases in their supply chain?

• Are rating agencies weighting the full range of credit risks associated with the introduction and volatility of a carbon price?

• Are portfolio managers fully aware that associated regulations and subsequent market movements could have significant effects on fixed income fund performance even with a diversified portfolio?

Debt markets are in the beginning stages of considering carbon risks as part of their decision making process. Much of their efforts to date focus on carbon risks related to relatively obvious sectors such as energy and utilities. But less direct risks from carbon costs are rippling through the supply chain and across various industries—these types of risks are harder to capture, but no less significant.

It is time for portfolio managers to scrub their portfolio, for rating agencies to reevaluate their rating, and for stakeholders to create tools that identify, “subprime carbon”-backed debt and the credit risks of underlying counterparties. No one denies that it is a challenge to assess and quantify carbon/climate risks accurately. But by ignoring them, we run the bigger risk of repeating some of the same mistakes that contributed to our current financial woes.