To be published as HC 191-i




Environmental Audit Committee

Green Finance

Wednesday 26 June 2013

James Leaton and Dr Nicola Ranger

Michael Liebreich, Donald MacDonald and David Russell

Evidence heard in Public Questions 1 - 74



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Oral Evidence

Taken before the Environmental Audit Committee

on Wednesday 26 June 2013

Members present:

Joan Walley (Chair)

Peter Aldous

Martin Caton

Zac Goldsmith

Mark Lazarowicz

Caroline Nokes

Dr Matthew Offord

Mark Spencer

Dr Alan Whitehead

Simon Wright


Examination of Witnesses

Witnesses: James Leaton, Project Director, Carbon Tracker Initiative, and Dr Nicola Ranger, Senior Research Fellow, Grantham Research Institute on Climate Change and the Environment, gave evidence.

Q1 Chair: I would like to commence our proceedings this afternoon by thanking both of you for coming along to give evidence to our inquiry. Will you begin by giving us a summary of the recommendations of the work that you have done on the carbon bubble? We have two sessions this afternoon, so we have quite a lot of detailed questions. What we really want to understand is the main thrust of what you are recommending and who those recommendations are aimed at, so that the conclusions are deliverable by somebody. If you would introduce yourselves briefly and then answer that question about the recommendations, that would be really helpful.

Dr Ranger: Thank you very much for inviting us to speak today. I am Dr Nicola Ranger. I am a Senior Research Fellow at the London School of Economics. On this particular report, I was responsible for the scientific modelling side of it.

James Leaton: I am James Leaton. I head up the research at Carbon Tracker, and fitted in with the contribution from Nicola and Grantham by bringing in the financial and reserves analysis.

Q2 Chair: What are the main recommendations of the report?

Dr Ranger: The key message from our side was that the total amount of reserves of oil, gas and coal, currently held by both states and listed companies, far exceeds what we call the carbon budget that would allow us to keep global temperatures to below 2 or 3 degrees, 2 degrees being the level at which Governments, through the UNFCCC process, have committed to try to reduce emissions to keep temperatures below. We found that total reserves at the moment are around, say, 3 billion tonnes of carbon dioxide equivalent, whereas to keep temperatures to about 2 degrees the budget is only 1,000 billion tonnes. You can imagine that if we burned everything that is currently held by these companies and by states, you are talking a temperature rise certainly in excess of 3 degrees.

We also found that even if we want to keep warming to 3 degrees, it would still mean that a lot of the reserves that we currently hold can’t be burnt. It would still mean around 60% of the reserves cannot be burnt, even for that much, much less ambitious climate goal than countries have currently signed up to.

Q3 Chair: Mr Leaton, did you want to add to that?

James Leaton: Yes, just to follow on from that. To use the title of the report, obviously that was around wasted capital and stranded assets. We felt, given this shows we already have more reserves than fit within the budget, that there is a risk that developing more reserves would be a waste of capital and could result in stranded assets that can be operated for their full expected lifetime, whether that is a power plant or a mine or an oilfield. This obviously has implications for investors, which we touched on, in terms of what they can do to scrutinise the business strategies and the models that companies are using to justify continued exploration and development of reserves.

I understand you are hearing from representatives of investors later who are better placed to explain the constraints that they operate within. We felt that, beyond that, there is a limit to what they can do, but there are other parts of the financial system, and the regulator, that need to send stronger signals to the market to factor in these risks to enable investors to shift capital. That relates to greater transparency around the carbon content of reserves that companies have an interest in, and also asking those companies to stress test their business model against different warming scenarios from 2 degrees upwards.

Q4 Chair: Who do you expect will do anything with the recommendations that you have made in the report? Were they aimed at a particular group? Is it aimed at Government? Is it aimed at investors? Is it aimed at shareholders? Who do you think will be taking action from your recommendations?

Dr Ranger: We propose a set of recommendations for different matters. For investors, for example, the suggestion is that potentially investing in these companies that are potentially at risk from stranded assets in the future could be a high-risk strategy for them, so investing in other areas might be better in terms of the returns. We also make recommendations for regulators, as James was saying. Do you want to speak to the regulation ones?

James Leaton: Yes. I think we do view the ultimate audience as the financial regulators, because there is obviously a role for the financial markets here that they are currently not playing. There is obviously an ongoing debate around the climate regulation, but we feel the financial regulation needs to be in tune with that and that currently it is not aligned. A lot of the recommendations are linked to making greater connections between that climate debate and the financial stability debate.

Q5 Chair: Are you communicating the message of your recommendations to those different groups of people?

James Leaton: Yes. We are doing that through some of the investor groups. We are working with investors, asset managers and pension funds to get them to review this issue and raise it. We are also pushing it directly, in terms of some of the key markets where we have seen high exposure. London and New York have very high exposure to fossil fuels, so we have sent this to the regulators in both countries and are following up with them now.

Q6 Chair: Assuming that we do get a global agreement in 2015 as part of the UN process, how do you feel that will have a bearing on the research that you are doing as far as the carbon bubble is concerned? Will that puncture it? Will that start to deal with the issues that you are raising? Is that directly relevant to the whole agenda that you are looking at?

Dr Ranger: If there is an agreement in 2015, which puts in place emissions reductions that will aim to stabilise global temperatures at 2 degrees, that implies a carbon budget, which is this 1,000 gigatonnes, so a billion tonnes of carbon dioxide. That would then mean that that is the maximum amount of carbon dioxide that could be emitted to meet that international agreement. If they agree at a higher level, say 3 degrees, which obviously means much higher impacts in terms of climate impacts, it gives you a bigger budget. The impact on the fossil fuel industry will be lower, but then of course the impacts of climate change will be much higher at that level. I don’t know if you want to say anything about how that budget then feeds through to the response.

James Leaton: Yes.

Q7 Chair: Also, the timeframe in which that would have an effect as well.

James Leaton: We would also be keen to note that it is not necessarily purely dependent on a global deal or a very clear overarching signal like that. The market could obviously deal with that quite simply. What we are seeing is there is already a patchwork of regulation around things like air quality that we are seeing China move on-so that is more of a driver politically in some countries-and in the US coal has declined due to competing technologies. We are seeing the price of other options coming down all the time. It could be lack of water. I think this term "stranded assets" could appear from a range of factors, not just whether or not we get a global deal in 2015.

Q8 Zac Goldsmith: Very quickly, it would be interesting to know if there has been any noticeable reaction by the markets to the announcement by Obama yesterday, which has effectively made fossil fuels into more of a liability than they were before he made his intervention. How have the markets reacted?

James Leaton: I did see an article in the Washington Post that suggested the coal stocks were down a few percent. I can’t comment on whether that is directly related but they certainly made that connection. Certainly, US coal has already seen 75% of the value of mining stocks wiped out over the last two years because the market has declined in their country.

Q9 Zac Goldsmith: If the market has reacted in such a marginal manner, is that because the intervention is weak or is it because the market does not believe that it is going to happen?

James Leaton: For the mining stocks it might be because they have already lost so much of their value, so they have already-

Q10 Zac Goldsmith: They have already priced them?

James Leaton: Yes. The fact they have already lost 75% of their value, to lose another percentage they are still getting down very low compared to where they were previously. I guess the question for us is whether the market saw that coming. I don’t think two years ago it did predict that coal stocks were going to be down 75%, 80%, on where they were then. That is the worry for us, that the market isn’t very good at seeing these systemic risks coming.

Dr Ranger: A further point is that, even if we have a strong global deal in 2015, the reduction in global emissions will not happen quickly. To get to the level of 2 degrees that they are aiming for means a halving of global emissions by 2050. We are probably still going to be using fossil fuels in 2050 but at a much, much lower level. So, in terms of the use of fossil fuels, we are talking more of a gradual tail-off. How the market will respond to that knowledge, that this industry is going to be tailing off, I think we can only speculate about whether that would be a rapid reaction or not.

Q11 Martin Caton: Dr Ranger, you have just given us a round figure for the global carbon budget. It would be very helpful if you could tell us a little bit more about how you estimated that figure and what, if any, were the main uncertainties that you had to grapple with in reaching it?

Dr Ranger: The way we estimated the figure-and I should say that a number of different groups have produced a similar figure, or actually the same figure, about 1,000 gigatonnes of carbon dioxide-was to run lots and lots of simulations of climate models, and estimate what the relationship is between the rising global temperature and the amount of emissions that we make between now and the end of the century. When you plot those two things together you can see that it is quite a linear relationship. Even though there is a strong relationship, there are a lot of uncertainties on that. For example, there is uncertainty about how much non-fossil fuel activity there is.

A lot of carbon dioxide emissions and greenhouse gas emissions don’t come from activities other than burning fossil fuel. Fossil fuels is about 60% of total emissions at the moment, so we have to make a lot of assumptions about those sort of gases as well. We have to make assumptions about how aerosols will change. Aerosols that are emitted when we burn fossil fuels have a cooling effect on the climate and offset some of the warming effect of greenhouse gases, so we have to make estimates about those as well.

Another estimate we make is about how sensitive the climate is to greenhouse gas emissions. For example, looking at the effect that has on the budget, if we take a more pessimistic estimate the budget could actually be as low as about 900 rather than 1,000 billion tonnes. If we take a much more optimistic estimate, it could be about 1,200, but still that range is quite narrow and is still a very big constraint.

Q12 Martin Caton: We have received different evidence from the scientific community suggesting that there are different views on climate sensitivity. Whose model did you use?

Dr Ranger: We did not use a single model. The approach we took is that we used a large number of models. We did a probabilistic estimate. For example, the IPCC-the Intergovernmental Panel on Climate Change-says that climate sensitivity could be likely between about 2 and 4.5. That is based on looking at the results of many, many different models. We used that range in our modelling. So it is not just one model, it is using the results of many, many different models and simulating those.

Q13 Martin Caton: Do you see the promise of carbon capture and storage as possibly delaying the carbon bubble being taken seriously? Also, do you think that CCS would potentially increase the amount of fossil fuel reserves that could be burnt?

Dr Ranger: I think that was a really interesting conclusion of this report, actually, which surprised me. We looked at the most recent projections from the International Energy Agency, the IEA, for carbon capture and storage. We looked at their most optimistic assumptions, which suggest that, between now and 2050, CCS could capture only about 125 billion tonnes of carbon dioxide compared to the 1,000 budget that we have. So it only increases the budget by quite a small amount.

That is not to say that CCS is not important. It is just saying that in the near term it will take quite a long time to get that technology to scale. It is only by around 2040, 2050, that we expect to see that it will be having a really big benefit, and beyond that, of course. But in the near term it actually does not make much difference to the carbon budget.

Q14 Dr Whitehead: In that analysis, did you look at where you put the stuff; that is, the actual capacity of various places around the world to store carbon? For example, a recently revised estimate for North Sea storage capacity was published. Secondly, did you consider or have you considered any other forms of what we call geo-engineering coming into play as far as elements of that total problem are concerned?

Dr Ranger: We did not do any new analysis on CCS. We only used the estimates that have been provided by the IEA. We did not look at where the carbon would be stored. As I said, this particular estimate from the IEA that we used was their most optimistic estimate. In this estimate, we go from about, say, 16 plants that are currently under construction and it would require 4,000 plants by 2050. That looks pretty optimistic given where we are now. Their more realistic scenario of what could be achieved by 2050 is much, much, much lower. Then on other sorts of technologies, no. All of our scenarios assume that there will be no geo-engineering. We could talk about geo-engineering in more detail if you would like to.

Q15 Zac Goldsmith: You have argued that, if fossil fuel companies continue to invest in finding resources, inevitably their investments are going to become stranded. Can you just explain what that means that before I move on?

James Leaton: I think the term "stranded" perhaps means slightly different things to different people. When we are using it, we are saying that those assets ultimately will not be burnt, basically, and that may be for a number of reasons.

Q16 Zac Goldsmith: Yes. Can you explain what you believe are the consequences of that, not just for the companies with those stranded investments but more widely as well, the wider economy and society? What are the implications of that?

James Leaton: The imperative to tackle climate change will require an energy transition. It will require changes to our energy system and infrastructure. We are pointing out the implications of that. We won’t need as many fossil fuel reserves and we won’t need as many fossil fuel power stations, but if we continue to build those that isn’t aligned with the direction the global community has indicated it wants to go in. The further we go down a path that heads towards 6 degrees or 4 degrees, the more we may be putting into assets that can’t fulfil the predicted lifetime that may be communicated to investors or to the public.

Q17 Zac Goldsmith: I am going to come back to that in one second, but you have mentioned the International Energy Agency’s report and that a lot of your analysis is based on their assessment. They take a different view on stranded assets to your report. They argue that only the investments in oil and gas fields that are yet to be developed will have to be written off, whereas in your report you argue that up to $6 trillion worth of investments will be stranded or could be stranded over the next 10 years. Given you are using the same data, I assume, can you explain what different assumptions you were using that led you to reach a different conclusion?

James Leaton: Sure. I think the way the IEA did it the 5% and 6% for the oil and gas essentially refers to the current policy situation, whereas there is also the 450 parts per million scenario where you would then get a higher proportion.

Q18 Zac Goldsmith: Your assumption is you are going to have more political activity or decisive activity?

James Leaton: Yes, or something. Also they have a narrower definition of stranded assets. Essentially, they defined it as where costs are not recovered. We would say that then does not include any asset where you have not spent anything. A company may have the right to explore an asset, and there are lots of fossil fuels out there that have not been started to be developed yet but they still could come into the pipeline and be developed. It is still something out there that we would argue is stranded because it can never go to market.

Q19 Zac Goldsmith: Are there any significant signs that the fossil fuel companies have taken on board the possibility of stranded assets accruing?

James Leaton: Yes, the other differentiation is for a commercial company or an investor they want to see a rate of return. The IEA only applied a breakeven requirement before it becomes stranded. For example, what we have seen is some of the large mining companies-like BHP Billiton and Rio Tinto-have pulled back from thermal coal in Australia. Rio has put up 3 billion worth of coal assets for sale and BHP has said it is not investing capital in any new coal projects. It is only completing the ones it has already started.

Q20 Zac Goldsmith: Even taking that into account, current trends suggest that we are going to reach a point where there will be these enormously valuable stranded assets, and that seems unavoidable by your analysis.

James Leaton: Certainly, if the market continues to place a value on them and assumes they can be burnt, then there may-

Q21 Zac Goldsmith: Then, logically, does that mean that the fossil fuel companies, which are already creating a situation where they will be sitting on what you define as stranded assets, simply do not buy into the possibility of decisive political action on this? Are they just assuming they are going to be able to exploit and realise those investments?

James Leaton: Certainly, the decisions they are making on investing capital in many of those companies are not reflecting that ambition of limiting global warming, no.

Q22 Zac Goldsmith: Before I move on, the concept of stranded assets as applied to fossil fuels-this is a question, not a statement-only becomes a reality in the event that there are a series of or a single political reaction. In other words, it is a market that becomes stranded as a result of political decisions and nothing else, is that correct?

James Leaton: There could also be market forces, with alternative technologies the costs are coming down all the time. As soon as you get a relative cost that is cheaper than-

Q23 Zac Goldsmith: That applies to all sectors, though.

James Leaton: Yes. I am just saying that, while we are waiting for regulation, solar is already approaching grid parity, and there could be other reasons. I don’t know if you have any?

Dr Ranger: General behaviour change could do it as well, but certainly I think to make it happen at any sort of rate it would be an international agreement; political action.

Q24 Zac Goldsmith: Yes. I do not know whether or not we are going to have some of the fossil fuel companies here to talk about what they understand to be stranded assets, but it would be interesting to put that same question to them. The International Energy Agency also predict that even with policies to limit warming to 2 degrees, future revenues from oil and gas will be greater still than in the last few decades. On that basis, is it logical to assume that the attraction to investors is not going to diminish regardless of political decisions? The upside is still very much there and growing?

James Leaton: Some of the assumptions we always look at with any scenario with investors is around the price and the demand compared to, for example, what HSBC did on this. They used a peak demand scenario and assumed that the oil price would essentially drop to $50, whereas the IEA still use quite a high level, even in a 450 scenario, of around $100. I think that is why there is still a high revenue flow under the IEA scenario, whereas I think to us this is where the market needs to do some more research around what are the price implications, what are the demand implications, and how does that feed through to the revenues of the companies.

Q25 Dr Whitehead: The question of stranded assets, in terms of the analysis that you have put forward as far as extraction is concerned, also absolutely logically applies in terms of emissions caps that may have been placed on overall emissions and, indeed, national allocations, for example. Therefore, that quite simply means that, say, if you have a gas-fired power station grandfathered until 2045, that will be stranded under your scenario. You will have to decommission it well before it has recovered its costs as far as its asset base is concerned?

James Leaton: That is certainly a possibility. From setting a budget and understanding that, you then go through and have to make political choices about how you use that budget, essentially, a bit like you would with a financial budget. Certainly, the IEA picked this up and they figured that over half of their current generation capacity would either have to be retired early, idled or would need CCS, so it could not carry on for the full predicted lifetime. So, yes, that is something to factor into planning for utilities and infrastructure.

Q26 Caroline Nokes: It seems clear from your report that investment is still quite readily flowing into fossil fuels. The report indicated $674 billion last year. What do you think it is that is driving that continued level of investment?

James Leaton: I think the financial system is still very short term and there have been recent Government reviews-the Kay review-around the short-termism that affects the energy markets. That whole system has various short-term drivers, whether it is the performance incentives for the fund managers based on quarterly performance, the recommendations from analysts, which are based again on the short-term revenue flows from that company and their ability to generate revenues in the short term. So that is not very good at factoring in long-term risks. To them, "long-term" is perhaps more than a year or more than three years, and that does not necessarily reflect the investment strategy of some of those large institutional investors, the pension funds.

There are issues around fiduciary duty that the Kay review has recommended that the Law Commission is looking into, so that it is clear that it should be more of an intergenerational issue, which pension fund trustees and fund managers should consider so that they look more long-term. So, yes, I think the current system is still based around these short-term metrics. If you are looking at an oil company, you are looking at: did you replace your reserves. As long as you have those traditional indicators, which are looking at the future will repeat the past, you are building up this problem. The one thing with climate change is we know the future cannot repeat the past either because of the impacts or because of the limits to emissions. That is why we need some new metrics or some new indicators.

Q27 Caroline Nokes: What do you think the non-fossil fuel alternatives are that could produce similar returns for investors?

James Leaton: That is part of the challenge that the investors can probably speak to better. They do need to meet their criteria for investment grade of scale and return, and work is ongoing to create things like climate bonds that can fit that bill. Again, this comes back to the way the market views risk. We think currently it is not factoring in enough of the risk associated with fossil fuels, so you end up with risk being defined as how much you deviated from your benchmark, the FTSE100 or whatever your benchmark is. Even if that went down, as long as you did not go down as much then you have still outperformed the market. Whereas we think you should be looking at how much value you have lost, and we see that there is value at risk here that is not being picked up by the market.

Dr Ranger: Just a small point is that I think another interesting finding of the recent IEA report, which came out a week or so ago, was that the impact on the power generation industry is going to depend very much on how they respond to this risk. Overall, globally, the revenues of the power sector could increase significantly under this 2 degree scenario, much more so than it is now, because of these opportunities for investment in new technologies. If they seize those opportunities, actually, a global deal could be a massive opportunity for them. It is just those companies that can’t, for whatever reason, take those opportunities where there could be these stranded risks.

Q28 Caroline Nokes: Do you think investors are already balancing out the risks and having broader portfolios or is there no evidence of that?

James Leaton: There are some funds where you can see it, such as the Environment Agency fund where they have a very explicit strategy to reallocate capital at the portfolio level. But I think there is still more work to be done to develop some of the tools to stress test portfolios against different climate change scenarios. I am not sure that the system has developed enough and there are still a lot of these short-term drivers that are holding that back.

Q29 Caroline Nokes: Is the crux of the matter that, quite simply, investors do not have the certainty that Governments are going to take the necessary action to tackle climate change so they still feel secure in investing in fossil fuels?

James Leaton: I am sure certainty would help any investor. I think we have seen with things, like the removal of renewables tariffs at very short notice, that has certainly warned off investors in some countries when they have been burnt by that. Certainty is definitely a good thing, and, yes, there are still a lot of other areas that are related. It is not just the climate regulation, there are still a lot of fossil fuel subsidies that are in place that do not make it a level playing field. That is a mature industry, yet it still has a lot of subsidies. Again, linking that financial regulation in, we would rather prevent a bubble and a crisis around this by having indicators built in. We have measures now hopefully to look at the financial stability of the banking sector, but we want to understand the carbon stability of the energy sector as well.

Q30 Caroline Nokes: Finally, isn’t one of the significant problems, as HSBC have identified, that the vast majority of fossil fuel reserves are held either by Governments or by state-backed organisations? Where then does that provide the incentive for Government to take action?

James Leaton: You can certainly see that, yes, some Governments do have a strong interest in fossil fuels. Equally, we are still seeing some of the Middle East countries are actually some of those leading in investing in solar, because they are having to subsidise the use of oil in their own country. It is still a cost to them in that sense. The flipside of that is obviously all the countries who have high import bills currently, because they are importing expensive fossil fuels, would be better off if they developed their own renewables and had energy security. So, yes, it would change the global balance, but I think through all this there are those who are going to seek to adapt and those who don’t adapt so well.

Q31 Dr Offord: I want to explore the role that financial regulators have in addressing a potential climate bubble. The Environmental Policy Committee’s report, back in November 2012, did not mention once climate change, greenhouse gases, carbon or emissions. Do you believe that the Bank of England is taking the whole agenda seriously?

James Leaton: The Bank of England obviously has had some other issues on its mind, with various crises and LIBOR scandals and a new Governor coming in and restructuring. We are going back in to see them next month, but I think we would certainly question at the moment whether they have the right data and information and indicators to give that view. We can produce our analysis of how much carbon we think is listed where, but when parliamentary questions have been asked there hasn’t been a clear response of, "Yes, we are monitoring it. This is the data we use. These are the people we speak to, to assess whether this is a risk". That would give us much greater comfort that they were at least looking at it in a more comprehensive way that we do not currently have.

Q32 Dr Offord: How do you feel about the Kay review? Did they take the issue more seriously?

James Leaton: I think it demonstrated some of the problems of the markets. I don’t think it followed that through. For us, climate change would be a very good case study of whether the markets can deal with long-term systemic risk, so I think that would still be a test we would like to see applied as to whether the markets are being properly regulated to deliver a long-term system. Yes, I think the fiduciary duty area that did come out is a key one.

Q33 Dr Offord: I also understand that you are an advocate of seeking that companies provide environmental information in their company reports. How did you come to make that assertion?

James Leaton: I think partly to help the regulator. Obviously, we see this as a systemic issue, so having piecemeal information does not enable you to build up a picture of the whole system. If every extractive company, which is only a subsector, had to translate its reserves-which we assume most companies know what reserves they have-into carbon, that would be a very simple indicator so we know: is London becoming more carbon intensive, less carbon intensive, what direction are we heading in? So that is the numbers side, and then there is the business model side of: how does the company’s management justify continuing to develop more reserves, when the overall conclusion is we have more than enough already; and how are they going to continue to provide returns to investors in a low-carbon scenario?

Q34 Dr Offord: Did you discuss this with any larger investors?

James Leaton: Yes. I think there is certainly interest in seeing how this can be put on the agenda. We have seen other examples, for example, around revenue transparency where the extractive sector is now having to report the payments it makes to Governments for the wider benefit of society. For example, we have talked to ratings agencies and they have said, "Well, we see it a bit like pension liabilities. We didn’t used to know whether companies had enough funds in their balance sheet to pay their pension liabilities and now they are required to do that". Things evolve over time when we understand new risks and we think this is a new risk worth looking at.

Q35 Dr Offord: Do you think that the reporting of such information alone will see a change in behaviour of investors?

James Leaton: No. The transparency would send a signal to the market that it needs to be looked at, and then that would require some further work and some further activity. I think it would certainly send a strong signal that would be welcomed.

Q36 Dr Offord: Considering that we are in a global financial context, do you think that introducing these measures into the UK domestic market singularly will be effective?

James Leaton: It would be a good place to start and show leadership. As we have already seen, London is a leading centre for financial services and prides itself on having strong governance. In a sense, the price people pay for coming to list in London is that they have to meet the requirements. We would see that as an additional measure, in the same way that if a company lists in London it has to give an independent assessment from a competent person that its reserves actually exist. We think they should also have to consider is there a market for their reserves. Certainly, London and New York we think are the leading centres that could set an example on this that the international community could then follow.

It is an international issue, you can have an investor in New York holding a fund in London that has companies in Australia that export to China. It is a global system, and there are global standards that we think would benefit from integrating this. But London is obviously a leading place to start thinking about that and take it to those global associations.

Q37 Dr Whitehead: One way in which companies could continue to maintain a healthy presence in the market would be by the very scarcity of the remaining fossil fuels, such as they are, depending on the scenario as to whether the rest of the potentially extractable fuel stays in the ground by pricing or by regulation.

James Leaton: Yes.

Q38 Dr Whitehead: On the basis of price then, it certainly would be more than possible for companies, if they already have ownership of those existing assets, to make a very good living by pricing for scarcity. Therefore the mechanism of investor flight, because the assets have been overvalued, is countermanded by the value of the remaining assets at that particular point. First, have you looked at how that effect might work, and, secondly, under those circumstances, have you considered whether mechanisms, which basically rely on regulation rather than pricing, would have different outcomes as far as that effect is concerned?

James Leaton: That is certainly one possibility that, yes, oil becomes a luxury good. We would then look at the volume. If you are saying, "You can only produce a third as much oil" how do you know if you own the company that gets to produce that third or are we saying every company only produces a third? What we see is that different companies have very different assets, in terms of their cost of production and the taxes they have to pay, the royalties, where they produce it. What we think the market should be thinking about is: if this limit is applied for whatever reason what does that mean? If we get a high price scenario, then who is best placed? If we get a low price scenario, who is best placed? At the moment that is not really happening. I think those are all very good questions. We would not second guess the market. If we did we would be a lot richer and I would be doing that job. But, yes, I think those are certainly things that need thinking through.

Chair: That brings us to the end of this part of the session this afternoon. Can I give a very big thank you to both of you for coming along? I hope you will follow the subsequent hearings that we have. Thank you very much indeed.

Examination of Witnesses

Witnesses: Michael Liebreich, Chief Executive, Bloomberg New Energy Finance, Donald MacDonald, Trustee, BT Pension Scheme and Chair of the Institutional Investors Group on Climate Change, and David Russell, Co-Head of Responsible Investment, Universities Superannuation Scheme Investment Management, gave evidence.

Q39 Chair: Can I start off by saying thank you to each of you for coming along this afternoon? I think that you sat through the previous evidence that we have just heard, so perhaps it will not come as a surprise to you that my first question is to ask each of you whether or not you feel that such a thing as a carbon bubble does actually exist? If you agree, to what extent do you agree with the proposal that has been put forward that a carbon bubble is developing in financial markets? I don’t know whether you have a spokesman among you or if you each want to reply. Just for the record, will you say who you are and who you represent at the start of that response. Mr Liebreich, I think you have been nominated first.

Michael Liebreich: Michael Liebreich. I am the Chief Executive of Bloomberg New Energy Finance. We are an information provider of about 200 people that I founded nine years ago and then sold to Bloomberg. What we do is provide news, data and analysis, which was initially on renewable energy but now on energy efficiency, smart grid, electric vehicles, water, gas, nuclear. That is what we do.

I am nervous with the terminology "bubble" because the technical definition of bubbles is that there are all sorts of things that go like that, then they pop and come back down again in some timeframe. There is an issue-I would not characterise it as a bubble-which is whether there is a systemic failure of valuation, an overvaluation of the fossil-related and extractive industries and various other utilities and some other asset classes. I think there is a real issue around that.

Then the question is: how serious is it? Is it just that there will be a nice orderly rearranging of priorities and valuations, and some people will lose money in the traditional way and some people will make money by calling it right? Or might there be some sort of systemic or disorderly adjustment, requiring perhaps some sort of macroprudential intervention? I am much less convinced. I veer towards thinking there probably will be a rather ugly readjustment, but I don’t think I would characterise it as a bubble that is going to pop and all that somewhat dramatic description.

Q40 Chair: If you are saying that there would be some kind of readjustment, are you thinking that that would be necessary in the short term, the medium term? In what kind of timescale might that happen?

Michael Liebreich: Let me take a step back to what might cause that readjustment. It was characterised by your last witnesses as very much dependent on a global deal. There will be a global deal and then something will happen. What we see, day in, day out, is actually that the energy system is changing. There is a phased change from the old school centralised fossil and nuclear related to something that is renewables, lots more efficiency, smart grid, gas, some nuclear, and so on. That change is happening partly because of lots of small legislative interventions, partly because of the underlying economics in the energy sector. I think that is a long-term trend.

Then to answer your question: will the valuations progress in an orderly way, just slowly readjusting, or will there be a mispricing and then suddenly the market is understanding that they have mispriced and then rushing for the exits on certain investments and rushing for the entrance in others? What I would suggest is, let’s look at history.

Q41 Chair: Which history would you look at?

Michael Liebreich: History would tend to say that markets will misprice for a considerable period of time, and then engage in very rapid and potentially disorderly adjustments.

Q42 Chair: Would you compare that with what happened with the banks?

Michael Liebreich: You could compare it to sovereign debt in the last century. I think it is probably more analogous to sub-prime than to any sort of bubble, where you hold these assets, you think they are good, and suddenly it becomes clear that they are not. At that point, the readjustment, the rebalancing of portfolios and so on, feeds on itself as people undertake fire sales to rebalance and then that pushes down the market values even further below books. As I say, I don’t like the terminology "bubble" but I do think we are going to see some rather messy adjustments.

Then you say, "What will the timeframe be?" I don’t know. I think it was Keynes who said that the market’s ability to maintain a mispricing will outlast most investors’ ability to bet against them. It is very hard to tell at what point the animal spirits will wake up and revalue. We are talking five to 10 years. We are talking five years, around that, not 30 years and not, as I say, purely dependent on what might or might not come out of COP 21, 22, 25, and so on.

Q43 Chair: In terms of the investors who you are advising, who are making decisions now about where to invest, is this something that they are acutely aware of? Are they looking to see how to position their investment decisions now, with that long-term view for the next 10, 20, 30 years? Are they asking for this kind of analysis from you yet on climate change issues?

Michael Liebreich: Just to be clear, we don’t advise anybody on their investments. We are infrastructure, energy and water analysts. We tend to work with clients who are concerned. There are other analysts who-

Q44 Chair: So ones who did not think that would not come anywhere near you?

Michael Liebreich: To be clear, we work with many if not all of the major utilities, the major oil and gas companies and so on, but we are working on these issues of: is there a future that looks considerably different and, if so, what should we do about it? I think if an investor really thought that this was all going to blow over then the chances are they probably would not subscribe to our services.

Q45 Chair: If I could perhaps move on to Mr MacDonald, from your perspective as a trustee, do you concur with what has just been said or do you see it through a different perspective?

Donald MacDonald: Well, if I can, our first duty as trustees is a fiduciary responsibility to our members and to the trust. Primarily, we have to ensure that all of the pensions are paid to the right people; the right pension is paid to the right people at the right time. That will continue to be the case until the fund closes, which will be somewhere between 60 and 80 years ahead. For us, climate change is a major risk factor that has to be taken into consideration. That is a mixture of adaptation measures, and we believe mitigation measures will be necessary.

Q46 Chair: Can I just interrupt and ask for how long has it been that major consideration? Is it something that has come about in the last couple of years?

Donald MacDonald: No. I would say that, probably, over the last five or six years we have become much more aware of those issues. One of the first steps we did to become more aware of the risks was to take an active part in the IIGCC-the Institutional Investors Group on Climate Change-which I now chair. We took an active part in that, quite deliberately, to try to get to grips with the information, try to get a better understanding of what is going on, and try to look at what best practice is within the investment sphere and to work with our peer group. That includes other pension funds like USS but also with fund managers and with private equity and infrastructure people. So, yes, it is becoming much more on the agenda, certainly of the large pension funds. I think there is a capacity issue for pension funds, in the sense that the smaller and medium-sized funds simply do not have the internal resource to have a look at those strategic issues. They tend to be much more reliant upon their investment and actuarial advisers.

Q47 Chair: Just picking you up on why you think the smaller ones don’t have the resource to pick up on this, is this because the staff that are in place are there because they are approaching it from a perspective that they have always approached it from, and they have not taken on the new skills to adapt to this new risk that is in the process of being identified?

Donald MacDonald: I personally come from a large pension fund so we do have resource, but for the small and medium-sized funds it is simply a question of the very small numbers of people employed directly by them and they don’t have the in-house expertise. It is quite a big investment in terms of time and commitment because, once you get into that, you then have to start engaging with investee companies, with fund managers and so on. There is more to it than just acquiring knowledge. It is then what you actually do with that knowledge. There is a genuine capacity issue, so I think one of the things that we would like to be able to think about is finding a route for the smaller schemes to get involved, and perhaps things like the pension infrastructure platform could be part of that process.

Q48 Chair: Then just moving to you, Mr Russell, in terms of the Universities Superannuation Scheme, what is your take on all of this?

David Russell: I am here representing USS Investment Management. We are the fund manager for USS, which is the second largest UK pension fund after BTPS, which is the largest, so you have two very unusual schemes here.

Looking at the Carbon Tracker report and analysis, I think that there seems to be something in the numbers. I don’t think you can very easily argue with the analysis that they have done. Our view is that, unfortunately, the basis of some of the assumptions that policymakers will act to implement policies that cause a bubble to burst-hopefully it won’t go there-and that there are alternatives to carbon-based fuels, are simply not there at the moment. The evidence we have is policymakers find it very difficult to act. We have seen that in Europe recently with the failure to support back-loading of the emissions trading scheme. We see it in Australia where it looks like, if the opposition gets in, they will unwind the emissions trading scheme there. So, notwithstanding Obama’s stance yesterday, policymakers don’t seem to be acting in a way that would drive policy to get us to a point where we will see emissions reductions.

The other point on the alternatives is there simply are not the alternatives there yet, which will enable us to have the energy supply that we need globally to replace carbon-based fuels.

Q49 Chair: Do you see a carbon bubble actually existing?

David Russell: I think long-term it is very likely, and part of what we do at USS is try to engage with policymakers in different markets to encourage putting in place the policies that would lead to a shift to a lower carbon economy.

Q50 Chair: You are saying it is not a question of whether; it is a question of when?

David Russell: I think, yes, it probably is, but when is a very open question. I don’t think it is five years’ time. I think it is a longer term than that. The IEA in its report would seem to think it is a longer term than that as well.

Q51 Simon Wright: Could you give us your insight, please, on the main drivers behind investors’ decisions, specifically where support for energy or environmental projects is considered. What relative weight is given to questions of possible environmental or carbon impact?

Donald MacDonald: We have a wide range of investments, really, in all asset classes and in all continents, apart from Antarctica as far as I am aware. What we try to do is to ensure that the issue of externalisation of environmental costs is tackled. Through our fund managers and through the engagement services that we use, we try to engage with the large energy companies, for example, as well as the large utilities, about the externalisation of costs. For us, we do try to integrate the whole issue of carbon and externalisation of costs across the whole of the energy sector.

In terms of new investments, you have to remember that big institutional investors are not only the drivers for investment for renewables but, historically, we are the largest owners of investment in coal, oil and gas. For us, there is an inescapable logic about the Carbon Tracker, the basic analysis about the possibility of stranded assets, particularly in the light of the possibility of major policy change. Therefore, in terms of future investments, there is a preference for low-carbon solutions. There is much greater knowledge about exposure to carbon, and we try to drive that through our investment analysis and into our portfolio. For example, we provided the seed money for a joint fund with the UK Government to set up a renewables fund. It is not particularly big but it is there. We have set up with Legal & General a carbon-tilted index. We take the FTSE All-Share Index but we then introduce a tilt factor into that to reduce the carbon exposure. Basically that is tracking or doing very slightly better than the normal index but with 18% less carbon.

A lot of investors, including ourselves, are now aware of the situation. We are not taking drastic measures, but we feel that there is a transition taking place. I think that some of the companies in which we invest are also going through a transition. For instance, in the mineral extractive industries where there is evidence-and that was referred to earlier on-that some of the larger companies are now reducing their exposure to coal, or actually quite quietly selling off some of their coal assets, because I think they themselves feel vulnerable. So there are mechanisms taking place and there are things happening.

It is becoming integrated into the investment analysis, and we are trying to integrate that into the portfolio. But the truth of the matter is we are all at the early stages of this and we are trying to come to terms with what is a really big issue. It is one that is going to be a long-term issue because trapped assets for carbon is only part of the challenge that we face with climate change because water, energy, food, agriculture, property, everything is actually affected. We have already taken very rigorous measures, for example, to protect our assets and property against the risk of flood and drought and all the rest of it. There are very significant areas and the possibility of stranded assets is one that we have to address, but I think we should do it within a holistic approach to climate change.

David Russell: From our perspective, I would like to break the climate change issue into two parts that affect investors. First, there are the policy risks, the emissions trading cost. If you are an investor in utilities or cement companies in Europe, you have to understand how climate change policy is impacting your assets because the emissions trading schemes currently gives carbon a very low price in those sectors, but there is an emissions trading scheme and you have to understand how that impacts your investments and look at how policy is developing.

The other bit of the climate change issue is the changing climate. That is far more difficult for investors to deal with mainly because it is a timeframe thing. This is an issue that could be happening now or it could be happening in 15, 20, 40 years’ time. How do you, as an investor in a retail company, look at the climate change impacts on that retail company? There are ways of doing it. Three or four years ago USS joined up with a number of other investors in the UK to look at how some of the sectors that we were investing in were looking at the need to adapt to climate change. From that analysis, basically, the water utilities were doing a reasonable job there, but other sectors we looked at were not really looking at it. So that issue of how a changing climate is taken into account by the companies, and other assets in which we invest, I believe is some way behind the issue of policy risk and cost of carbon, which can be more built into investment decision-making.

Q52 Simon Wright: HSBC believes that lower fuel prices, driven by a fall in demand, is a greater risk to the value of oil and gas companies than investment in stranded assets. Would you agree with that?

Michael Liebreich: I am not sure you can distinguish between the two, in the sense that if you look at the new sources of oil as being Brazilian subsalt, if you look at the Arctic, if you look at tar sands, they have very high costs of production. Whether your price drops because you can do Brazilian ethanol competitive at $45 and $50 per barrel, whether it is because electric vehicles become cheap enough, whether it is because a tax is put on, the point is there is a risk there to the investors for whatever reason. Perhaps for the purposes of today the idea is to focus in on the climate risk, and the risk of action on climate, as driving some of this. I think those risks are there and they are very real, whether you can ascribe them to that single cause or not.

Donald MacDonald: Might I just add a point to that, because I think one of the difficulties that pension funds have, particularly mature schemes, is the vast majority of our members are drawing a pension and we have a relatively small number of contributors nowadays. It is a big gamble to take for a pension fund, with major responsibilities to beneficiaries, to put the shot on a bet on the price of oil because, as we have seen, the price of oil can be quite volatile. Oil and gas prices have separated relatively recently because of the fracking technology and, of course, Lord Browne was quoted not very long ago as saying that, having been in the oil industry all of his life, trying to anticipate oil prices, he was never terribly successful at it. I think he is in a much better position than a pension fund would be to make that sort of analysis and bet.

From the point of view of a pension fund, the issue of fiduciary duty, and how we respond to that, is very critical. A rapid response, by getting out of oil for example, could mean severe loss of revenue over what could turn out to be quite a sustained period of time. On the other hand, a "do nothing" scenario could also expose risk in the other direction. I think each pension fund will probably have to try to find a balance of risk, share that information and learn from each other, and try to make an informed judgment as to the best way for them to proceed. Is that helpful?

Q53 Simon Wright: Yes. There is often talk about political risks associated with uncertainty over energy policy and how this influences investment in renewable energy projects specifically. I guess there is always an element of political risk with most things, but just how clear cut is that risk in your view, specifically over renewable energy investments? How does that political risk compare with other types of energy investments?

David Russell: It is an absolutely clear risk, and the best example that we have is what happened with Spanish photovoltaic investment about two years ago. In the last few years of the last decade the Spanish Government put in place some very generous tariffs to encourage significant investment in solar energy in Spain and, not surprisingly, investors took advantage of that and built and developed a large number of PV sites. Unfortunately, post 2008, that became unaffordable for Spain, and what Spain decided to do was to retrospectively change its tariff, which is almost unheard of. It really does not happen very often that you make an investment decision, based on what you are told you will earn from that investment, and then they say, "We are going to change the rules". That does not happen very often. The knock-on implications for that is not only for the investors who were invested in the Spanish PV sector, where we did lose money, but it raises the risk level for investment in renewable energies across Europe, if not globally, because investors now consider the additional risk that someone else might change their tariffs retrospectively has gone up. If it can happen in a developed market, like Spain, it can happen almost anywhere.

Michael Liebreich: Let me add to that. That is exactly right. I have just come back from Asia and I talked to some of the most significant infrastructure investors in the world, organisations that are always in the top three or five debt providers to infrastructure of all sorts. One of them said to me, "We are not doing any deals in southern Europe, none, not in any sector". The reason is they say, "Country risk we can deal with, but retroactive changes we can’t". Very obviously there is a contagion, first there was Spain, then there was Greece, then there was Bulgaria, now Romania; even Belgium has made retroactive changes that affect the returns. We are not talking about a company making a technology and the market might be there and the market might not. We are talking about projects where you do the spreadsheet, you think you have managed all the risks and then, retroactively, somebody comes along and says, "That line there, you know you thought you were going to get this revenue, you are just not". It is equivalent to a sovereign default. So it is very real.

I would point out a couple of other things. With renewable energy in many cases most of the cost is upfront, very little maintenance and no fuel cost. It is very, very sensitive to cost of capital. If you look at gas, it is cheap to build but you have to buy the gas for a long period. Clean energy, renewable energy, is very sensitive to cost of capital. So messing with the cost of capital, by doing things that make people demand extra risk premiums, is circular because then you drive up the cost. Of course, if you drive up the cost, it then becomes more politically difficult to maintain whatever support you have in place. There is a sort of circularity that goes on there.

Also, I would say, "Look at the contagion". Originally it was Spanish solar, but the words that one hears are "Spain" and then, therefore, all of Europe. Then you hear "solar" and so it spreads to other sectors across clean energy. It is a behaviour that we have not seen in other heavily regulated sectors. It does not happen in telecoms. It does not happen in aviation. This is no different from confiscation of landing slots or whatever. You just don’t see it without proper consultation, without signalling of intent and so on. I would say right now it is one of the key issues, certainly, in the renewable energy sector but really in the energy sector worldwide.

Q54 Peter Aldous: Looking at how Britain is viewed in this respect-and I will give you two examples: the retrospective windfall tax on oil and gas exploration in North Sea in the 2011 Budget; and then there was the fairly sudden reduction of FITs in the solar sector-I welcome your views on how those were viewed in the marketplace.

Michael Liebreich: I am fresh from this experience of meeting probably 200 investors in about seven or eight countries in the last month. I think Britain is seen as a good location to invest. We don’t generally engage in retroactive confiscations. Occasionally we have done other windfall taxes in oil and gas-going back to the 1980s, I believe-but it is not regarded as the rule. I don’t think that has really spooked many investors.

The solar one was more of a worry for clean-energy investors, partly also because the solar industry’s response to sue the Government was probably the best possible way of signalling that it could not possibly survive without elevated levels of Government support, which ultimately turned out not to be the case. So I think the solar industry bears equal blame in that situation, but it was a damaging situation.

Donald MacDonald: I totally agree with what Michael is saying there. The UK does have a good track record. From the pension fund point of view, probably, we would like closer discussions with Government on infrastructure. I believe there may be some sort of announcement coming out shortly, so we will see where that takes us. But, yes, the UK is generally seen as a stable country in that respect.

New technologies do need some form of stimulation. There has to be a degree of certainty. Of course, the argument the other way could be that too much subsidy for too long stifles innovation. The trick, from the policymakers’ point of view, is to try to get the stimulation and provide the incentivisation but do it in a way that does encourage innovation and improvement. I think the investors would be willing to work within that dialogue.

David Russell: To add to that, the difference between what happened in Spain and what happened with the FITs in the UK-the short notice was one of the concerns the sector had-was that it was not retroactive. It was for future developments. It wasn’t for those people who already had PV on their roofs. So that was a significant difference between the two markets.

Peter Aldous: Just for the avoidance of doubt-Madam Chair, I wasn’t here at the beginning of the session-I should have started off by declaring that I do have interests in farms where renewable energy projects are being pursued.

Q55 Chair: That is absolutely fine. Can I just go back to what you were just saying, Mr MacDonald, about the infrastructure plans that are being announced? You said it would be helpful to have some kind of dialogue on that. What would be the mechanism for doing that?

Donald MacDonald: There are a number of mechanisms coming into being. The pension funds were involved in discussion with Government in setting up the Pensions Infrastructure Platform, which, from memory, I think is designed to generate something like £2 billion to £3 billion of investment. Once it is all in place, and they appoint a manager and so on, that should provide a helpful opportunity for the small to medium pension funds to become involved, and perhaps the larger ones as well. The larger pension funds are already in the space working through a variety of avenues, partly through private equity, partly through direct investment and so on.

If and when there is a new tranche of infrastructure projects coming out, I think it would be very helpful for the Government to try to directly engage-whatever they can do-with all of the institutional investment players. That obviously includes the pension funds but also the investment banks, the private equity and the venture capital sectors, because all have roles to play but they might not be the same role. There is an interesting discussion going on within the investor community about risk capacity: who takes on the technology risk; who takes the build risk; who then does the long-term heavyweight, the more boring stuff, providing the capital for interconnectors, for example, which is hugely capital intensive, not terribly exciting. You are looking towards a fairly long long-term approach, which may not be of interest to the private equity or the venture capital people. So there is an issue of churn that comes into play, and I think the more dialogue the industry can have with Government-and that is the various parts of Government, including the Treasury, I think-then the better.

Q56 Dr Whitehead: Looking specifically at investments, Mr Russell, I think your fund has by far the largest single holding in Royal Dutch Shell and your fourth largest holding is in BP. Is that anything you have given any thought to over the period? How do you see those holdings, in the light of what we have been discussing relating to your fund investors?

David Russell: As a UK pension fund, we are heavily exposed to the UK market, which is the FTSE. If you look at the structure of our holdings, the top 10 will probably be the top 10 that are in the FTSE index. I am not here to defend Shell or BP or HSBC, which is our largest holding, or Nestlé, on anything. If the companies come in there will be an interesting discussion there, I suspect. From a climate change perspective, Shell is a company that is exposed to oil sands on one side and gas development on the other side. It has a big bio-fuels business buried within itself. It is also one of the few oil companies that is involved in carbon capture and storage in Alberta, associated with its oil sands developments there. So, yes, it is an investment we have, but we invest in basically everything in the UK as a holder of the UK index.

Q57 Dr Whitehead: From your point of view, as a fund manager, do you see how or whether those sorts of considerations are likely to change your view of the relative nature of holdings within your fund?

David Russell: What we do with Shell and BP, and other oil companies and other companies in different sectors-for example, the mining sector-is actively to engage with them on how they are responding to the climate change risks that they face, whether that is the cost of carbon or the physical impacts that our changing climate could have.

As a UK pension fund, we don’t have an ethical screening policy. As I have said already, we hold everything in the UK market but we do actively engage where we see risks or opportunities for these companies. Shell would be an example of that where we do talk to management on a regular basis about how they are dealing with these issues; how they are engaging with policymakers around these issues. So we do actively talk to companies around climate change and other related issues.

Q58 Dr Whitehead: Mr MacDonald, on the other hand, among its highest investments, your fund has bonds and Treasury bonds and you don’t appear to have much in the way of investment in oil and energy companies. Is that correct?

Donald MacDonald: That has become the case. We have changed that over a period of years, not because of the carbon issue but simply because we are now a mature scheme and, with regulatory compliance, we have to have a very conservative approach to investment, particularly with over half of our members already being pensioners. A huge slice of our assets nowadays is in bonds and in other assets; we have a 5% allocation for infrastructure for example; we have 11% allocation for property. So we don’t have significant holdings in listed equities as we used to have and that has been reduced, but it is more for fiduciary reasons and prudence rather than because of the carbon issue. If we were a younger and expanding pension scheme, as is USS, our capacity for risk would be much higher and, therefore, our equity exposure would be higher.

David Russell: Just to complete that, we are still a growing fund. An immature fund is what we would be called. So we do have a higher equity rating than mature funds like BTPS. Also, because we are a direct investor, you can see what we are investing in, because we publicise that on our website. That is one of the reasons we come up top of the list of shareholders in companies, because we do directly invest and our name is against the shareholding whereas, for many pension funds and other investors, they are hidden behind a fund manager in an account where you don’t get a separate name.

Q59 Dr Whitehead: In general, funds do hold diversified portfolios, offset higher risk against lower risk. In your view, what might that look like in terms of some of these considerations we are discussing; in terms of the sorts of ways that one might hold funds in the future?

David Russell: Currently our holding in the oil and gas sector, globally, is about 7.5% of our assets. For mining it is about 3%. For utilities it is about 0.5%. So that gives a spread of some of the more exposed sectors. We have something under 1% in renewable energy/clean tech, which is a relatively low percentage but actually, if you look at other pension funds, that is not a bad level of investment. That is in renewable energy funds, or lower carbon funds, which has more exposure to direct gas as well.

Going forward, something that pension funds in general are looking at is greater investment in infrastructure, and renewable infrastructure is just part of that. With BTPS and another organisation, we were bidding for the OFTOs, which is the connectors that connect offshore wind to the land. Basically, it is the network that provides electricity so people can use it. We are looking at direct investments in renewable energy in the UK. There has been a change in regulation within Europe. There is something called the unbundling regulations that basically stated that you could not own generation and the network because you could corner the market, so to speak. That was put in place a few years ago, mainly to stop utilities holding both distribution and generation. But it also impacted pension funds. So we could not invest in the OFTOs, which provide us with a very stable long-term return, and invest in generation. So we could not buy wind farms directly, and that is something we have looked at in the past and will look at in the future.

One of the issues in the UK is that the onshore wind farms tend to be very small. As a fund, we would prefer to buy existing assets rather than build new wind farms and build new infrastructure, because there are different levels of risk associated with that, whether it is planning or technology, or whatever. But it is something we will look at going forward.

Donald MacDonald: May I just add to that point? It is this business of the technology and build risk. Sometimes we have been asked, "Why don’t you own more wind farms?" "We do own wind farms." "But why don’t you own more? Why don’t you do start-ups?" The reason for that is partly-as we said earlier-we are not the right people to do that. It does need the venture capitalists to do that; the people who really know that sector. But the good thing is the churn of investment. Having churn does not necessarily mean it goes against long-term investment because, once that stuff is built, if the long-term pension funds then come in and take it over for 20 or 25 years, that then frees up the capital that the venture capitalists and the private equity people have at their disposal. They can then allocate that capital to new technologies, into new innovation. That is an example of how the capital markets can work very effectively.

I think we should realise there is a different capacity for risk and there are also different capacities for scale. The large pension schemes will tend to look for the very large and boring investments rather than small investments. Small investments are probably better for pooled vehicles where a whole number of different projects can be wrapped up by a single manager with perhaps a number of clients. Is that helpful?

Dr Whitehead: Yes.

Q60 Peter Aldous: In the first instance I will address this to Mr MacDonald. Could you tell us a bit more about the Institutional Investors Group on Climate Change that you chair?

Donald MacDonald: Yes, certainly. I am very honoured to chair it. We are a European-based organisation, originally formed by investors in the UK. My own scheme has only been a member of it for a handful of years. We weren’t among the founder members, which I think included my colleague from USS. We have over 80 members. In total, their investments are worth something of the order of €7.5 trillion. I would guess that only a very small part of that would be in renewable and clean tech at this stage. What that reflects is the fact that a lot of very heavyweight investors recognise climate change as a risk to their long-term portfolios. There is a recognition of the need to understand the risks, share best practice and see how well we can then adjust our portfolios and what investment measures we can take to either adapt or to mitigate those risks.

Q61 Peter Aldous: Can you point to a specific impact or win the group has had?

Donald MacDonald: Yes. Certainly, over the last two years, a lot of our work has been in the public policy space, trying to identify the obstacles to institutional investors investing in clean tech or in low-carbon technologies. Because so much of our work is European-based, and so much of the regulatory environment is set in Europe, the two big issues that we had were Solvency II-as applied to pension funds and insurance companies-but also the unbundling regulations, which were designed to improve competition. But of course, as usual, the law of unintended consequences kicks in. We have spent a long time discussing with the Commission, with the member state Governments and with other interested parties.

For instance on Solvency II, as you know, there was a huge coalition of member state Governments, employer organisations, trade unions and investor groups, such as ourselves, and so on. Certainly we have pushed it back, at least for a temporary period, pointing out that the rigorous application of Solvency II, in the way that the Commission was describing, would effectively restrict our ability to invest in infrastructure, and all of the other things that are required, and will be a serious inhibitor factor. The energy unbundling regulations were not terribly well understood to begin with and, again, we were involved in building up a coalition-involving even people at the OECD-who referred to both Solvency II and the unbundling regulations in their documents about obstacles to investments.

I think on both of those counts, on Solvency II, at least we have been able to push that back for the time being. Of course there is a new Commission going to come in next year. We don’t know yet what the end game is going to be. The Energy Commissioner has issued a statement on Solvency II, saying that the unbundling regulations should not necessarily inhibit investment in both generation and in infrastructure. Our concern now is, well, that is fine but when those opportunities for investment come up, once the process of due diligence has been gone through, the assembling of partners and actually putting in a bid, sometimes that bid can be narrowed down to a two to three week period, as it has done in some of the bids so far. In that situation, we need to be able to have that information turned round very quickly at Commission level. So we made those points to Philip Lowe at DG Energy, and I think that there is a willingness there. That demonstrates the value of investors working together because the public policy areas are terribly important for us, because those obstacles need to be addressed and we need to look at incentivisation; we need to look at clear policy signals; we need to look at signals to the market. All of those areas are important for us and we have been very active and, I think, successful in that area.

Q62 Zac Goldsmith: Just for Michael first. You were talking about mispricing earlier in your introduction. What do you think will cause that mispricing to become obvious to the market and for the adjustment to happen? In your view, is it likely to result from political acts and decisions, or from emergence in technology or a combination of the two? What will trigger that moment do you think?

Michael Liebreich: It is very difficult. First of all, this is really complicated stuff. Energy is hard. It is 10% of the world’s economy, but it is also very dynamic. You have long asset lives; you have heavy regulation; you have new technology. I think that the mispricing is partly just human weakness. It is impossible, I now have 214 people. If I could double my staff, we still would not have perfect knowledge of all the costs, prices, policy interventions, technologies and so on. I think what you have is the right model. It is just an eco-system that is changing from a prairie to a rain forest and, at some point, individual people and then groups of people will realise that the future does not look like the past, to use the words of one of the panellists.

People put too much faith in a global deal, because that would clearly send a big signal. My own view is that that will follow many, many different micro economic changes, cost reductions in all sorts of technologies and, also-I don’t want to belittle them-lots of individual interventions, as we have just heard from my co-witness here. Those will build up to the point where people have "Aha" moments and think, "Hang on a second, why do I have only 0.5% in this stuff and 7% in the other?" and they will rebalance.

Q63 Zac Goldsmith: Do you think there is anything specific that the Government can and should do to help address that risk and perhaps ensure that, when it happens, the adjustment is not profound but more manageable?

Michael Liebreich: The answer is, yes, I think there probably are. Again, on the earlier panel there was some conversation about disclosure. I am not sure if the first thing to do is disclosure or the next thing on my list, which would be stress tests. There are believable scenarios where you could see a rapid adjustment. Whether it is an oil price drop, whether it is a bad hurricane season, leading to the Americans moving more quickly on policy, there are scenarios where you can see quite a rapid adjustment. I would certainly suggest stress tests to look at: does that mean that people start breaching covenants? Having to engage in fire sales? What does it do? Other contagion issues? Can one rebalance portfolios? One should at least be looking at that. So I think disclosure and stress tests would be the first thing.

In a sense, you have reserve ratios already to protect macro stability. Whether you want to move to reserve ratios of, "You are not allowed to have more than this amount of carbon or fossil fuel" that is really dangerous stuff. It may be that it is necessary, but I think first would be the stress test and disclosure and really understanding the dynamic of the system much better.

Q64 Zac Goldsmith: Before I come to the other two panellists, there have been quite a lot of calls recently for the Financial Policy Committee of the Bank of England to take a more active interest in carbon risk. Is that something you support?

Michael Liebreich: I think they should be the ones doing or managing those stress tests because, if this issue leads to a disorderly rebalancing of portfolios and potentially contagion, in terms of the valuations of assets, that absolutely is their business. It is always good to ensure that the last crash does not happen again. But I would like to think that there is at least as much thought going into scenarios of potential future instabilities, and I do see this as one of them.

Q65 Zac Goldsmith: Can I come to the other two and actually go back to the first question. For both of you, what would be the most useful practical thing the Government could do, in order to make it easier for you to shift your focus more towards low-carbon investments and away from some of the investments we were hearing about earlier?

Donald MacDonald: With respect to the Select Committee, I think the greatest contribution that Government can make is to try to depoliticise and make the whole issue of climate change less partisan because I think, to a certain extent, there is a public policy issue in there and that is quite worrying.

Q66 Zac Goldsmith: Do you think things have become more politicised on these issues?

Donald MacDonald: For example, there is a tendency for sections of the press to play up the politics of climate change, in a way that I don’t think is justifiable. But that is my personal opinion. From the point of view of the investor, I think that is a worry because it does create policy uncertainty. Nobody wants guarantees, but they want strong policy signals. What we want is a much clearer longer-term approach from Government, which recognises the fact that there are different layers of capital available for different periods of time. For the very big heavyweight investors, long-term investors, security of policy I think is really important.

Joan Walley: Can I just bring in Peter Aldous on that point?

Q67 Peter Aldous: Mr MacDonald made a comment there, which I think had all of use shaking our heads quite vigorously in agreement, which was depoliticising climate change. I would welcome your views about how we might go about that.

Chair: We are coming to the end of the session.

Donald MacDonald: I wish I knew. We would be very happy to work with you to assist in that matter. Policymakers have to sit down and say, "What is the scientific opinion?" We are not climate scientists. We have to take the best informed opinion on energy, on climate science, in the same way as we have to take the best informed opinion on transport, on agriculture, on food policy and so on. I think there seems to be something different about the way that climate science is approached in the political arena. It is becoming a bit of a football, and I think it is to the detriment of the long-term interests of citizens. From a pension fund point of view, it is to the detriment of the long-term interests of our members. From the political point of view, from your point of view, you would probably benefit as well from a more harmonious approach to the issue. So anything we can do, we would happily help.

Q68 Chair: There was an all-party agreement before the Climate Change Act was introduced.

Donald MacDonald: Yes, indeed.

Q69 Zac Goldsmith: Before I move on, do you want to add anything?

David Russell: Yes. There is no doubt that over recent years the UK has been one of the leading countries in trying to drive global policy to address climate change, but in the last year we have seen DECC arguing with itself about renewable energy and land-based wind farms; we have seen a section of our MEPs voting against the Government’s position on back-loading in Europe. So the signals being sent to the market are that policy on climate change is all over the place at the moment within the UK. That does not strengthen our confidence in investing in renewable energy or in energy in general in the UK, because of the way that carbon is all through that system. One of the strong things that the IIGCC, as a group of investors, have been pushing for is supporting back-loading and supporting a strong carbon price. That sends a signal to the market, for the foreseeable future, that this is the direction of travel and we don’t keep jumping around in that direction of travel because that again reduces confidence.

Q70 Zac Goldsmith: If I could ask for quick responses because I do want to come back to you on that point. Do you believe in greater reporting by the oil companies on the potential carbon emissions in their reserves, and would that have any impact on your investment? Briefly.

Donald MacDonald: We actively ask our managers to engage with the oil companies on all carbon emissions and to go for maximum disclosure. The more information that is available on that will ultimately affect the pricing mechanisms. The market will have to take those issues into account. One of the problems in all of this is that, in terms of environmental concerns, those costs have been externalised for a century and it is going to be difficult to recover that. I think we need to go there and we are actively working in that direction.

David Russell: Just looking at the data available about the oil companies in particular, if you work out what the reserves are, Carbon Tracker has calculated what their carbon exposure is-it is possible. The next step then is to give that meaning and that is where the policy comes in. It is just numbers without having a price on it.

Q71 Zac Goldsmith: Can I come to you in one second, do you mind? Just a last question relating particularly to Donald MacDonald. In terms of influencing the direction of your investments, and the nature of the investments, would active pressure by your pension fund members be the thing that would have the biggest immediate impact, do you think?

Donald MacDonald: Pension fund members becoming involved in that, undoubtedly, would change the nature of the equation. In my own scheme we have not had a lot of pressure from our members. Obviously some members do have a point of view on this. Other schemes-and I think it is probably because of the nature of the schemes-I would imagine that the University Superannuation Scheme probably has a more active layer of people who are concerned about that. But we have not had that pressure from our members. We are doing it and we are reporting on it to our members.

Q72 Zac Goldsmith: How would that balance then match up with your fiduciary duties? Do you think they would get in the way of the shifting nature of the investments?

Donald MacDonald: Active involvement of the members in the area would impel pension funds to actively consider the whole issue much more vigorously than they have done in the past. I think that would be true for every single pension fund. At the moment, I don’t think pension funds are on the back heel on any of this, but I think it is quite possible that in the future there will be more activism oriented towards pension fund members.

Q73 Zac Goldsmith: Is that already the case with you?

David Russell: There is a group called ShareAction, which is a campaign organisation that runs various campaigns to encourage pension funds to look at these sorts of issues. They recently ran a campaign on the stranded assets issue. I checked yesterday, we have had 80 emails around this issue. We have 300,000-ish active, deferred and other members, so it is a very small proportion that is involved in this particular campaign, fewer than we have had in other campaigns. Before ShareAction it was called FairPensions and before Fair Pensions it was called Ethics for USS. So we do have a relatively active membership around these issues.

Q74 Zac Goldsmith: Just as a last question, unless anyone else wants to come in, and I only want to comment on something before you or even perhaps after you. On this issue of political uncertainty, given what you know about the growth in the green sector, given what you know about the success story of the last few years, why do you think that we don’t have sufficient commitment across all levels, all parties, in terms of Shadow Ministers, Treasury Ministers and so on? Just purely from the point of view of economic growth and development and opportunities and jobs, why do you think that message has not got across? How is it possible this is still as political as it is?

Michael Liebreich: That is a very big question.

Zac Goldsmith: I know.

Michael Liebreich: It involves sociology, media studies and all sorts. But, broadly, I would say that the reason is that those who feel the problem most urgently tend to come from-how shall I put it?-a more interventionist, statist or a more collectivist tradition. I am trying to do this in a very neutral way. The Left feels the problem very urgently, but the solutions that it proposes are just so difficult for the Right to accept. There are very few people-you are one example-who come from the Right who also think this is a really, really big problem and are able to think of solutions that are not on that single line spectrum.

So what I see is people on the right of the political divide-and this is whether it is in the US, the UK, Germany, Japan-tend to so dislike the interventions that are being suggested, that they go back up the food chain and say, "This can’t possibly be a problem or, if it is a problem, then it is much less of a problem than the solutions that are being foisted on us". Tactically it has become a football, for all sorts of reasons, on both sides of the Atlantic, but I think that both sides of the polarisation have been equally at fault in that. What the solution is, is perhaps for a separate session.

Zac Goldsmith: You wanted to add something else.

Michael Liebreich: I want to come back in on the question of disclosure. It also relates back to your point about Shell. There are rules, and in oil companies it is not difficult to find out what their carbon exposure is because it is directly related to their reserves. But what the most responsible oil companies are doing-and Shell is a good example, so is BP-is using a shadow price for carbon in their investment decisions. I believe it is $40 per tonne in the case of both of those. In a sense, that is equivalent to a scenario saying, "Well, if there was a $40 price, would our investment be resilient?" because, if we can only extract one-third of the reserves, then the answer to, "Who is going to get to do that?" is the ones who have used a shadow price and only invested in things that are profitable in that environment. One, not many oil companies do that. Two, lots of other companies that might be dependent on fossil fuel, whether it is utilities or the car industry and so on, have not gone through that exercise. If you look at companies, the Glencores or the Billitons and so on, have they done that exercise? Have they shared the results with their owners? It is not a question of suddenly there will be a $40 carbon price; it is a question of how resilient is our system?

I can’t let the session finish without mentioning the ratings agencies. The question is: are they looking at the micro and macro resilience as well? Are they saying, "Well, what would happen in a scenario with a carbon price and so on?" They have a privileged position in the financial system, where a lot of municipalities, pension funds, life insurers, the only risk assessment they have to do is to make sure that there is a rating by a proper ratings agency. So they have a very important position, and they are not running this sort of stability scenario, and this is possibly one place where-and I don’t know how the mechanics would work-there should be more scrutiny of the methodologies ratings agencies are using on this.

Zac Goldsmith: Thank you.

Chair: I sense that we have reached the end. We certainly have time-wise and we have gone into extra time. Between the three of you, you have raised a huge number of really far reaching issues, which sooner or later will have to be addressed and tackled. So can I thank all of you for being so generous with your time with your evidence this afternoon? I don’t know how long our inquiry will go on, because so many issues keep on being raised, but thank you very much indeed.

Prepared 2nd July 2013