Implied Valuation of Environmental Externalities

Abstract

The Clean Development Mechanism (CDM), one of the flexibility mechanisms launched under the Kyoto Protocol, is intended to internalize environmental externalities and to help developing countries achieve their developmental objectives employing cleaner, albeit possibly more expensive, technologies. Project proponents are required to establish the “additionality” of a project, that is, demonstrate that the project overcomes significant technological, financial, and social barriers in its wake, and, therefore, additional cash flows from trading the “carbon credits” would be required to sustain operations. The registration process is clearly defined, and rather elaborate, involving, among other things, approval by the designated national authority (“host country approval”) and culminating in the approval and issue of emission reduction certificates (CER) by the CDM-Executive Board (EB).

This chapter estimates the environmental externality embedded in the market valuation of a portfolio of publicly traded Indian firms whose project proposals had been approved by the national authority in India but had eventually been rejected by the CDM-EB. It is observed that approval by the host country generally triggers a positive response from the market; investors factor in competitive returns on capital employed, owing to the CDM-related accruals. However, responses on rejection tend to be uncharacteristic and inconsistent. A few suggestions are presented to try and explain such anomalous behavior.

Since the house is on fire let us warm ourselves.

- Italian Proverb

Appendix

Implied Valuation of Environmental Externalities

Background

Communicating the potential risks from, and the consequences of, a warming planet and the changing climate is a major challenge in itself. Perceptions relating to climate risks are generally shaped by discerning the erratic patterns and the rapidly changing frequencies of rainfall and drought sequences and by painting a picture of the local impacts of such events over ever shortening spans of time. Even as large changes in weather-related phenomena, rainfall patterns, and crop and fishery yields are observed in one’s own sphere, the psychological resistance to accepting the existence of such threats, and the failure to summon the energies to face up to the ensuing costs and potential hardships, could come in the way of remedial action or required adaptation. Drawing up risk scenarios, therefore, is subject to society’s ability to manage realities and to align expectations to observed events. Social practices thus need to evolve and provide opportunity for incremental learning from the synthesis of experiences (Metzner-Szigeth 2009). Such learning or otherwise could be wrought by appropriately structured reports, suitable focus, and accurate reporting in the media and transparent discussions within other such forums (Pasquare and Oppizzi 2012). The inadequate understanding and appreciation of the underlying complexity is compounded by the necessity to make personal and business decisions under tremendous uncertainty relating to the immediate future and to the medium term (Patt and Dessai 2005). Above all, such risks and the probable losses therefrom need to be quantified and estimated in money terms to enable a meaningful discussion on suitable remedial or compensatory action in society’s attempts to establish intragenerational and intergenerational equity and to strike the best balance between mitigation and adaptation to the seemingly inevitable.

Reinsurance as an Indicator

• Insurance is the business of spreading the losses of a few over the many. Reinsurance refers to obtaining partial or complete risk coverage from another insurer for risks that have already been assumed. While several direct and indirect approaches to valuing environmental externalities have been adopted, the approach described herein also provides an insight into the evolution of threat perceptions and of the economic agents involved.

• Share price movements have often been studied, and the response viewed as a vindication or otherwise of certain events presumed to cause such movements. Though correlation as evidence by itself, especially when measured against a constructed counterfactual scenario, has its limitations, consistencies observed within such analyses provide for a general direction of movement in support or otherwise of the hypothesis being tested.

• The implied valuation of the perceived loss due to a deteriorating global environment is measured as the cumulative abnormal returns on companies forming part of the reinsurance industry over 3 trading days subsequent to an event in question.

• Attempts have been made to eliminate the speculation that these movements could either have been triggered by other company-specific or macroeconomic shocks or by both. First, the companies forming the reinsurance industry have been considered as a group with a view to averaging out company-specific shocks. Likewise, the counterfactual scenario is drawn up for each company’s stock price movement and thereby for the industry as a whole, with a 10-day moving average.

• The abnormal returns are then computed by deducting the returns on the S&P 500 – employed as a proxy for market returns – and on the counterfactual scenario slated to represent the business as usual, thereby eliminating the impact of systematic as well as unsystematic shocks.

The event that is slated to trigger the threat perception, as considered herein, is the release of the assessment reports (AR) by the Intergovernmental Panel on Climate Change (IPCC). The final reports have respectively been adopted by the panel in the years 1990 (first AR), 1995 (second AR), 2001 (third AR), and 2007 (AR 4). In addition to the final reports, the IPCC also releases reports by various working groups (WG) a few months prior, with these WG reports eventually forming part of the synthesis (final) reports. The report by WG2 provides an assessment of the impacts of, adaptation, and vulnerability to (and consequently losses from) climate change. The report addresses future impacts of climate change on sectors and geographic regions, the potential for adaption and the implications for overall sustainability, and the interrelationships between adaptation and mitigation, key vulnerabilities, and risks. The reports are produced through an open, peer-reviewed process and incorporate extensive research findings on each of the areas. It is presumed that the WG report (especially WGII) would appeal to researchers, climatologists, and scientists and the final/synthesis report to a wider audience, including among others political leaders and policy makers.

Data Analysis and Findings

Bloomberg, reputed providers of global business and financial data and information, has listed a total of 117 reinsurance companies from across the world⁸ – including an exhaustive listing of several companies traded in different exchanges. Based on the availability of data and convenience of access and relevance, the list is pruned down to 17 US listed companies hereinafter collectively referred to as the reinsurance industry for the purpose of this analysis.

The abnormal returns earned by the reinsurance industry over the trading days immediately prior to (“t  −  9”) and immediately after (“t  +  9”) the release of each of the final reports are presented in Table A.1 and Figure A.1. Likewise, the abnormal returns earned by the reinsurance industry over the trading days immediately prior to (“t  −  7”) and immediately after (“t  +  7”) the release of each of the working group II reports are presented in Table A.2 and Figure A.2.

Table A.1 Abnormal returns earned by the reinsurance industry for the period, “t  −  9” to “t  +  9”, “t” being the date of adoption of the IPCC final reports

The annualized cumulative abnormal returns for the period, “t” to “t  +  3”, starting from the FAR, are, respectively, +6.63%, +0.21%, +109.14%, and −44.62%. These results point to no specific and consistent impact of the adoption of the final reports by the IPCC on the reinsurance industry which is ultimately required to bear all risks, including those relating to climate change. It is possible that the contents of the reports are available in the public domain and the “adoption” is a mere diplomatic formality, and hence the risks are already factored into the prices prevailing at the time of such adoption. It is also possible that the perceptions of the reliability of risk estimates contained in the reports vary by company, and hence potential volatility is cancelled out within the industry itself. The lack of direction could also be attributed to the small and dwindling sample sizes of listed reinsurance companies as one journeys back in time unto 1990 when only one listed entity is analyzed.

Figure A.1

Abnormal returns earned by the reinsurance industry for the period, “t−9” to “t  +  9”, “t” being the date of adoption of the IPCC final reports

Table A.2 Abnormal returns earned by the reinsurance industry for the period, “t−7” to “t  +  7”, “t” being the date of adoption of the IPCC working group II reports

The annualized cumulative abnormal returns for the period, “t” to “t  +  3”, starting with the WGII report corresponding to the FAR, through the release of the WGII report forming part of AR4, are, respectively, −1.08, −3.64, −17.16, and +12.14%. These results represent a certain trend, of increasing losses through the first three reports, and a positive cumulative abnormal return correlating with the fourth report. Needless to mention, the results need to be conditioned by the thin population of listed reinsurance companies during the early years of the IPCC reporting process. It is possible that the investor community and technical experts and advisors have been in conformity with the risk estimates contained in the reports while overestimating the very same risks in the run-up to the fourth. It is also possible that the increased scrutiny of the most recent report (AR4), and the widespread discussion of the technical and reporting errors that had crept in, have tended to weaken the correlation between the release of the report and the consequent reactions.

Table A.3 below provides the statistics relating to the number of peer-reviewed journal articles containing the text-string “first assessment report” et al. either in the title or within the abstract, coinciding with the release of respective reports. An additional time window of about a year is provided to accommodate articles that are authored and accepted for publication prior to the release of a subsequent report but actually appear in the public domain after such a release. The sample sizes are decided basing on the progressively diminishing numbers of articles carrying the search string and eventually being followed by 20 or more consecutive articles not containing the string. Clearly, the numbers of citations as a proportion of the sample size (except for FAR which is surveyed 100%) consistently range between 18 and 20%. Yet, the frequency of the appearance of the articles increases steeply following the release of AR4, confirming the intense scrutiny mentioned earlier.

The widespread coverage and the scrutiny, combined with the acknowledgment of technical, procedural, and structural flaws in the reports, could have contributed to a marginal decline in confidence, especially with respect to the final reports. Given the observed correlation, the investor community apparently reposes greater faith in the robustness of the technical reports with some degree of consistency, relative to the final reports.

Figure A.2

Abnormal returns earned by the reinsurance industry for the period, “t−7” to “t  +  7”, “t” being the date of adoption of the IPCC working group II reports

Table A.3 Citations of the respective IPCC reports in the titles and abstracts of peer-reviewed journal articles, broken down by publication horizons

While firm, and possibly far-reaching, conclusions may not be drawn from the foregoing analysis given the small population size and the limited number of events studied, the brief study provides one with a general direction and trend in terms of analyst reaction to pronouncements relating to environmental risks. The study itself could be expanded to include other such reports or declarations to add to the depth and breadth of the conclusions. Yet it is observed that stock analysts appear to believe that the tone, content, and focus of the IPCC reports have evolved over time as indicated in some of the extracts annexed hereto. While the earlier reports are fairly sober and provide for the uncertainties associated with data collection, projections, and impacts, the recent reports tend to be more firm, grave, and increasingly pessimistic. A considered reading of the texts could provide one with an indication of the probability of adverse events and the correlation of their projected severity until a certain inflection point beyond which the prophecy appears to be accompanied by diluted academic rigor and tends to appear increasingly authoritative and alarmist. There appears to be limited or no correlation between the loss in stock market valuation of the reinsurance industry with the degree of climate risk or the potential impact estimated by the latter reports. This might explain the limited consistency observed with responses to the WGII reports and the randomness embedded in the responses to the adoption of the final (synthesis reports).

References

Metzner – Szigeth A (2009) Contradictory approaches? On realism and constructivism in the social sciences research on risk, technology and the environment. Futures 41(3):156–170

Pasquare Fdderico A, Oppizzi P (2012) How do the media affect public perception of climate change and geohazards? An Italian case study. Glob Planet Change 90–91:152–157

Patt A, Dessai S (2005) Communicating uncertainty: lessons learned and suggestions for climate change assessment. C R Geosci 337(4):425–441

Excerpts from the IPCC Reports Attempting to Convey the Progressive Change in Tone

	WGII	Final report
Report no.	Technical summary of main findings	Observed changes in climate and their impacts
AR4 (2007)	Qualitative, internally consistent narratives of plausible future scenarios underpin quantitative projections of future change	11 years over 1995–2006 are among the 12 warmest years since 1850
	“Magnitudes of impact can now be estimated more systematically for a range of possible increases in global average temperature”	Global average sea level has risen by 1.8 mm/year since 1961 and by 3.1 mm/year from 1993 to 2003
	“Some large-scale climate events have the potential to cause very large impacts, especially after the 21st century”	“It is very likely that over the past 50 years: cold days, cold nights and frosts have become less frequent over most land areas, and hot days and hot nights have become more frequent. It is likely that: heat waves have become more frequent over most land areas, the frequency of heavy precipitation events has increased over most areas, and since 1975 the incidence of extreme high sea level has increased worldwide”
	“Impacts of climate change will vary regionally but, aggregated and discounted to the present, they are very likely to impose net annual costs which will increase over time as global temperatures increase” (emphasis added)
	http://ipcc.ch/publications_and_data/ar4/wg2/en/tssts-summary-of.html	http://ipcc.ch/publications_and_data/ar4/syr/en/spms1.html
	“Many millions more people are projected to be flooded every year due to sea-level rise by the 2080s. Those densely-populated and low-lying areas where adaptive capacity is relatively low, and which already face other challenges such as tropical storms or local coastal subsidence, are especially at risk. The numbers affected will be largest in the mega-deltas of Asia and Africa while small islands are especially vulnerable”	“Approximately 20–30% of plant and animal species assessed so far are likely to be at increased risk of extinction if increases in global average temperature exceed 1.5–2.5 °C (medium confidence)”
		“Increases in the frequency and severity of floods and droughts are projected to adversely affect sustainable development. Increased temperatures will further affect the physical, chemical and biological properties of freshwater lakes and rivers, with predominantly adverse impacts on many individual freshwater species, community composition and water quality. In coastal areas, sea level rise will exacerbate water resource constraints due to increased salinisation of ground water supplies”
	http://ipcc.ch/publications_and_data/ar4/wg2/en/spmsspm-c-4-coastal-systems.html	http://ipcc.ch/publications_and_data/ar4/syr/en/mains3-3-1.html
TAR (2001)	“Natural systems at risk include glaciers, coral reefs and atolls, mangroves, boreal and tropical forests, polar and alpine ecosystems, prairie wetlands, and remnant native grasslands. While some species may increase in abundance or range, climate change will increase existing risks of extinction of some more vulnerable species and loss of biodiversity. It is well-established6 that the geographical extent of the damage or loss, and the number of systems affected, will increase with the magnitude and rate of climate change”	“[The TAR] provides an assessment of the potential for achieving a broad range of levels of greenhouse gas concentrations in the atmosphere through mitigation and information about how adaptation can reduce vulnerability”
	“While there are uncertainties attached to estimates of such changes, some extreme events are projected to increase in frequency and/or severity during the 21st century due to changes in the mean and/or variability of climate, so it can be expected that the severity of their impacts will also increase in concert with global warming”	Preliminary indications suggest that some social and economic systems have been affected by recent increases in floods and droughts, with increases in economic losses for catastrophic weather events. However, because these systems are also affected by changes in socio-economic factors such as demographic shifts and land-use changes, quantifying the relative impact of climate change (either anthropogenic or natural) and socio-economic factors is difficult
	http://www.grida.no/publications/other/ipcc_tar/ (Summary for Policymakers)	http://www.grida.no/publications/other/ipcc_tar/
	“Among the large number of assessments of climate change impacts reviewed in the TAR, only a small fraction include comprehensive and quantitative estimates of adaptation options and their costs, benefits, and uncertainty characteristics”	Synthesis report for policy makers
	http://www.grida.no/publications/other/ipcc_tar/ (Technical summary)
SAR (1995)	“Unambiguous detection of climate-induced changes in most ecological and social systems will prove extremely difficult in the coming decades. This is because of the complexity of these systems, their many non-linear feedbacks, and their sensitivity to a large number of climatic and non-climatic factors, all of which are expected to continue to change simultaneously” (3.0, p 29)	“Global mean surface temperature has increased by between about 0.3 and 0.6°C since the late 19th century, a change that is unlikely to be entirely natural in origin. The balance of evidence, from changes in global mean surface air temperature and from changes in geographical, seasonal and vertical patterns of atmospheric temperature, suggests a discernible human influence on global climate. There are uncertainties in key factors, including the magnitude and patterns of long-term natural variability. Global sea level has risen by between 10 and 25 cm over the past 100 years and much of the rise may be related to the increase in global mean temperature” (#2.4, p 5)
	“Climate change clearly will increase the vulnerability of some coastal populations to flooding and erosional land loss. Estimates put about 46 million people per year currently at risk of flooding due to storm surges. This estimate results from multiplying the total number of people currently living in areas potentially affected by ocean flooding by the probability of flooding at these locations in any year, given the present protection levels and population density. In the absence of adaptation measures, a 50-cm sea-level rise would increase this number to about 92 million; a 1-m sea-level rise would raise it to 118 million. If one incorporates anticipated population growth, the estimates increase substantially. Some small island nations and other countries will confront greater vulnerability because their existing sea and coastal defense systems are less well-established. Countries with higher population densities would be more vulnerable. For these countries, sea-level rise could force internal or international migration of populations” (#3.4, p 34)	Warmer temperatures will lead to a more vigorous hydrological cycle; this translates into prospects for more severe droughts and/or floods in some places and less severe droughts and/or floods in other places. Several models indicate an increase in precipitation intensity, suggesting a possibility for more extreme rainfall events. Knowledge is currently insufficient to say whether there will be any changes in the occurrence or geographical distribution of severe storms, e.g., tropical cyclones (#2.11, p 6)
		(Emphasis added to highlight possible levels of ignorance and uncertainty)
FAR (1991)	“…there are several scientific uncertainties regarding the relationship between climate change and biological effects and between these effects and socioeconomic consequences”	Data and observations within the report are broken into the following categories: “certain,” computed “with confidence,” “predictions” based on current models, “uncertainties,” and “judgments”
	http://ipcc.ch/ipccreports/far/wg_II/ipcc_far_wg_II_spm.pdf p.1
	“Changes in the availability of food, fuel, medicine, construction materials and income are possible as these ecosystems are changed. Important fibre products could also be affected in some regions.” Ibid p. 3	“Measurements from ice cores going back 160,000 years show that the Earth’s temperature closely paralleled the amount of carbon dioxide and methane in the atmosphere. Although we do not know the details of cause and effect, calculations indicate that changes in these greenhouse gases were part, but not all, of the reasons for the large (5–7°C) global temperature swings between ice ages and interglacial periods”
	“Globally, the ice contained in glaciers and ice sheets is projected to decrease, with regional responses complicated by the effect of increased snowfall in some areas which could lead to accumulation of ice. Glacial recession will have significant implications for local and regional water resources, and thus impact on water availability and on hydroelectric power potential. Glacial recession and loss of ice from ice sheets will also contribute to sea-level rise” Ibid. p 4	http://ipcc.ch/ipccreports/1992%20IPCC%20Supplement/IPCC_1990_and_1992_Assessments/English/ipcc_90_92_assessments_far_overview.pdf # 1.0.5, p 53
		“Narrowing the gap between the industrialized and developing world would provide a basis for a full partnership of all nations in the world and would assist developing countries in dealing with the climate change issue” Ibid. # 3.1, p 57