Financial Markets at the Crossroads
Abby Joseph Cohen, Partner and Chief U.S. Investment Strategist, Goldman, Sachs & Co

John Mutter: Thank you very, very much. That was just wonderful. And there was no need to apologize for not being a scientist. Scientists can do just so much. Part of what the Earth Institute tries to do is combine the talents of scientists with those of economists, people in the business sector, and other parts of this common endeavor to define solutions to the problem we face, the feasibility of sustainable development.

Next we will have a panel that will address market forces as part of the solution to our impending problems of sustainable development. It will be led by a moderator. We will have three speakers prior to a break, two after. Remember that questions for this panel and others are to be collected outside in a question box and will be high graded and presented as part of the concluding panel at the end of the day today, led by John Rennie of Scientific American. This panel will be moderated by David Nissen. He is Professor in the Practice of International Public Affairs here at Columbia University where he directs the program in international energy management and policy at the Center for Energy, Marine Transportation and Public Policy at SIPA. For twelve years prior to joining the School of International and Public Affairs here he managed the Liquified National Gas and the Gas Strategic Consulting practice at Poten and Partners, Incorporated, a leading commercial and energy consulting firm here. He has held senior positions with Exxon Corporation's planning department and Chase Manhattan's corporate lending group. Nissen also served in the US Federal Energy Administration, the predecessor of the Department of Energy during the Carter administration where he directed the quantitative assessment of the Carter administration's national energy plan. He has held faculty positions at Rutgers University, and Rice University. He received his Bachelor of Science from Caltech, Masters in statistics, and Ph.D. in economics from the University of California at Berkeley. He is the ideal person to conduct the proceedings of the upcoming panel.

David Nissen: John, thank you for that wonderful introduction, and thank you for the opportunity to talk about my favorite subject, and what is the favorite subject in our energy policy program across the street, and that is for the most part if things are going to get done they're going to be done by business, by enterprise. And for them to get done…

…and with those ideas we have a collection of business, financial and academic leaders who can't be more competent in addressing the problem of tapping into market forces and the economy in the context of sustainable development.

Rather than read the questions in the program out what I want to suggest is you're going to hear about three ideas in this session, management, finance, and externalities. Management. The keynote speaker said eloquently what I was intending to say, and that is if you measure it and manage it you will do it. There is abundant evidence that in manufacturing, in the operations of buildings and enterprise that a focus on measuring materials in and out, a focus on understanding sustainability of investment is, among other things, a massively positive net present value investment of time and energy and money, and that there's a huge margin to be exploited in the context of the regular things we do and making them more efficient and more effective.

With respect to finance and institutions, energy is a big piece of the environmental impact and the development part of the sustainable development challenge we face. It's in the general case a highly capital intensive activity, and the capital that you invest often is devoted to specific markets in specific places. The IEA calls for sixteen trillion dollars of investment of the next twenty-five years in the energy systems of the world, half of which must be invested in developing economies. This is a rate of investment which is several times the current level. It is a rate of investment which can not be sustained by anything like aid and state-owned enterprises. Those stories are over. The funding must come from capital markets in international investment and domestic investment. The institutions that currently exist in these countries do not provide sufficiently bankable markets to sustain this investment, and an institutional transformation in business structures, market structures and transparent governance is required for sustainable development in the energy businesses, and the other businesses, to be implemented over the next twenty-five years.

We have two speakers who will speak to the financial aspects of developing these businesses and one speaker who will speak to the other half of the problem, and that is that amongst the two billion people in the world who do not have access to adequate energy a new kind of self-sustaining ?? and structures are necessary to provide energy for education, health and household practices at an efficient level. Professor Hart in particular will talk about that set of issues.

Finally with respect to externalities, I think that the principal discussions of how governments construct markets that internalize costs will probably occur for the most part in the discussion session, which we look forward to now.

Our first speak is Abby Joseph Cohen, who needs no introduction to those of us who've watched Louis Rukeyser for years. Abby Joseph Cohen is Partner and Chief US Investment Strategist at Goldman Sachs, serves on the firm's partnership committees, Investment Retirement committees, and on the board of Pine Street which is charged with management and leadership development. A long biography which you can read. Let me just note she is a member of the Council of Foreign Relations, hold degrees in economics from Cornell and George Washington University, and has received three honorary doctorates in engineering and humane letters. Her talk will address Financial Markets at the Crossroads. Abby Joseph Cohen.

Abby Joseph Cohen: Hi, good morning, everyone. I hope I can be heard well without speaking at the podium. Anyone having a problem at the back? Excellent.

I am absolutely delighted to be part of the discussions here today. I think this is a wonderful forum for conversation, and I'm happy to have the opportunity to give a presentation which you will see in a moment has the title of Capital Markets at the Crossroads. For some reason it says Financial Markets at the Crossroads over there, but it is Capital Markets at the Crossroads. And one of the things to keep in mind is I stole the title. Later in this panel discussion you will hear from Professor Stuart Hart, who has written a book that has captured the attention of many people in the business community called “Capitalism at the Crossroads,” and so I do think that there's a very nice point of intersection between the thoughts that he will be expressing later and the comments that I have for you right now.

Well what do I mean to Capital Markets at the Crossroads? There are four main themes for my discussion today. First, in the financial community for many years there has been an area of what we refer to as niche investing, that is a small segment of investing, which we've called SRI, socially responsible investing. And the fact that it has remained a niche rather than mainstream investing is very telling to me. What we have now, however, is a very significant increase in interest and momentum, and very importantly a new acronym, which is ESG, environment, social and governance issues are all now commanding dramatically more attention from investors, and this has gone from being a niche investment area to something that is becoming increasingly mainstream.

My second theme will relate to what investors need to worry about. Many people in the NGO community have expressed puzzlement about why investors just don't run out and do “the right thing,” meaning focusing in on the specific issues of interest. Let me point out to you that for investors, professional investors, who are responsible for other people's money their number one fiduciary responsibility is those other people. It is generated sufficient returns for those individuals, not necessarily following other metrics or other goals, unless the owners of that money tell them that that is what they need to do. I'll be spending more time on the details of that.

The third element behind my presentation relates to the idea that environmentally sensitive investing recognizes both the good and the bad, recognizes the risks, as was just described by John, but also talks about the opportunities. And if there is one change that we have noted over the last two to three years it has been this broadening of the approach that investors can now use. Not that long ago investors who considered themselves to be environmentally sensitive focused in on the investments they should be avoiding. And instead now we see investors are also looking very much towards the investments that they should be supporting, because of companies or other activities that are engaged in research and development or changes in processes that might help solve some of the problems.

And the fourth and final theme that I'll touch upon is the idea that sometimes things change. Maybe it's not driven by policy, maybe it's not driven by regulation, but we do see that sometimes things do change, and I will provide what I think are two very interesting examples from the area of energy supply and usage.

So let me go back to the first theme, and that is the new acronym. SRI has now become ESG. What you're looking at right here is a compilation of the money under management in strategies that are referred to as socially responsible. And while this is not an inconsiderable amount of money, I think you will notice that SRI mandates have flattened out. There really has not been any sort of notable growth in this overall category in the last five or six years. But I'd ask that you take a look at the following, which is a breakout of ESG, specifically the E. And these are data that are taken from the Investor Network on Climate Change data that were compiled by Ceres. In 2003 Ceres and the United Nations hosted a joint meeting in which investors who were interested in these issues came together and the investors in the room who signed a statement saying that environmental issues were important to them, their assets under control were 600 billion dollars. When the next meeting was held at the UN less than two years later that number had grown to 2.7 trillion dollars. And to put that in some perspective, that is about 15% of the total market capitalization of the US stock market. That is a considerable amount, an indication that we are going from a niche area for investment to something which is mainstream. Keep that in mind because it does have a very significant impact on whether momentum can build from this level. We think that it can.

The next page provides just one simple look at some of the ways in which investors are now able to invest in environmentally sound communities and opportunities. Exchange rated funds, mutual funds, and professionally run portfolios for large institutions like pension funds and so on are now increasingly common. But that leads to my next point.

I mentioned before that for the investment managers themselves fiduciary responsibilities come first. They are managing money for other people. Very typically pension fund managers are managing very large pools of capital, and the beneficiaries of those investments must be, by law, the pensioners, the people who will ultimately be receiving the payouts, and what matters therefore, under law, are the returns that are generated in a risk controlled environment. Furthermore, until very recently there was very little evidence that suggested that investing in an environmentally aware way generated returns. There were many studies that showed that environmentally sensitively run portfolios in fact generated returns that were below average. And so from the standpoint of fiduciaries they ran a very significant risk of investing in this manner, knowing that the returns would not be there. However fairly recently, in fact just about a year or so ago, a very interesting paper was published in the Financial Analyst Journal, and it refers to the eco-efficiency premium. For those of you who are not familiar with the terminology, a premium is that extra bit of return that you can get in a portfolio by focusing on something. And for the first time a major study showed that environmentally aware portfolios could in fact generate not just average returns but in some instances above average returns. Work done at Goldman Sachs shows that this applies not just to the US markets, but my colleagues have done studies showing that we can generate returns in European markets, in Australian markets, that are better than average by focusing in on these issues, but is a fairly recent phenomenon. And we think that this is related to the critical mass of assets that are now increasingly available for investment in this manner.

If you have a wonderful idea, and let's not think about environmental sensitivity, just a wonderful investment idea, either something that you think should generate a great return, or for that matter something that should be an underperformer, you may be right, your analysis may be correct. But until enough other investors see things your way the mispricing, the inefficiency in the markets stays there. One of the things that we believe is that now in many markets around the world there are enough investors and enough money moving following this direction, concerned about these matters, that the inefficiency that previously existed with regard to environmentally aware strategies is no longer so inefficient. Stated differently, those companies that are generating good returns because they are very environmentally aware will be rewarded, and those companies that are on the other side of the spectrum, those whose returns should be dinged because they've not done what they should as corporate citizens, they will see lessened returns as a consequence.

Here you see a number of different ways that businesspeople and investors primarily are thinking about moving ESG and specifically the E of that into the mainframe. Mutual funds, ETFs, looking at company-specific relative advantage, something that John mentioned before, not only insurance but also reinsurance, and then let's not forget that there are also now markets being made in carbon emissions. Several years ago there were markets made in sulfur dioxide emissions that we believe was very useful in terms of reducing acid rain. We believe that carbon emissions trading will also be very important ultimately in the United States. It already is, where Goldman Sachs is a very significant trader of carbon emissions in the London exchanges.

The next theme, what are companies themselves focusing on? Well previously the earlier focus was on those who perhaps were not doing what they should be doing. In our business we refer to this as the at risk industries, where investors identified the usual suspects. However we have now moved into a much more sophisticated form of analysis where investors are looking not just at participants in at risk industries, including energy and utilities and chemicals, but are looking at all industries and all activities. And there is this idea of the opportunity of making green by being green, an expression that was used by Jeff Immelt just about a year ago when he introduced the General Electric approach to ecomagination.

It was mentioned before that you have to be able to measure things, though, to understand where you are and then sort out where you're going. One of the things that we have seen a significant improvement in, in just a small handful of years, has to do with disclosures by companies. On the next page you will see a listing of things that we think that companies are increasingly focused on. They are aware that they need to be concerned about reputation, regulation, litigation, their competitive position, new product development, and impact upon business operations. And I think what you'll notice here is that there are two columns, both risks and opportunities. Previously the focus was all on mitigation of risk. Increasingly we see it's no longer mitigation of risk but also seeking positive opportunities in these different areas.

How does a company do that? Well first they tell us what they're doing through disclosure. We see, for example, that the at risk industries and companies in the United States, 65% of them provided non-mandatory disclosures to the SEC in the previous fiscal year. That to us is a statement that they understand that their shareholders are looking. In addition companies need to set their priorities in terms of the areas they want to emphasize and de-emphasize, they need to think about corporate restructure, and then of course research and development. So when you think about what they can or can not do, I'd also ask that you take a look at this. This particular table, by the way, is extracted from a report that is available outside. And I wanted to show you just a few examples of companies and what they have disclosed to their shareholders via SEC filings. If you're wondering about the order in which they're listed it's really very simple, it's alphabetical by economic sector. We didn't want to show favorites in any way, or to make our own determination with regard to which were the better disclosures. So we start with the consumer, we move our way to energy, and you'll see comments here from GAP in terms of what they've done to reduce GHG emissions. British Petroleum, the very significant steps taken by that company. United Parcel Service, a major user of energy because of their delivery fleet. Technology companies have also been very up-front in terms of what they plan to do. Chemical companies. And then of course electric utility companies.

Let me point out to you that these disclosures are enormously helpful to investors. It allows us through these disclosures and through real information to make judgments that can go into the construction of portfolios. We believe, by the way, that the right way to look at this information is not in isolation, because portfolio managers and pension plan sponsors and others will not build portfolios on the basis of one metric, whether a company is a good camper or a bad camper on environmental issues, but rather we're incorporating this work into our main line research. This goes very well with the idea that ESG investing is no longer niche but is now mainstream, critically important.

There's one final topic that I'd like to raise. By the way, this is the list of the other companies. The final topic has to do with the idea that things change, not just because of policy, not just because of regulation, but there have always been through the millennia things that affect economic players, economic decision makers, and the structure of companies, industries, and ultimately the nations. And I have two examples that I'd like to discuss for you, one having to do with the energy sector, related to changes in the structure of that industry over the last 150 years, and the second having to do with changes in macroeconomic structure and the impact that that could have on energy use, and by implication, emission of greenhouses gases and pollutants of a variety of forms.

This particular slide shows you the shift in the use of different sources of energy within the United States. Let me give you some of the high points. 1855, wood provided 90% of the energy used in the United States. By 1910 coal was responsible for 75%. And so whether there were concerns about greenhouse gas, pollutants, or whatever there were other economic factors including availability and price that drove these sorts of decisions. More recently in the age of petroleum, petroleum and derived products now provide about 45% of energy in the United States. But something that's a little bit hard to see on the screen unfortunately are the areas that you'll find on the top right portion of the slide. This is the growth in other fuels, natural gas, hydroelectric, nuclear, as examples. I hope you see that they are growing. And you can see here that energy companies have themselves moved forward to develop both renewable and alternative energies. We see investments. The first set of companies listed there are the international majors, this is the terminology we use in my business to describe the largest of energy companies that do business around the world. The second group of companies are the US regionals. I would point out parenthetically that the US regionals have been less active in this area of renewable and alternative energy than have the larger global majors. Maybe it is a function of their size, maybe it's a function of something else.

And finally my last slide is related to something we refer to as energy intensity, that is, how much energy, measured in BTUs, is used to produce a unit of GDP. The first four bars represent major economies in the United States, the United States, Germany, France, Italy. We could put all the rest of the G7 there and it would look about the same. But those three much taller bars represent the energy intensity, again that's the energy used per unit of GDP, by China, India and South Korea. And what we see is that the fastest growing nations are also the nations that use more energy per unit of GDP. They are also emitting more GHG per unit of energy than are the other nations. And so an example of something we need to keep in mind, it's not just the regulation but it's also changes in economic structure that can lead to some very interesting conclusions and considerations.

Thank you very much.