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The effects of climate change on corporate valuations: Part One

Hydrocarbon Engineering,

In order to gauge the stress that climate change will place on the cash flows of large public companies, McKinsey & Company assessed the cash flow of large public companies, in three scenarios: business as usual, a scenario involving the greatest degree of change executives can now imagine (the executive scenario), and a scenario that many scientisits believe would be required to stave off a high likelihood of catastrophic climate change – related events (the experts’ scenario). McKinsey looked at six different industries in order to understand how the impact could vary.

Fundamental demand shifts

In some industries shifts in demand will have a broadly negative impact on company cash flows and therefore valuations. Oil and gas consumption, for example, would have to decrease to an average of approximately 0.2%/y from now until 2030 in order to meet emission reduction targets associated with success in stabilizing greenhouse gases.

The upstream oil and gas industry would therefore experience falling demand over the long term (2016 and beyond) as the economy shifts towards cleaner sources of energy, and as oil consuming sectors increase their emphasis on energy efficiency. Upstream companies could experience falling production and sales volumes by 2015, with a substantial impact on cash flows. If that happened, valuations would fall by approximately 5% in the executive scenario and by approximately 15% in the experts’ scenario. The potential impact on value is relatively low because of the short term nature of the valuations of upstream companies – which mostly reflect their current high yielding discovered and developed reserves. These have an average lifespan of 10 – 15 years and will be largely depleted by the end of the next decade. The value of the cash flows affected could fall further if a dramatic decline in demand pushed down prices.

In contrast, other industries could enjoy considerable gains. Companies in the building materials sector – particularly those that do business in places where building efficiency is not yet a major issue – will probably benefit from rising demand for improved energy efficiency and insulation products, which will increase their cash flows. In developed economies, more stringent building standards are already creating demand for such offerings and the same thing will happen in developing markets as well. Analysts are already calculating the impact on demand of existing regulations and factoring it into company valuations. As compared with the business as usual scenario, the valuation of a representative building-materials company in the developed world increases by 35% in the executive scenario and 80% in the experts’ scenario. If more stringent regulatory measures do not materialize, valuations could fall by 10 – 20% as a result of possible short term cost pressures.

Changing competitive dynamics

Efforts to offset climate change will structurally transform some sectors, according to McKinsey. The way a company reacts to changing technologies and business systems will determine its performance.

In the automotive sector, novel technologies will create new competitive dynamics and transform business systems in the next one to five years. Cash flows could be affected both positively and negatively. In the short term, tighter emission standards will have an impact on the mix of cars sold, helping manufacturers with lineups of smaller, more fuel and emission efficient cars. Such standards will affect the margins of both winners and losers and thus their cash flows and valuations, which many already reflect some potential changes in value.

Changed fuel efficiency and emissions standards, combined with high oil prices, will spur the introduction of new drivetrain technologies, such as electric and hydrogen, which could start to reach scale by 2015. A number of competing technologies, including more efficient internal combustion engines and hybrids, will be introduced, and so will vehicles powered by compressed natural gas, hydrogen, or electricity. The impact on valuations will depend both on which of these proves dominant and on the ability of the automotive OEMs to pass along the costs of new technologies and parts to consumers or to capture value from other segments of the value chain, McKinsey reports.

According to McKinsey, while the actual impact on industry valuations is highly uncertain, it is not unimaginable that its discounted value could rise 10% as compared with the business as usual scenario if the electric and hydrogen technologies become dominant, in combination with a new and cheaper way of generating power, which could let OEMs raise margins by charging higher prices. Certain types of regulatory interventions, however, could raise the industry’s costs, with no concurrent price offsets. In that case, the industry’s value could fall by as much as 65%. Nonetheless, well positioned players with clear leadership in technologies and products should always be able to outperform their competitors.

Structural resilience

Some sectors will experience minimal long term stress from carbon abatement efforts: they will be able to pass along any short term cost pressures to customers and will not face substitution by other products of significant shifts in demand. In such cases, profit margins would revert to average levels over the medium to long term. The consumer electronic industry, for example, will probably have the technology to deal with regulation in a way that will not harm the bottom line.

Consumer electronics represents a large and growing portion of residential electricity demand. Using technologies that exist today, the industry can make its products dramatically more efficient at low and diminishing costs. McKinsey expects increased efficiency improvement pressures, as well as efficiency labeling requirements. The overall impact on the value of the industry will be limited. Some of its revenue and margin opportunities could have a positive impact of up to 10% on its discounted case flows in the executive scenario, or up to 35% in the experts’ one. Higher costs that could reduce the industry’s value by 7% could, however, offset these opportunities.

Adapted from a report by Emma McAleavey.

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