Investors in agriculture ignore environmental risks at their peril

Forget hi-tech stocks or shares in fast-growth pharma. Farming is where the clever money is heading these days. With the world enjoying the longest agricultural commodity boom since the second world war, billions of investment dollars are funnelling into farm-rich emerging markets such as Brazil, Nigeria and China. More established agricultural powerhouses such as North America and Russia are surging too.

Many investors are sitting pretty as a consequence. Global farmland asset values, for instance, have quadrupled in value since 2002. Commodity prices have spiked as well, with the benchmark FAO Food Price Index more than doubling between 2002 and the end of 2011.

Yet, agriculture is not without its risks, particularly those relating to the environment. Climate change, green regulations, disease, fertiliser availability: the list of potential wobbles along the way is vast and complex. Take water. Global agriculture is currently responsible for 70% of all water withdrawn from aquifers, streams and lakes. If the taps are turned off or these water resources run dry, the implications for the farming sector are potentially disastrous.

"You can't invest in agriculture without thinking carefully about these issues", warned Ben Caldecott, co-author of the new report, Stranded Assets in Agriculture, and a programme director at the University of Oxford's Smith School of Enterprise and Environment.

Waking up

The potential losses are colossal. Using a high-level value at risk (VaR) assessment, Caldecott and his colleagues at the Smith School estimate that there's a 5% chance of agricultural-related losses amounting to more than $8tn (£5.17tn) in a single year.

Other than a "very small band of investors", pension funds and other large financial institutions fail to factor environmental risks into their due diligence or product pricing when it comes to agriculture, according to Caldecott.

Such disregard is surprising. The idea that environment-related risks could cause assets to decline in value, or even turn into liabilities, has been preoccupying energy investors for a while now. A recent report by the think tank Carbon Tracker suggests that climate change could wipe trillions of dollars off the value of the world's largest oil companies.

"The valuation of companies like BP, Shell and Exxon is entirely based on their ability to extract and sell their reserves. But if you extract and sell all those reserves, we are set on a path by all scientific consensus of six degree celsius warming", said Richard Mattison, chief executive at Trucost, an environmental data analyst firm.

The implication is that either low-carbon regulation will be introduced or the world will warm up accordingly. In either scenario, the long-term viability of the "business as usual model" for oil companies is doubtful. Agriculture isn't so different.

Looking around

Another reason for surprise is the nature of many of the pending risks. Think of wheat. At present, farmers in Southern Asia access water for irrigation either for free or at highly subsidised rates. As water scarcity increases, their water costs will almost certainly rise. Counting the externalities of their water use , the region's wheat industry would turn from $31.8bn going concern to a $234.8bn loss leader, a recent report by the TEEB Coalition for Business calculates.

The experience of biofuels presents another clear-cut case. Biofuels mark the merger of agriculture with energy, a potentially revolutionary prospect that has won many an investor's heart – and funds – over the last decade. However, spikes in food prices in 2008-2009, which were partly blamed on the use of land for bio-fuel feedstocks, put pay to much of this early bullishness. "Many operators of first-generation biofuel plants mothballed or sold their plants for only a fraction of their book value", the Smith School report revealed.

Caldecott concedes that not all material risks are so immediate. Declining ecosystem services, water quality and land degradation are longer-term risks, he said: "Such problems often take a long time to manifest themselves [although they] are difficult to remedy once they have occurred."

James Cameron, chairman at the London-based investment firm Climate Change Capital, has some sympathy for mainstream investors. Environmentalists have historically struggled to convey non-financial risks and externalities in a way that markets can understand and act upon. The concept of 'natural capital' - within which the argument of agricultural stranded assets is framed - is the best effort so far.

Even so, the "numbers and the narrative" are still far apart, Cameron noted: "someone will win a Nobel Prize by connecting the two one day, because we really need to have a proxy for the value of the underlying resource for our commodity trade."

Drilling down

Given this context, today's report marks a significant step. Caldecott and his colleagues not only spell out the range of risk factors at stake, but how and where these can affect different agricultural assets (from natural assets such as farmland through to financial assets such as farm loans and derivatives). The report also provides a basic framework for evaluating the speed at which various risks might occur and their potential for material impact.

It's not just for investors. Agribusinesses and food companies should listen up too. Some already are. Unilever now purchases 36% of its agricultural raw materials from sustainable sources. UK supermarket chain, Sainsbury's, recently announced plans to shift its long-term sourcing of citrus fruits from southern Spain, to South Africa, where water supplies are more secure.

"Business and investors both need to do more work to understand how these risks might affect them in different markets and geographies. The next step is drilling down and seeing how these risk factors might play out for a specific investment in, say, a seed-crushing facility in China or a bio-ethanol plant in Brazil", said Caldecott.

Another critical audience is the insurance industry and, in their role as insurers of last resort governments. Losses of $8tn will make a serious dent on the world economy. As Caldecott warned: "Private insurers are never going to be able to cover this kind of catastrophic loss."

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