The Rainforest Action Network (RAN) is the least of Citigroup’s problems.

For months the environmental watchdog has targeted Citigroup, along with Merrill Lynch and Morgan Stanley for arranging eleven pulverized coal power plants for TXU for $11bn that would emit an estimated 78mn tons of carbon monoxide per year. RAN’s activist tactics are being eclipsed now by a fast moving coalition which includes the new Democratic Congressional majority, evangelical Christians and corporate heavyweights like GE, DuPont, Lehman Brothers, Duke Energy, and Alcoa which are moving to impose a firm nationwide limit on carbon emissions.

It remains to be seen whether and how new carbon legislation will impact the plants. One scenario is that TXU would be required to implement clean coal technology (like IGCC). This would require additional costs to incorporate the new technology and could delay construction. Another scenario is that electricity output deviates from projections in order to comply with new carbon emissions caps. The worst-case (and least likely) scenario is that new legislation means that new coal-fired power plants are rejected, or become too costly to build.

However, the question isn’t so much what the costs in terms of delay or compliance will be, although they are not insignificant. The real question is why didn’t Citgroup anticipate this risk as effectively as its competition, and incorporate these risks into its projections before arranging the deal? It also raises the bigger question of how vulnerable is Citigroup’s energy portfolio to carbon legislation relative to its peers?

The very real possibility of a nationwide limit on carbon emissions will force the entire financial sector to rethink its energy investment strategy. What assumptions about the environmental regulatory landscape were used when banks projected future earnings streams in their energy investments? Are those assumptions valid anymore?

Investors in the finance sector must now distinguish between banks that manage environmental risk as a reputational liability versus banks that manage environmental risk as an earnings liability. A nationwide limit on carbon emissions will illuminate a sharp distinction between banks that manage environmental risks in order to avoid embarrassing blemishes to their brand (like a public dispute with the Rainforest Action Network) and banks that manage environmental risk because of the financial threats it poses to their earnings streams and regulatory liabilities.

For years Citigroup has carefully cultivated an impressive portfolio of socially responsible investments which included investments in renewable energy, carbon trading, clean technology and microcredit backed up with active participation in leading edge sustainability initiatives like the Equator Principles. If a buy side analyst were to ask, "how impressive is Citi’s ‘green’ investment portfolio relative to its competitive set?" The response would have to be, "superior."

But at the end of the day these investments constituted a miniscule fraction of Citigroup’s loans and investments. If a buy-side analyst were to ask, "How well does Citigroup forecast environmental and social risks and how thoroughly does it incorporate this intelligence into the 99% of its loans and investments that fall outside of its ‘sustainability’ portfolio?" The response would be, "Not as well, and not as thoroughly as its comparably sized competitors".

This is in contrast to Bank of America which is proactively reducing its exposure to carbon intensive businesses. The company has set a target to reduce the carbon footprint of its energy portfolio by 7% per year. There is no doubt that brand considerations factored into this decision. But the main driver was that Bank of America forecasted more intense and costly carbon regulation and positioned itself in front of this trend. It understood that to reactively adapt to it or to merely handle carbon emissions as a "headline risk" would be too costly and too risky.

Incidentally, Bank of America turned down the opportunity to participate in the TXU deal.

Ratings and research reports from Innovest Strategic Advisors analyzing the environmental, social and governance performance of over 1,750 companies and their industries, including the Global 100 Most Sustainable Corporations, is available at www.csrwire.com/reports/independent.

About Innovest (www.innovestgroup.com)

Innovest Strategic Value Advisors is an internationally recognized investment research and advisory firm specializing in analyzing companies’ performance on environmental, social, and strategic governance issues, with a particular focus on their impact on competitiveness, profitability, and share price performance. By assessing differentials typically not identified by traditional securities analysis, Innovest’s IVA ratings uncover hidden risks and value potential for investors.

Innovest was judged the #1 global provider of "extra-financial" research in the Thomson Extel 2006 survey of institutional investors.

Innovest Strategic Value Advisors, Inc.

Innovest Strategic Value Advisors, Inc.

Innovest Strategic Value Advisors is an internationally recognized investment research and advisory firm specializing in analyzing companies’ performance on environmental, social, and strategic governance issues, with a particular focus on their impact on competitiveness, profitability, and share price performance. Innovest currently has offices in New York City, Toronto, San Francisco, London, Paris, Sydney, and Tokyo.

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