Author: Maha Khan Phillips
In this roundtable, industry experts talk to Professional Investor about the scale of the climate change challenge for the investment industry, the risks and opportunities it presents, portfolio optimisation, and what other steps asset managers can take to bring real, sustainable change.
PI: How big of a challenge is climate change for the investment industry?
Marte Borhaug:
Climate change is an existential challenge for our industry, our economy and society. It will impact every sector, company, project and country. The good news is that we have the goalpost. The Paris Agreement was the landmark environmental accord adopted in 2015 and signed by nearly every nation in the world. It is now up to governments and business leaders to ensure we keep the temperature rise above pre-industrial levels this century to 1.5 degrees. While ambitions still need to be raised and delivery accelerated, it is positive there are now over a thousand global companies that have committed to net zero goals, and more are joining them every day. When business gets behind an agenda, history tells us that things start to happen, and quickly.
Kate Faraday:
Climate change has become a key area of strategic concern for a large and growing proportion of investors and asset managers. This concern is underpinned by the moral imperative to act as a responsible corporate citizen, as well as a prudent assessment of investment risk and return dynamics across investment strategies.
Addressing climate change, alongside other ESG issues, will only become a more dominant and mainstream part of the investment manager’s role, so it’s critical to be one step ahead of both client concerns and regulatory changes. Thinking about our approach at PineBridge, we have been incorporating ESG factors as part of our investment process for 15 years and feel we are starting from a good position. That said, in 2019 we launched our Corporate Responsibility Steering Committee to make the environment and climate change a stronger priority, and to take steps to reduce the company’s environmental footprint and to align our stewardship and engagement activities with industry best practice.
Yesim Tokat-Acikel:
Climate change is no longer a hypothetical risk. Our planet is warming at an accelerating pace. The impacts of climate change are likely to affect many aspects of human life, including the global economy. From the perspective of a long-term investor, climate change is a source of considerable uncertainty. The transition to a sustainable economy in possible climate change scenarios poses both significant risks and opportunities for investors’ portfolios. The future path of climate change remains unclear. The way forward is dependent on regulatory, governmental and societal actions. It is difficult to predict when and how climate externalities will be fully reflected in economic outcomes and market prices.
Taimur Hyat:
There is increasing evidence the world is reaching tipping points in climate change that will have lasting, irreversible impactsThe critical takeaway for investors is clear: even under the most benign scenarios, our planet and climate will continue to change rapidly. Regardless of whether investors tilt towards ESG objectives, the sweeping impact of climate change cannot be ignored.
The impacts will be highly uneven across and within countries and sectors, with growth in developed markets likely to be less impaired than emerging markets.
The transition to a low-carbon economy is already underway, creating the threat of stranded carbon assets, often referred to as transition risk. Renewable energy faces significant challenges today; energy storage capacity needs to grow tremendously, a massive amount of investment and time is needed to build out renewable energy capacity, and even as the transition away from fossil fuels progresses, the end goal is moving further away.
PI: What are some of the risks and opportunities for asset owners and asset managers?
John Wilson:
Asset owners and managers have opportunities to push companies to enact positive change via engagement on climate change issues, through company selection, proxy voting, direct dialogue and shareholder resolutions. Calvert considers opportunities to improve our position as a shareholder in our portfolio companies, and looks at which tools are best suited for driving the positive change we hope to see. Risks can be seen in evaluating companies who delay making necessary changes. For example, energy companies who push planning for a low-carbon energy system transition to a later date could further lock in emitting technologies for longer, exacerbating climate change and making an eventual transition for companies in those industries costlier, which meaningfully increases risk from the perspective of ESG investors.
Tokat-Acikel:
Economic risks from climate change can be bifurcated into two categories: physical risks and transition risks. Physical risks include the actual economic costs of extreme weather events, or the net impact of gradual changes to the climate, and can involve business disruption, asset destruction, or reduction in productivity. Transition risks reflect the financial impact of changes to regulation and policies from transitioning to a more sustainable economy. These can involve changes to technology or consumer preferences, or additional costs of production due to policy changes. To assess the future economic impacts of climate change, it is important to consider physical and transition risks in both optimistic and pessimistic climate scenarios that may unfold.
To date, there have been efforts to measure the environmental impact to firms within a broader ESG framework. Various sources may help investors assess their exposure to environmental or climate risk, with a focus on microeconomic and firm-level implications. This bottom-up focus can be complemented by evaluating the top-down and cross-asset implications of climate change to provide a fuller picture of the impacts of climate change for long-term investors.
Borhaug:
A major risk is physical risks, which are directly related to climate change impacts, like a hurricane destroying a factory or climate variability affecting crop production. A landmark case was when PG&E, California’s largest utility, filed for bankruptcy in 2019 after the state was gripped by a prolonged period of drought and the company was held liable for triggering a series of wildfires. These risks will increase as temperatures rise. Another key risk is transition risk, which includes the impact of policy changes to support a low-carbon economy, such as carbon taxes or the removal of fossil-fuel subsidies.
However, there are opportunities. CDP reviewed the climate filings from 215 of the world’s largest companies and found that while those companies flagged $1 trillion of potential climate risks, this was dwarfed by climate-related commercial opportunities, which were estimated at $2.1 trillion. We have no time to lose.
Hyat:
While virtually all sectors will feel the impact of climate change, some will be adversely impacted more than others. For example, airlines, utilities and energy are highly vulnerable to transition risk, given reliance on high-carbon fossil fuels. Many segments of the food complex – including soft drink and beer producers, fisheries and wineries – face challenges from physical risk. Additionally, construction and areas within the hotel and entertainment sectors are vulnerable to physical risk.
It may be intuitive for investors to avoid sectors most vulnerable to climate change. However, such an approach may overlook significant opportunities, given there is extensive variation within each sector as well.
Many opportunities lie in innovative and transformative technology. These range from identifying technology-forward companies adept at transitioning to the new ‘low-carbon economy’, to incorporating physical and transition climate risk in analysing real assets, all the way to providing seed capital to start-ups pioneering technologies.
Faraday:
The investment industry has historically viewed climate change solely as a risk factor; particularly considering the recent escalation of events tied to climate change. Climate change, of course, exposes companies to specific material risks, alongside fiscal and regulatory implications such as carbon pricing and carbon taxes. Companies that have a poor environmental track record and, crucially, lack a strategy to improve are likely to suffer competitive disadvantages and could face significant penalties as global environmental policies become more stringent.
Investors often fail to realise that the reverse is also true. Companies that have a credible strategy to improve their ESG credentials, particularly related to climate change, are likely to outperform their peers. From the perspective of an investor, we therefore view improving ESG trends as an alpha-generating opportunity, particularly if we can encourage and drive this change via engagement with management teams.
PI: How can asset managers optimise portfolios to have low carbon footprints without penalising returns?
Faraday:
We view a low carbon footprint as a risk mitigation factor and a potential driver of alpha that can boost, rather than penalise, performance. Evidence is mounting that ESG-friendly investments may also be more resilient to challenging conditions and deliver stronger returns relative to traditional assets.
As such, we favour the full integration of ESG considerations into end-to-end due diligence, asset selection, and portfolio monitoring processes for all investments. Likewise, while many firms favor a “negative screening” approach that excludes companies based on a point-in-time assessment, we prefer to focus on a company’s improvement on ESG metrics. Studies have shown better risk-adjusted returns for firms that are improving upon their ESG practices, irrespective of their starting points, relative to those that may score high but are not improving.
Lastly, we embrace active engagement to encourage the greatest number of companies to improve on ESG measures.
Borhaug:
A disrupted and depleted planet means disrupted and depleted companies and disrupted and depleted investment returns. Tackling climate change is not at odds with seeking strong returns. The only certainty is that the future will not be the same as the past and that markets are not pricing in the dramatic shift to a low-carbon economy.
Our economies will look very different as some companies transform and others don’t, which will lose their license to operate. Tackling this demands an active approach, transitioning all our assets in a way that really addresses issues linked to climate change, balancing integration, active ownership, and market reform. The non-profit think tank 2 2° Investing Initiative (2DII) made an important distinction between ‘alignment’ with climate goals and ‘contribution’ to tackle climate change, arguing asset managers can’t just focus on cleaning up portfolios by discarding high-carbon stocks, but must use their power to change companies and governments.
Wilson:
The concepts of financial materiality and risk mitigation associated with ESG have gained considerable traction with corporations, investors and institutions in recent years. Lowering the carbon footprint is a material ESG issue to many investments, which as a long-term investor we believe may reduce risk and help improve performance. At Calvert, our engagement team has specific expertise advocating for change in corporations on matters of importance to shareholders, like climate change. Working closely with our dedicated ESG research team, we leverage our company and industry knowledge to identify opportunities to improve a company’s overall approach to ESG, its response to controversies, or its management of ESG-related risks and opportunities.
Hyat:
The time has come for long-term investors to view climate change not just as a risk factor in their investment framework, but as an opportunity for active alpha generation along the path to a greener economy.
Until recently, climate risk was a distant externality, largely uncaptured by market mechanisms and only partially reflected in asset prices. However, this is changing. Climate risk will increasingly be reflected in market prices, leading to a potentially dramatic repricing across asset classes, sectors, companies and individual securities.
Across public and private markets investors must position their investments and overall portfolios for the accelerating climate transformations in our economy and markets. No one can perfectly predict the dynamics of asset price adjustments as climate risks get internalised – or whether the adjustment will be smooth or abrupt – but a repricing will occur, and investors will need to be prepared.
Tokat-Acikel:
Investors who view climate change as a credible risk have demonstrated various responses to this challenge. Some tilt their portfolio away from investments that may be exposed to potential negative consequences. Others engage in activism, influencing management behaviour or financing new green projects.
The physical risks of climate change are expected to be negative for most investments. It is generally accepted that the energy, utilities, materials and industrials sectors will feel the greatest negative impacts. Our top-down analysis suggests that growth-oriented assets, such as equities, would be the most directly affected by climate change. As such, equity returns would decline in a pessimistic scenario. This impact is likely to vary significantly across countries, with the most sizable impact expected in certain emerging markets. These countries also seem least prepared to handle the economic, political and societal challenges that may be awaiting them. By contrast, the implications for the impact of climate change on inflation and interest rates are ambiguous.
Our analysis also found that the impact on developed sovereign bonds, Real Estate Investment Trusts (REITs) and commodities is likely to be more localised at the micro level of individual securities, rather than at the asset-class level. Credit segments of the bond market, whether on corporate or emerging sovereigns, will also likely be negatively impacted.
The transition to a sustainable economy, however, will also create advantageous circumstances for investors. We have not yet quantitatively modelled opportunities that will benefit from the transition to a sustainable economy.
PI: What is the best practice approach the assessment and measurement of climate change?
Hyat:
Measuring portfolio-level climate risk can be daunting given the complexity of the risks and the inconsistency in data quality and granularity. High-quality data and metrics are simply not available across all asset classes.
To evaluate the full extent of their portfolio’s exposure to both transition and physical risk, investors will need to go beyond conventional data resources and methodologies and adopt an unorthodox approach. According to PGIM’s survey of major global investors, for those who already incorporate climate change into their investment processes, fewer than one in five utilise alternative data such as satellite imagery, flooding maps, drought data and air quality data.
The field of climate research is evolving rapidly, with new research published almost daily. Investors will want to ensure analytics providers continuously update models using new, cutting-edge research. Analytics firms that monitor and incorporate the most current thinking will be able to develop the most useful models.
Borhaug:
We do not underestimate the scale of the challenge ahead. Many pieces of the puzzle are still missing: the data is imperfect, methodologies are incomplete and there is no consistent global set of standards. However, although we may not know every step, the key is to take action and work with what we’ve got.
First, you need to understand the climate risk inside a portfolio. Second, you need to understand your exposure to the opportunities. Third, and perhaps most importantly, you need forward-looking indicators that give you a sense of where you’re heading. Across all three dimensions, we mix quantitative metrics with qualitative assessments carried out by ESG analysts, which is more robust and built on engagement with the company to better understand its pathway to net zero. Two companies can have a similar emissions profile today, but a very different ability to transform. Leading practices can discern leaders from laggards.
Tokat-Acikel:
Academics and policymakers take two main approaches to estimating the relationship between climate and economic variables: structural models and reduced-form models, which use historical data under various climate path scenarios to project potential future economic costs. Given the long-term nature of the costs from climate change, there is necessarily a considerable amount of uncertainty in these estimates.
It is important to note that certain events, such as rising sea levels or ocean acidification, have no recent historical precedent from which to draw inferences. These unprecedented events will almost certainly have significant, net negative economic consequences. This suggests that even the latest studies may still be underestimating the economic impact of global warming.
Faraday:
To integrate climate-related risks, we combine proprietary due diligence and metrics with external resources to gain real-time updates on potential risks and opportunities across our portfolios. When assessing companies, it is crucial to have a strong bottom-up analysis infrastructure in place to understand what is driving the investee companies and what their priorities and longer-term goals are. We focus on the current profile of our companies but also a forward-looking assessment of what they are doing to improve. As climate change risks come in various forms, from direct physical to indirect physical to transitional risks, we need to understand how management teams are set up to deal with a variety of risks.
A well-planned sustainability report can give you a decent idea of how a company stacks up, but structured engagement with companies provide tangible inputs which we can factor into our investment decisions. If a company’s plan falls short of our expectations, we will seek to engage and encourage management to change tracks. To hold companies to account, we actively monitor upcoming votes on companies that are falling behind on climate change, or have climate-related shareholder proposals, as an additional vehicle to ensure change.
Wilson:
At Calvert, our assessment and measurement of climate change research is rooted in materiality. We strive to create a holistic view by identifying which specific ESG factors are most relevant (i.e. financially material) within a given subindustry. This process then enables us to identify the key aspects of the business most likely to affect financial outcomes, ultimately guiding our investment decisions and corporate engagement efforts. Our nuanced approach to materiality-based analytics takes into account the fact that different ESG factors have more or less impact from one industry to another. So, our process begins by refining established industry classifications into custom peer groups based on common ESG risks, which allows us to make more relevant comparisons, ultimately leading to better investment decisions.
PI: Is the investment industry doing enough to engage with companies on this issue?
Borhaug:
There is a lot of positive momentum across the industry with initiatives like Climate Action 100+, which bring investors together to drive change with companies in key sectors. We are pleased to see this, having engaged on these issues for a long time, including embedding climate change into our voting policy back in 2001.
Last year we voted in favour of 98% of climate and social shareholder proposals. However, some CEOs have spoken out, saying many investors say one thing in public and another in private as the journey to net zero will involve balancing short-term profits with long-term survival. Rankings by ShareAction also show that several of the world’s largest asset managers are not using their engagement and voting powers to push for action on climate and biodiversity. It is important that all asset managers use their voice to ensure companies are held accountable.
Wilson:
Shareholder engagement has proved to be an effective tool to influence corporations to disclose and reduce their greenhouse gas emissions. Today, investor influence could be an important catalyst towards encouraging companies to commit to eliminating carbon emissions from operations and products, and executing on those commitments. However, many investors fail to support shareholder proposals advocating for more aggressive carbon mitigation and do not disclose much information about their dialogues with companies. At Calvert, engaging on climate change is an important part of our investment activities. In 2020, we added to our efforts to address climate change, emphasizing the utilities and banking sectors. For the most recent proxy season, Calvert voted on 47 climate proposals related to reporting, renewable energy strategy and fossil fuel divestment. We voted in support of 35 (74%) of these proposals, opposing proposals that sought to micromanage the company. For the 2020 proxy season, we filed one proposal related to climate change. We also filed one resolution on climate change, which was also withdrawn after further dialogue with the company.
Faraday:
While many firms, PineBridge included, are taking a highly proactive approach to engagement on ESG issues, there is a wide variation and always more that can be done.
We believe that a “consultivist” approach is ultimately the most beneficial way to produce real change. This process involves engaging in a dialogue with companies to encourage them to adopt better climate change related practices. That said, taking account of the risks attached to climate change requires extensive investment diligence, sustained engagement, escalation when engagement does not appear to be working, voting against while always explaining why, and finally, if all else fails, divesting.
To take one example in Brazil’s beef sector, the world's largest beef exporter and an environmentally intensive industry. As investors in this sector, understanding the environmental risks has been crucial to our investment decisions and our interactions with management. The three largest issuers, which represent 70% of Brazilian beef production, committed in 2009 to a policy to prevent deforestations due to pressure applied from both the investor community and international organizations such as Greenpeace. Since then, our engagement has focused on the steps each company has taken to manage the environmental risks along their supply chains and the transparency of supply chain management. Progress along those fronts has enhanced our ability to analyse environmental risk, with an expansion of quantitative data regarding each company's breadth of supply chain coverage. This, in turn, has had a major impact on which positions we have added, held, and sold out of in the relevant portfolios.
Wilson:
Making progress against climate change is a year-round effort, and corporations and investors each have an essential role to play. Asset managers can help by utilizing a rigorous corporate engagement approach to encourage improvement in corporate behaviors in a way that contributes to a more sustainable and equitable world, and potentially contributes to an investment's business prospects. One way asset managers can do so is to make arrangements to become carbon neutral, by measuring and then offsetting its greenhouse gas (GHG) emissions. It’s also essential for asset managers to regularly evaluate its current business practices and policies to reduce its annual GHG emissions. Calvert was also one of the founding signatories of the Net Zero Asset Managers Initiative, whose participants agree to work toward the global goal of achieving net zero greenhouse gas (GHG) emissions by 2050, or sooner. In line with the Paris Agreement.
Tokat-Acikel:
Investors are increasingly voting with their feet and rejecting managers and funds that are not ESG- compliant. While many investment managers today speak of the integral role ESG plays in their investment process, it is not always clear what impact that has on portfolios.
At QMA, we developed our own proprietary ESG investment approach. We believe that one of the most important contributions a quantitative process can bring to ESG investing is the careful integration and balancing of ESG insights with other performance drivers. We continually review our quantitative equity ESG process to ensure that it is up-to-date with the latest enhancements. For multi-asset portfolios, a climate risk-aware portfolio using top-down strategic return expectations could tilt away from regions and assets that are expected to be adversely affected for better risk-adjusted returns. We believe that combining such top-down expectations with bottom-up views is critical, as this is likely to provide better opportunities for desired portfolio outcomes.
Hyat:
Corporate engagement will be vital. Simply excluding ‘dirty’ industries, like fossil fuel extraction, from portfolios has been a tenet of ESG investing for many investors. Fossil fuels, however, will remain a major source of global energy supply for decades, despite the ongoing and necessary transition to a low-carbon economy.
Public and private equity owners can actively influence fossil fuel users and extractors to employ more sustainable practices. By actively engaging with these companies – rather than excluding – a group of like-minded shareholders can positively impact carbon emission outcomes over the decades-long wind-down period for fossil fuels.
As for the range of new ‘green’ opportunities emerging, many are at an early stage and may not currently be at the scale required for larger investors. However, these less mature markets offer sophisticated investors that are willing to engage a unique opportunity. Early investors can shape the market for new climate change-oriented asset classes.
PI: Are asset managers and owners doing enough in terms of looking at their own backyard, and their own policies and procedures?
Borhaug:
Increasingly, clients are asking us not just what we do with their capital, but whether we are walking the walk. It’s not enough to hold other companies accountable if we don’t act ourselves. For example, we have set a very ambitious target to achieve net zero by 2040 across all of our investments and we will get the targets verified by the Science Based Target initiative.
The good news is that the investment industry is increasingly under scrutiny, which will help hold asset managers to their promises. For example, in addition to rankings by ShareAction, Influence Map assessed fund managers’ lobbying efforts on sustainable policies while the World Benchmark Alliance will rank financial institutions on their impact to the Sustainable Development Goals. Together, such initiatives will give all stakeholders more transparency on how asset managers and asset owners are taking action, hopefully driving a race to the top.
Tokat-Acikel:
Investors are increasingly voting with their feet and rejecting managers and funds that are not ESG- compliant. While many investment managers today speak of the integral role ESG plays in their investment process, it is not always clear what impact that has on portfolios.
At QMA, we developed our own proprietary ESG investment approach. We believe that one of the most important contributions a quantitative process can bring to ESG investing is the careful integration and balancing of ESG insights with other performance drivers. We continually review our quantitative equity ESG process to ensure that it is up-to-date with the latest enhancements. For multi-asset portfolios, a climate risk-aware portfolio using top-down strategic return expectations could tilt away from regions and assets that are expected to be adversely affected for better risk-adjusted returns. We believe that combining such top-down expectations with bottom-up views is critical, as this is likely to provide better opportunities for desired portfolio outcomes.
Faraday:
While it’s hard to make a blanket statement, we have embraced a firm wide commitment to promoting sustainable investing both within our own company and in terms of our investment processes.
We have begun several key climate-related initiatives in the past year, including a global review of travel and airline options, utilities, and the firm’s offices, to measure, reduce, and offset our carbon footprint.
The firm provides resources to help local offices become more energy-efficient and environmentally friendly. These include a robust recycling programme, reduced paper consumption, proper disposal and recycling of computer equipment, and water filtration systems to reduce bottled water usage, along with the use of energy-efficient hardware, lighting, and air conditioning systems. Importantly, this initiative also discourages nonessential travel, increases videoconferencing, and encourages lower-carbon commute options by offering bicycle storage facilities in certain offices.
PI: What is one step (small or large) that every practitioner can take today to make a step forwards in terms of climate change?
Wilson:
For responsible investors, one of the most direct means to influence corporate behavior on climate change is through proxy voting. Shareholder resolutions are a way for investors like Calvert to get issues that are important to them, like climate change, onto the proxy ballot. These often call for the company to take specific action, and even though the results of the vote are generally nonbinding, they can serve as an important signal to companies about investor interest in specific issues that may not otherwise be a priority for them. Using your proxy votes to signal that climate change is important, and that you’re watching to see whether the products you’re invested in are preparing for a low-carbon future, can help influence positive change.
Tokat-Acikel:
Education is key. In addition to doing in-house research for our portfolios, QMA participates in various educational and collaborative events with other stewardship and governance organizations to raise awareness of all of our employees on this topic.
Borhaug:
We can change how we invest and engage, but we really need to be more vocal with policymakers and regulators so that they take action to support the transition to a low-carbon economy. Unfortunately, there are still businesses lobbying against policy interventions to tackle climate change; research has found that companies expected to lose something lobby harder than those expecting gains.
That makes it harder for politicians to act and we can’t meet the Paris Agreement without government action. We call this macro stewardship. We have advocated in favour of market reform on climate for decades, including as members of initiatives like the Task Force on Climate-related Financial Disclosures (TCFD) and the EU High-Level Expert Group on Sustainable Finance. If our investments are going to perform for our clients in the future, we need to support them having the best possible operating environment, one where climate leaders are rewarded and major carbon emitters penalised.
Faraday:
The asset management industry will necessarily play a vital role in the transition to a sustainable future. Still, this change will require a cultural shift that we can all help to achieve. At the individual firm level, I believe it is important to create a dedicated resource to ensure climate change is given the attention it deserves. Likewise, investment teams should be changing their thinking to address climate change factors as a security selector. Thinking more broadly, PineBridge is a longstanding advocate for engagement and transparency around climate risk. We view this not just in terms of our engagement with management teams across our portfolios but also with wider stakeholders, including our counterparties and clients, to understand how their preferences are evolving concerning climate change.
Listen to CFA UK Climate Change Podcasts to hear about the the challenges, risks and opportunities of climate change.
| Participants | |
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Marte Borhaug, Global Head of Sustainable Investing, Aviva Investors, and co-chair of the 30% Club Investor Group |
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Kate Faraday, Global Head of Corporate Responsibility, PineBridge Investments |
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Yesim Tokat-Acikel, Director of Multi-asset Research, QMA |
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John Wilson, Vice President and Director of Corporate Engagement, Calvert Research & Management |
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Taimur Hyat, Chief Operating Officer, PGIM |