An important factor driving the interest in sustainable investments and Environment, Social and corporate Governance (ESG) factors more broadly, is the portfolio risks associated with climate change.
In this article we provide an overview of the nature of climate risk, including developments in measuring and managing these risks such as engagement and divestment.
Climate risk has moved to the top of the agenda for policymakers and regulators, driven by the Bank of England Governor’s speech in September 2015 which identified that physical, legal and regulatory risks make climate change a threat to financial stability. As a result, it is becoming ever more important for investors to understand and, where possible, to start managing their climate risks.
Under Germany’s G20 Presidency in 2017 one of the key initiatives will be to discuss the recommendations of the Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosure, which include stress-testing if business plans align with the Paris Climate Agreement.
While the low-carbon transition will move at different speeds, we believe that all governments will have to enact more stringent policies in legislation and that the cost of doing so is lower if action is taken sooner.
Despite the uncertainty of the new U.S. government’s approach to climate and energy policies, we believe it is investors’ fiduciary duty to measure and ultimately reduce climate risks. Given investors’ long-term perspective, they should focus beyond political cycles. If some regulators do not support implementation of the FSB Task Force’s recommendations, we expect investors could make greater use of proxy voting and engagement to improve corporate disclosure, as well as trying to persuade stock exchanges and accounting standards to eventually require climate risk disclosure.
Physical climate risks already exist and are only likely to grow over time. Despite scientists’ sophisticated climate models, physical climate risk data needs to become more available for investors and linked to companies’ facilities and supply chains. Improved supply chain risk analysis could be created by enhancing the FSB Task Force recommendations to require disclosure of ‘1 in 100’ year, ‘1 in 20’ year and annual disaster risk exposure. Improved disclosure of most at risk and important company facilities may also be needed, while maintaining security and confidentiality. Improved disclosures linked to climate models will become increasingly important for many types of investors.
Legal risks include attributing the increased strength of individual extreme weather events to climate change and seeking penalties from the largest carbon emitters. Investors could also become liable for insufficiently managing climate risks. The history and magnitude of asbestos related liabilities is a cautionary case study.
Regarding transition risks, while currently prevailing carbon prices appear low, many observers were surprised that governments managed to reach the Paris Climate Agreement and that it became international law so quickly. Investors should be prepared for rapid policy changes and the possibility of an abrupt re-pricing of asset valuations. Some investors may believe that economic impacts will not appear over the next few years or that they will be able to exit any at-risk holding with sufficient foresight. However, a recent study for a group of major investors shows that markets could abruptly re-price climate risks which could reduce returns over the next five years by 11% to 45%, depending on the portfolio allocation (CISL Nov. 2015).
Measuring portfolio carbon intensity has been a starting point, but, this fails to capture the entire picture. Improved disclosure, robust analysis and new indexes are needed that account for sectoral differences and all climate risks. To truly address climate risks, asset owners and managers need to incorporate climate and other ESG issues into their investment beliefs and processes. Topics for discussion include stress-testing and creating low-carbon investment targets and risk reducing benchmarks.
The fossil fuel divestment campaign has played a key role in putting climate change more firmly on the agenda of investors, governments and carbon intensive companies. More investors are divesting some or all of their fossil fuel assets but many others are more inclined to favour engagement and climate/ ESG integration.
In 2016, a number of leading investors became increasingly vocal and active in engaging carbon intensive companies and governments. This led to several European energy and mining company boards’ supporting shareholder resolutions that called for improved carbon risk management and stress testing. Investors also played an important role in the adoption of the Paris Agreement. Policy engagement is therefore becoming an increasingly important role for investors.
We are seeing a growing trend towards strong ESG and climate related proxy voting, more proactive engagement with companies and policy makers as well as the consideration of selective divestment (not just with carbon intensive companies) if corporate investees do not sufficiently improve their climate and ESG practices.
U.S. research shows that engagement on climate change, environmental and corporate governance issues can improve companies’ performance and reduce volatility (Dimson et al Aug 2015). Engagement with companies and policy-makers can lead to important changes, but there is over-reliance on a few active and vocal investors. Meeting fiduciary duties will require asset owners, asset managers and regulators to live up to their stewardship responsibilities by encouraging companies and governments to shift their strategies to reduce climate and ESG risks and seize opportunities. The EU Shareholder Rights Directive and other regulations are likely to lead to more focus on engagement.
The growing shift to passive and exchange traded funds is a challenge to engagement strategies. Asset owners, managers and regulators are likely to look for ways to expand the level and quality of investee engagement on climate and ESG issues, including in passive funds. Investors are also increasingly seeking out investment opportunities in green revenue streams. It is therefore becoming a necessity for every major asset class to consider climate risk and low-carbon technology investment options.