The momentum and excitement in Paris last month at the COP21 UN Conference on Climate Change marks a turning point in the perception of climate change as an economic risk, reinforcing a growing mainstream consensus that institutional investors need to do two things.
First is the need to accept the downside risks, such as stranded assets in energy companies, paying heed to the growing number mainstream figures, such as the economist Bob Litterman, the former US Treasury secretary Hank Paulson and the Bank of England governor Mark Carney, who have publicly argued the case for taking climate change risk into account.
Second, many investors also want to benefit from developments in clean and renewable energy, where they see growth potential and attractive revenue streams. Pension funds and other institutional investors will play a pivotal role as suppliers of capital to infrastructure projects to develop renewable energy sources, which will be crucial if the world is to meet even modest temperature mitigation targets.
There was a seriousness and determination at the COP21 talks in Paris to act on climate change, which implies considerable changes in the global economy. Certainly, increasing numbers of institutional investors take portfolio carbon risk extremely seriously and view it as a mainstream risk management issue, even if they are not yet entirely sure about precise implications in portfolio construction and asset allocation.
But embracing the economics of climate change is not about virtue, even if some investors are genuinely passionate about climate change issues or see ESG as a means to align investment strategy with the perceived long-term interest of pension fund members. For Mats Andersson, CEO of AP4, this is a rational matter of investor self interest.
More than 120 leading investors with assets in excess of $10trn (€9trn) have signed the Montreal Pledge to measure the carbon footprint of their investment portfolios. But what will they be measuring? Carbon measurement and disclosure have improved recently, although there have been some schoolboy errors over the years. The German utility RWE overstated its carbon output by 70m tonnes in 2009, equivalent to the entire output of Denmark, while in 2005 one airline reportedly added three zeros to its sulphur dioxide figures.
Notwithstanding improvements and mandatory reporting for listed companies in the UK, data is still patchy, despite the best efforts of the Carbon Disclosure Project and others. Trucost, the carbon data measurement specialist, for instance, finds that emerging market companies have the highest carbon intensity but the lowest levels of disclosure and the lowest quality disclosure. It also raises problems in that perennial bugbear, the assessment of supply chains. On top of this, the Volkswagen emissions scandal also brings up the matter of outright fraud. Overall, high levels of opaque modelling are necessary to fill in the gaps.
The institutional investors with high levels of commitment to decarbonisation tend either to be public pension funds or sovereign entities, with some notable exceptions. Private sector pension funds lag, and one is reminded that it took many institutional investors a long time to embrace modern liability-driven investment-type risk management or to embrace diversification.
For now, carbon risk management will be the preserve of an expanding group of first movers and early adopters. But given the gaps in the practices of data collection and disclosure, investors and stakeholders must be aware that headline claims made on decarbonisation may be subject to later revision, with all that might entail in terms of loss of credibility.