Unique challenges of climate risk
The environmental, social and governance (ESG) community believes it is making great strides in driving investment chain participants, particularly pension funds, towards greater long-termism.
The leading pension funds have already appointed ESG or sustainability professionals – some initially as trend followers and to protect their reputation, but others in a genuine process in response to challenges such as climate change.
Some ESG and sustainability professionals were given a clear scope of work when appointed and others a free reign to approach the issues as they saw fit.
The debate about unburnable carbon has driven this new class of professional into greater conflict with other internal stakeholders and in some cases provoked a heated debate.
CIOs, in particular, are facing a barrage of climate risk issues that is sometimes beginning to shape their role.
It could be argued that an ESG professional and a CIO should always exist in some degree of conflict. The ESG professional argues for the early anticipation of various externalities, while the return-hungry CIO pushes in favour of timing the market or waiting for the market entirely.
But the world is changing for the CIO in terms of climate risk now that market data is available via the Asset Owners Disclosure Project (AODP) Global Climate index (www.AODProject.Net), and strong evidence that civil society has finally realised that following the money to the top is the only real strategy to drive change and debate.
This new pressure has put CIOs in a difficult position. The market has priced in little more than a business-as-usual position on future climate liabilities for companies, and the concern for members and ESG representatives is that a rapid repricing period will leave exposed assets stranded.
To deviate from traditional strategic asset allocation and indexation strategies creates a problem for CIOs used to signing off their consultants’ recommendations without having to do too much thinking. The leading investors in the AODP index have started to manage this issue proactively without any noticeable return penalty – yet significant carbon hedging positions are still only evident in the very few funds rated AAA in the AODP index.
Put simply, the CIO role will never be the same again, thanks to the climate risk issue. Members are not going to stop demanding answers to questions about systemic risk, but there are no models available for CIOs to price a possible carbon hedge.
Such a hedging strategy implies some kind of short-term, and probably a medium-term, return sacrifice in return for greater stability in the event of carbon repricing. This may not even be driven by pro-active policies from governments at all but rather by a combination of innovation, emerging economies of scale in low-carbon sectors and by other low-carbon pathways that all serve to strand their high-carbon exposures.
But these pathways are uncertain. How can we predict their timing and severity? We can’t, of course, which leads us to ask how best to hedge uncertainty. In theory, this shouldn’t be too difficult – financial institutions hedge FX and interest rates all the time. But hedging carbon risk is of a completely different scale and nature.
These new pressures on CIOs will, of course, be reflected at trustee level. While a CIO can discuss VaR, quant models, tracking errors and asset allocation with a perfect spreadsheet model, the uncertainty of climate risk provides no comfort whatsoever, and possibly no win for a CIO.
Such a challenge will inevitably bring the trustees into focus for a judgement call on the ultimate decision – how are we going to guess? For an industry used to the false precision of computer models to give them comfort in their decisions, the internal dynamic between pension fund stakeholders is bound to change forever, perhaps for the good.
As Anne Simpson, CIO of the California Public Employees’ Retirement System (CalPERS), said recently: “Investment is judgement in the face of uncertainty”. Now, management of this uncertainty has given ESG professionals the ammunition they need to take their subject area from meeting footnote to centre stage in investment strategy and member communication.
Deciding the level of carbon hedging is a challenge in itself, let alone explaining the analysis used to inform the necessary guesswork. But herein lies the solution for the CIO and one that could satisfy ESG staff and trustees in their fiduciary responsibilities.
CIOs must acknowledge that a perfect model does not exist. Instead, they can reasonably point to some kind of carbon base case in the form of their own carbon risk premium, give this premium to fund managers to use in valuation, and explain it to members along with its hedging benefits.
The only alternative course of action is to tell ESG staff, trustees and members that their current 20-1 high to low carbon asset ratio, that represents the degree of their bet against a low carbon transition, is roughly the right odds and that the market and fund managers have priced it correctly. That is where their real problems might begin.
Julian Poulter is the founder and executive director of the Asset Owners Disclosure Project (AODP). He is also business director of Australia-based research and advocacy group The Climate Institute