Investors like AP4, AP2 and the Church of Sweden are ahead of the game in portfolio decarbonisation, writes Caroline Liinanki

With the September New York climate change summit focusing on financial industry action, Swedish pension fund AP4 found itself the centre of attention. 

At the UN general assembly, Mats Andersson, chief executive officer of AP4, presented a new initiative to encourage other investors to both disclose the carbon footprint of their portfolios and commit to reducing it. 

The Portfolio Decarbonisation Coalition, which was launched by AP4, Amundi, the Carbon Disclosure Project (CDP) and UNEP FI, the UN’s environment programme finance initiative, is one of several developments that has given renewed momentum to addressing climate change risk. 

While AP4 is far from the only Nordic investor looking for innovative ways of reducing climate change risk, the pension fund has gained attention through pioneering the development of low-carbon equity indices, which enables investors to reduce climate change risk with a low benchmark-tracking error. 

Andersson explains: “About three and half years ago, some of us at the fund felt that this thing with climate change probably was for real and that carbon dioxide emissions could be one of the greater risks in a portfolio. So we looked at different strategies to reduce the risk – lowering the carbon footprint without taking too much beta risk.” 

At a glance

• Prominent commentators such as former US Treasury secretary Hank Paulson and the FT’s Martin Wolf have drawn attention to the risk of carbon exposure in portfolios in recent months.
• Sweden’s AP4 is the most prominent Nordic investor in the portfolio decarbonisation coalition, launched in New York this autumn.
• The fund will invest in low carbon indices developed by S&P, and by MSCI and Amundi. 
• AP2 and the pension fund of the Swedish Church have also been leaders in assessing the carbon exposure of equity holdings.

The international praise comes as a stark contrast to domestic sentiment, where the AP funds have frequently been criticised for not investing ethically, or on a basis that is sufficiently environmentally conscious.

“The responses have been close to overwhelming,” says Andersson. “It feels really strange that we’ve become one of the leaders in this field. It’s very flattering but it also comes with a great responsibility to do things as well as possible.” 

Andersson says that the coalition’s first step will be to get investors to disclose the carbon footprint of the portfolios. The Principles of Responsible Investment’s Montreal Carbon Pledge, to which signatories commit to measure and disclose the carbon footprint of their portfolios, will be the platform for this. 

“If you require others to do it, then you should also do the same. Someone told me that 95% of the world’s pension funds demand of companies to disclose their carbon footprint but less than 5% of the pension funds publish their own carbon footprint,” Andersson says.

Some of Europe’s largest asset owners, like Dutch PGGM, French FRR and some of the Swedish AP funds, have already signed up to the Montreal pledge. 

One of the early movers when it comes to measuring the carbon footprint of its portfolio has been AP2. As far back as 2009, the fund scrutinised its global equity holdings, the largest part of its portfolio, somewhat ahead of its time. 

Tomas Franzén, AP2’s chief strategist, says measuring the carbon footprint was a matter of curiosity, sparked by the climate change summit in Copenhagen. 

“We thought it would be interesting to see how you could make such a measurement and we wanted to familiarise ourselves with looking at the portfolio in this way,” Franzén says. “One of the thoughts that triggered the idea was that there would be a price on carbon emissions at some point in the future, which would lead to a more efficient use of resources. And at that stage the price would impact the companies’ profits and cashflows, which would lead to a financial risk.”

Asset managers rise to the decarbonisation challenge as investors seek to reduce risk

Until recently, institutional investors have responded to climate change risk by investing in renewable energy or other ‘green’ investments, or by joining the growing divestment movement and selling all their holdings in fossil fuels. 

However, there is growing attention on how to reduce the climate change risk in the equity portfolio and for investors to become transparent about the carbon footprint of their portfolios, beginning with equities. 

The recently launched Portfolio Decarbonisation Coalition, backed by AP4, Amundi, the Carbon Disclosure Project (CDP) and UNEP FI, the UN’s environment programme finance initiative, is looking to mobilise investors in this direction. 

Frédéric Samama, deputy global head of institutional and sovereign clients at Amundi, is convinced that recent innovation will help investors overcome the obstacles to act on climate change risk. 

“There’s a clear recognition now that climate change is not only a threat to society but also to investors,” says Samama. “Some high-profile investors are conveying this message and the topic is moving from the hands of governments to investors. But what is striking is that when you ask investors what they do, they take very little action.”

Part of the reason, he believes, is time horizon – everything around climate change will happen a few years down the line – and also complexity. “If you’re investing in wind farms there is a political risk and you may need to consider things like who will win the next election in Spain,” he says. 

However, Samama believes that new products like the recently launched MSCI Global Low Carbon Leaders indices, developed with the help of AP4, FRR and Amundi, offer a solution to these obstacles. 

“We say let’s take indices, the most liquid product. You take a classic index that investors already are invested in and switch to an index-light where you have almost no tracking error – it’s like diet coke; you don’t have the sugar but you have the market,” he says. 

The problem of complexity is further solved, he says, by trying to identify the companies that will be punished, rather than the winners.

The first aim of the coalition, as well as the aim of the PRI Montreal carbon pledge, is to get investors to start measuring and disclosing the carbon footprint of their investments. 

“The problem at the moment is that investors say that they don’t understand how [disclosing their carbon footprint] is going to help them,” says James Hulse, head of investor initiatives at CDP. “And just knowing what your carbon footprint is doesn’t tell you very much – that’s absolutely true. That’s just a static number.”

Rather, it is the analysis of what the companies are doing about their emissions and forward-looking data that is interesting, he says. 

“There is a lot of data that suggest a link between companies that have emission-reduction targets and better performing companies. The links between financial performance and carbon efficiency are still emerging but are becoming clearer,” says Hulse. 

Another obstacle has to do with data of companies’ emissions. The CDP has data from about 60% of the world’s companies and while Hulse notes that this is rising, the missing data needs to be modelled. 

He adds that more sophisticated and clearer guidelines for how investors should calculate their carbon footprint – which has been standardised for companies but not investors – is expected next year. 

Franzén notes that while the exercise did not result in any specific change in strategy, it has perhaps helped influence the fund and shape sentiment. This autumn, AP2 is again investigating its carbon footprint. 

“We have been thinking about updating this study for a while. But we haven’t decided exactly what we are going to do with the information as we are currently revising our ESG strategy,” he says. 

However, Denmark’s ATP – the biggest pension fund in the Nordic region – views climate change risk as one of many risk factors and appears unlikely to jump onboard recent investor initiatives. 

“ATP does not follow thematic investment strategies,” says Ulrik Dan Weuder, ATP’s head of alternative investments. “There are a lot of important risk factors in investments and climate-related issues can be one of these important factors. We integrate climate-related risk and opportunities in the specific investment decisions, where it is relevant.”

Asked whether ATP, which together with some Danish asset owners exited the PRI last year because of governance issues, is looking to sign up to any of the recent initiatives around climate change, Weuder responds: “We chose to sign and contributed to the development of the IIGCC Climate Statement,” he says. “In our view, this organisation represents European institutional investors on the climate policy issues.”

Several large Danish investors have also favoured a focus on renewable energy and other green investments. One example is PensionDanmark, which is aggressively looking to increase its exposure to such assets. 

Together with the Dutch pension fund APG and the US pension fund CalSTERS, PensionDanmark pledged to allocate more than €24bn to green investments by 2020 during the recent New York summit. 

An important observation, however, is that climate change risk in the equity portfolio is probably a more pressing concern for Swedish investors, which traditionally have much larger equity allocations than their Danish counterparts. 

One of the most drastic actions among Nordic investors to reduce climate change risk in the portfolio comes from the Swedish Church. Not only has it excluded all companies extracting fossil fuel, but it is actively looking for investments that will be the winners in a low-carbon economy and investments that will help such a transformation. 

Anders Thorendal, the Swedish Church’s chief investment officer, who manages its SEK6bn (€660m) assets, explains that the starting point was an attempt to streamline the investment policies in line with the values of the Church. 

The trigger was the 2008 inter-faith climate change summit organised by former Swedish archbishop Anders Wejryd to discuss with other religious leaders what could be done to fight global warming. 

“Since climate change was an important issue for the Swedish Church, we thought that this should be reflected in our investments,” says Thorendal. “So we went through our holdings, spoke to asset managers and realised that removing most of the fossil fuel companies from our investment universe would not involve any greater risk.” 

As a result, the Church excluded all companies extracting oil or coal. This summer, it revised its investment policy to make it more coherent and divested from its gas company holdings, which had previously been allowed. 

While starting from the point of view of its values, financial risk reduction has also become an important objective for the Church. Furthermore, the fact that the shift has not had any negative impact on returns has sped up change. 

“The focus has often been on just excluding companies. However, you should also focus on what’s good and not just what’s bad. We’re trying to find good alternatives – companies that will be the winners or that can make a difference in the shift to a more sustainable society,” says Thorendal. 

Last year, the Church measured the carbon footprint of its Swedish equity portfolio, primarily to gather hard evidence that its portfolio actually did what it was supposed to. Its carbon footprint was indeed a third lower than that of the Swedish equity market. 

Over the coming years, AP4 will continue its shift towards low-carbon investments. At the moment, about 15% of the fund’s global equity portfolio is invested in low-carbon strategies, but its target is to shift its whole global equity portfolio of $20bn (€16bn) to such strategies over the coming years. 

“S&P is now developing a low-carbon index for Europe which we will invest in, and together with Amundi we are creating one for Pacific ex Japan,” notes Andersson.

Like AP4, AP2 is also looking to come up with an index-based solution that can take climate risk into account. But its approach is wider than just being based on carbon emissions and aims to focus on companies from a more fundamental perspective. 

“The carbon footprint is one out of 30-something factors,” says Franzén. “There are a lot of factors that could be important for a sustainable business model – not just those linked to carbon emissions. This is a continuation of work that has been ongoing for several years and we’ll see exactly where we will end up.” 

AP4 refers to its low-carbon investments as a ‘free option’, meaning that the portfolio achieves the same returns as the traditional benchmark index until such time as the carbon emissions are priced in. When it happens, the low-carbon index will outperform the benchmark.

However, AP2’s Franzén notes that carbon emissions may have already been priced into the valuations of some companies. “I think it’s important to assess whether the carbon risk has been priced in or not – and not just assume that it hasn’t been and act on that. This may require you to look at things on a company level rather than an index or macro level,” he says.

The Swedish Church, which only uses managers with a sustainability profile, will continue to closely follow any innovation in the market that addresses climate change. 

“We will keep on looking at new products that are addressing these issues. Index-based solutions, like AP4’s initiative, are interesting but we prefer active management,” Thorendal says.