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Special Report

ESG: The metrics jigsaw


Environmental Risk: The Changing Climate: ‘It’s precisely the “how” that matters’

ERAFP tells Rachel Fixsen how it applies its climate risk criteria across its whole portfolio

If investors want to reduce their exposure to climate change risk effectively they should avoid dealing with the issue separately, according to ERAFP, the €14bn pension fund for civil servants in France. Rather than creating a dedicated thematic pocket in their portfolio, or integrating climate change into risk management models for just one asset class, investors should take a whole-portfolio approach. This reduces the risk of introducing marked sector biases at portfolio level, but also ensures that the approach to climate change and other ESG risks is properly coherent and comprehensive.

“We think that no sector should be excluded from the investment universe,” says Oliver Bonnet, head of SRI at ERAFP.

“How can you expect to have an impact on climate change if you exclude the biggest polluters from the scope of your actions?”

As such, when ERAFP gets ready to invest in a new asset class – as it did with sovereign bonds in 2005, and subsequently with local authority bonds, euro and OECD equities, credit bonds, and listed small and mid-caps – it first relates its general approach to ESG to the specifics of these new investments.

For example, ERAFP is now beginning to invest in its first real estate mandates. Before launching into this, the fund considered in-depth how it should deal with the environmental dimension of these investments – and the issue of climate change in particular. It decided to focus not only on new eco-friendly programmes, but also on existing buildings that had a relatively low environmental performance but which also had significant room for improvement. ERAFP reckons that property accounts for 14% of European CO2 emissions, and while much has been done to cut the energy consumption of new buildings, the fund says the reduction of energy use in the existing building stock is still a big challenge.

Investors should also work upstream of the investment phase, ERAFP believes, by taking part in debates with regulatory authorities at national and international levels, for example.
The fund has joined the Institutional Investor Group on Climate Change, and says it plans to use this forum as a channel for promoting tools to support the creation of an efficient global carbon market based on a relevant carbon price.

ERAFP’s responsible investment approach is based on a charter of five principles it is committed to promote through all its investments. The principles are environmental protection; respect of human rights and the rule of law; promotion of social progress; promotion of democratic labour relations; and good governance practices and transparency.

For each asset class the fund is likely invest in, these principles are broken down into more detailed rating criteria to adapt the ESG rating/assessment framework to the specific features of each type of security and issuer.

For example, for corporate bond issuers the ESG assessment framework comprises 45 criteria overall. A weight is attributed to each criterion reflecting its importance in ERAFP’s system of values, with the management of greenhouse gas emissions accounting for a third of the environmental rating. The weight of this criterion is similar for the other types of issuers, such as governments and local authorities.

For government bonds, ERAFP has set a system of limits based on this ESG rating framework; the pension fund cannot overweight countries with low ESG ratings in its portfolio compared to the Markit iBoxx Sovereign index. Although these ESG ratings include a wide range of social, environmental and governance issues, climate change is one of the most heavily weighted criteria, making it very unlikely that any country lagging in the climate change area will be over-weighted in ERAFP’s portfolio.

Equities management is outsourced to external asset management companies, which are then responsible for implementing ERAFP’s SRI policy. While ERAFP defines the criteria, as well as how to analyse and weight them, it is part of each asset manager’s mission to customise and review the criteria according the exact nature of each sector and company.

Through the rating framework, these asset managers have to implement, the pension fund aims to have an overview of the company’s ability to handle climate change risk in a very broad sense.

“We want the analysis of climate change risk not to be limited to the emissions resulting from the company’s direct activity but also to cover related risks carried by its suppliers or via its products,” says Bonnet.

It is important, the fund believes, to focus on more than just quantitative indicators on CO2 emissions. These figures are often difficult to normalise – and consequently to use for comparisons – even within a sector, it says, pointing out that multinational companies often have diversified activities. Furthermore, relying on quantitative indicators alone to assess a company’s ability to manage climate change risk could introduce a bias towards large companies, because these tend to have better reporting tools.

A bias towards quantitative assessment can also result in contentious CO2 emissions valuation models being used to fill information gaps. As an example, ERAFP says some models calculate the CO2 emissions of companies that do not disclose full data, by using ‘emission factors’ relating to that firm’s various activities. These assume a particular activity leads to a certain level of emissions, no matter how it is carried out. “On the contrary, ERAFP considers that it is precisely the ‘how’ that matters,” Bonnet says. “By comparing how companies with similar activities strive to reduce their exposure to climate change risk, an investor will be more likely to distinguish between future climate change losers and winners.”

A forward-looking analysis should include not only the review of quantitative figures, but also the assessment of more qualitative elements such as the commitments and targets formalised at management level and the mitigation programmes that have been implemented, it says, and emphasises the importance of pairing all of this with a robust engagement policy.

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