Environmental Risk: The Changing Climate: Pricing climate change
The physical and regulatory risks from climate change already exist. But Nina Röhrbein finds that the pricing signals remain suppressed by still-evolving regulatory frameworks and a lack of data
December 2012’s UN climate change conference in Doha saw the extension of the Kyoto Protocol, which sets binding targets for the reduction in greenhouse gas (GHG) emissions by participating countries. Prior to that, in 2010, governments agreed that emissions needed to be reduced so that global temperature increases are limited to below 2°C.
However, in its World Energy Outlook 2012, the International Energy Agency forecast that, according to its new policies scenario, energy-related CO2 emissions would rise from an estimated 31.2 gigatonnes in 2011 to 37.0 gigatonnes in 2035, which would lead to a long-term average temperature increase of 3.6°C. A lower rate of global economic growth in the short term would make only a marginal difference to longer-term energy and climate trends.
Combating climate change is not an easy battle. It is no wonder that it is also proving difficult for investors to address the issue in their core investment portfolios.
Investors first need to be aware of the threat climate change poses to their investments.
The key risks from climate change on investor portfolios are regulatory risks such as international, national and regional regulations on greenhouse gas emissions; and physical risks, such as droughts, floods, storms and rising sea levels. Regulation may affect an organisation financially by putting a price on CO2 and other greenhouse gas emissions, while physical risks can affect specific sectors such as fisheries, forestry, healthcare and insurance. Company-specific risks include competitive, litigation and reputational risks.
“The Thai floods in 2011, for example, crippled the global computer-hard-drive industry as well as parts of the automotive supply chain,” says Chris Davis, director of investor programmes at the Boston-based sustainability leadership advocate Ceres, which runs the Investor Network on Climate Risk (INCR).
“The physical impacts, particularly in the US, have dramatically increased lately. In 2011, we had 12 over-$1bn (€759,000) disaster losses attributable to extreme weather, and due to hurricane Sandy and the droughts in the Mid-West 2012 will probably be worse. The insurance sector is particularly heavily impacted and insurance can make up a big part of equity portfolios, as well as other asset classes. Coastal infrastructure, such as that in the oil and gas sector or the tourism, travel and hospitality industry can also be significantly impacted. In New Jersey, post-Sandy, for example, some coastal communities were temporarily unable to fulfil their monthly interest payments on their bonds.”
Heads in the sand
Given these risks, investors primarily need to understand how their portfolios are positioned around them, says Mark Robertson, head of communications at ESG investment research provider EIRIS. “They need to know who the better and worse performers are and develop a strategy for dealing with poorer performers,” he argues.
There are indications that parts of the pension fund industry do seem to be approaching a turning point: the Asset Owners Disclosure Project (AODP) Global Climate index 2012 shows that some are genuinely attempting to change the structure of their portfolios in order to manage climate change, for example. But it also suggested that many asset owners still have their heads in the sand over climate risk, particularly in Asia and North America.
The survey found that a lot of pension funds do not have a climate policy and many of those that do have not changed any of their investment decisions as a result.
“Beneath that leadership pack there are funds that are signed up to the idea of managing climate risk – they might be signatories to the Principles for Responsible Investment (PRI) or Carbon Disclosure Project (CDP) – but have no material information to prove that, at an investment level, they are doing anything to manage climate change,” says Julian Poulter, AODP’s executive director. “The remainder of the industry is conducting business as usual. Those are the funds which, when climate change manifests itself through some kind of market re-pricing events in the 2020s, shrug their shoulders and say it has nothing to do with them.”
Whether and how to address climate risk in investment decisions depends on the investment beliefs of the individual pension fund and its resources allocated to responsible investing in broader terms. According to Steffen Hörter, co-head investment consulting and analytics at Risklab, the specialist investment and risk advisory subsidiary of Allianz Global Investors, for any pension fund that intends to change its investment strategy there should be a chain of causality and of quantitative argumentation, in addition to qualitative argumentation.
The difficulties in establishing this chain in terms of climate change stops some pension funds from assessing this risk in their portfolios at a time when, due to the financial crisis, the topic is of much lower priority anyway.
“Based on the surveys we have undertaken, the most immediate reason for integrating climate change in portfolio analysis is a price on carbon,” says Stephanie Pfeifer, executive director at the Institutional Investors Group on Climate Change (IIGCC).
“The biggest barrier to integrating climate change risks into investment analysis remains regulatory uncertainty, limited regulation or frequent changes to the regulatory regime, which prevent market signals that would require a more immediate proactive stance from pension funds. With the introduction of the European Emissions Trading Scheme (ETS) investors have had to integrate a carbon price into their analysis of sectors covered by the scheme. Where policy incentives exist, investors will start focusing on an issue and it becomes almost a standard part of their investment analysis. It is much easier to quantify policy risk when a policy like carbon pricing is in place. Even if the carbon price is low – as it is currently the case, with €6.64 per tonne carbon dioxide EU emission allowance (EUA) in mid-December – it is still integrated into the analysis because the broker model does that automatically. If it is too low, however, it does not have an impact on companies’ investment decision-making, which is why the IIGCC advocates measures to push up the carbon price.”
In the US, investors are mainly focused on physical impact risks – such as the consequences from hurricane Katrina on the oil, gas and petrochemical infrastructure in the Gulf of Mexico – due to the absence of a comprehensive carbon-pricing scheme.
Some pension funds take a top-down strategic approach, looking at climate risk from an asset allocation perspective and following recommendations from Mercer’s 2011 ‘Climate Change Scenarios – Implications for Strategic Asset Allocation’ report. From a bottom-up perspective, one of the simplest ways to assess climate change risks in an investment portfolio is through carbon and water audits of the companies it holds, which can also help to assess where funds are more exposed to climate risk than regional or global benchmarks.
Risklab quantifies environmental risk through the implied carbon footprint of industries and measures the risks based on an unexpected price hike of carbon emissions. In its research, this was concluded to be a significant tail-risk factor, particularly for industries with a high carbon footprint.
In its ESG portfolio strategy analysis, Risklab leverages the research from Allianz Global Investors’ global ESG team to build quantitative assumptions for modelling carbon risk, and analyses how carbon risk and other ESG risk improved equities and corporate bonds could contribute towards reducing the extreme risk profile over the long term.
“For sovereign bonds, investors may want to consider ESG ratings which include environmental risk as part of the sovereign issuer analysis and for illiquid alternatives they may want to include an environmental and climate risk analysis before investment,” says Hörter. “Investors may also decide to enter renewable energy assets in order to contribute towards a de-carbonised world. Analysing concrete investment opportunities in the alternatives arena and the analysis of climate change risk in broader terms is crucial too.”
Finding and cleaning the necessary environmental data from portfolio companies is a cumbersome task for pension funds. Various data providers are able to supply that information – for instance, Trucost provides data on pollution and resource use to several asset owners, including the UK’s Environment Agency Pension Fund and Railpen, and AustralianSuper – but the challenge often lies in the scarcity or quality of data that companies provide.
“The starting point for risk assessment has to be data and some companies still do not provide very good data about their environmental impacts,” says Lauren Smart, executive director at Trucost which, faced with data gaps, falls back on econometric modelling techniques to build a tool to convert business information into environmental information.
“And if they do produce data on their resource use and pollution, they might not report on the most material issues. Banks, for example, tend to report on recycling and electricity use, which is irrelevant in terms of material financial impacts – those lie in their loan books and the companies they invest in, which the Greenhouse Gas Protocol defines as Scope 3. Similarly, in the fast-moving consumer goods sector risk often lies in supply chains, which can be long and complex.”
Moreover, Robertson at EIRIS argues that investors need to find out what kind of greenhouse gases are being reported – is it solely carbon or also other greenhouse gases like methane? – and how are they being reported? “Are they normalised or not and do they refer to a company’s entire global operations or not? Is there a fall in a company’s emissions year-on-year because of its improvements on climate change, or simply because of the global financial crisis and lower production? A more standardised way of reporting is needed because, at the moment, reporting is often very disparate.”
Many of Trucost’s clients prefer to start with a carbon assessment because it is more tangible to them. But some clients have progressed to looking at water, too, which may have a greater financial impact in the near-term. An understanding of which portfolio companies use the most water globally can be used to build up a more detailed regional assessment where it matters most. Trucost also looks at supply chain risk exposure, land, air and water pollutants and a whole range of the natural resources that are used, which adds up to what the firm calls ‘ecosystem services’.
“Some factors are much harder to measure than others but environmental economists argue that if you do not try and measure natural resources that businesses depend on, their value by default is put at zero, which leads to damaging economic decision-making,” says Smart. “We worked recently to help one of our clients understand all of the natural capital issues across the spectrum, taking a regional approach. This, I believe, will be the future direction of environmental analysis.”
On the strategic asset allocation level, climate change risk assessments can also be approached through a deterministic scenario analysis based on the works of, for example, the Intergovernmental Panel on Climate Change (IPCC), which can reveal blind spots in investment strategies or beliefs. Investors would then discuss, with climate and finance experts, the repercussion of the various scenarios on the real economy and financial markets, and the long-term impact on different asset classes. Based on that, they may draw conclusions as to what asset classes, sectors or regions they would like to under or overweight but also how they want to engage with different industries.
“The problem with a scenario approach is that there is no direct conclusion over return and risk assumptions in terms of quantitatively-driven analysis,” says Hörter. “The different climate change scenarios are typically based on whether and to what extent global warming will exceed 2°C versus pre-industrialisation levels and what damage this will cause. It is not fully clear how to adjust those quantitative investment assumptions because there is no overall model integrating climate change and financial scenarios.”
Given the absence of an historic time series, at least in the context of the shorter history, climate change risk modelling, and translating the results into financial risk, remains a cutting edge process. “Climate change is a new type of risk factor and needs to be looked at intensively,” says Hörter. “Weather derivatives, which have a slightly longer history, are an example of how findings can be translated into financial investments, or catastrophe bonds.”
There is a long way to go before the appropriate pricing signals for climate-related risk are no longer absent, as they appear to be today. A big part of the reason for that is lack of progress on the regulatory frameworks necessary to set the context for those signals, which is why institutional investors are collectively calling on governments to implement policy changes and provide stronger regulatory frameworks through collaborative organisations such as the IIGCC.
“Ultimately, climate change presents a huge systemic risk to the whole economy,” as Davis puts it. “We need both national and global climate and clean energy policies to support investment in low-carbon assets because unless you get the right price signals and market signals there are not enough low-carbon assets to invest in. Therefore, collective engagement with policy-makers is also an important strategy for mitigating the risks arising from climate change.”