Environmental Risk: The Changing Climate: The seven-step programme
There is a clear route to making sure your portfolio is ‘future-proofed’ against climate change rather than a contributor to it, argues Raj Thamotheram. But, so far, very few investors are on it
There has been a sea change in investor attitudes to climate change in the decade since I started the Institutional Investor Group on Climate Change (IIGCC). Several funds that were initially sceptical have now joined and the IIGCC has been the catalyst for parallel projects in the US, Australia and Asia. Indeed, all the regional groups have now come together under a common banner, the Global Investor Coalition on Climate Change. And some asset owners – such as the Local Government Superfund of Australia and the UK’s Environment Agency Pension Fund – have made big steps to future-proof their funds and shift market norms.
I was always confident that, sooner or later, science and climate-related events would triumph over ideology and corporate capture of the political process. I do confess, however, to completely mis-judging how far and for how long things would slip backwards. Nonetheless, like an addict that has wasted several decades, today we are where we are.
Organisations as varied as the World Bank, International Energy Authority and PwC warn that we are on track for a world that is 4-6°C warmer. Investment gurus including Jeremy Grantham (“we should not unnecessarily ruin a pleasant and currently very serviceable planet just to maximise the short-term proﬁts of energy companies and others”) and Bob Litterman and, increasingly, mainstream consultancies like Mercers and Towers Watson have sought to translate these macro insights into investment decisions that are better future-proofed.
Critical as these technical solutions are, they are not on a scale commensurate with the damage investors have enabled, and continue to enable. Nor are these technical changes in line with the power the investment community has to trigger and support transformative change.
So what can be done to better safeguard the financial well being of pension fund members, current and future? Here is my seven-part strategy:
1. Acknowledge and adapt to the mother of all preventable surprises. Aside from those who are invested in denialism, we know the mother of all ‘preventable surprises’ is under way. Actually we face both an unpreventable component – which requires adaptation – and a preventable part – which calls for mitigation. Even if companies and investors do enterprise risk management (ERM) well – and many do not – ERM isn’t able to deal with some high-impact events even if they are high probability, man-made occurrences. The core challenge in doing what is needed – system-wide business continuity management – is not technical but rather more mundane: it’s career risk. Acting too soon and being too contrarian – even if this benefits pension fund members – is too dangerous. Framing the challenge in this way is the first step to dealing with it – and some practical actions are outlined below. I cannot emphasise enough how important it is that responding to climate change ‘ becomes part of the core investment beliefs and then gets pushed down into all aspects of the business. Moving well beyond statements of principle and niche allocations, this means a phased, multi-year plan with clear targets and accountabilities for reducing the risks of climate change facing the fund (such as impacts and stranded assets) and taking advantage of ‘no regrets’ actions (such as improved energy efficiency), as well as moving the market. Anything less represents a failure of fiduciary duty, not least because most institutional fiduciaries are legally required to seek to balance the interests of different generations of fund beneficiaries impartially.
2. Ensure public policy supports sustainable and resilient markets. Today, public policy largely does the opposite; the huge, perverse subsidisation of dirty energy companies is just one example. Investors have started to try to influence politicians but writing the occasional joint letter and going to essentially private meetings with policy advisers is certain to have minimal impact.
As EU Climate Commissioner Connie Hedegaard, said during a session I chaired at the 2012 IPE Awards Seminar event, this type of lobbying is simply dwarfed by those corporations who object strongly to change. Just a tiny bit of investors’ often unwise expenditure on chasing largely imaginary alpha, if pooled, would allow investors to have much greater collaborative public policy impact – and so safeguard the beta. Interestingly, in an anonymised poll taken before any discussion on this topic started, 70% of the IPE Seminar audience voted in favour of engaging in lobbying of this kind, and half of those were in favour of more assertive lobbying work.
3. Exercise stewardship authority with companies – on capex, political influence and pay. How companies allocate capex is critical both for alpha and beta. As McKinsey & Co comments: “While most perceive markets as the primary means of directing capital and recycling assets across industries, companies with multiple businesses actually play a bigger role in allocating capital and other resources across a spectrum of economic opportunities.” Institutional investors need to act like the owners they are and challenge company executives to demonstrate how they will deliver long-term cash flows in the transition to a low-carbon, resilient economy. Informed assertive engagement of this kind would, for example, divert capex from more unburnable fossil fuel assets – arguably a much more useful outcome than divestment.
And, most urgently, investors are owners of those companies that are actively blocking a suitable policy framework. This trend is most obvious in the US, Australia and Canada and is done both directly and via trade bodies/front organisations. Bizarrely, several well-respected companies that are pro-sustainability are also supporting these climate change denialist organisations. At the very minimum, owners should ensure boards are held accountable for this lobbying and therefore disclose what money is being provided directly and indirectly to politicians.
Of course, this work on capex and political influence really only makes sense if executives are truly incentivised to worry about the long-term health of the company. On this front, investors have been largely ineffective, if not worse. The challenge investors face is a dual one – to overcome flawed thinking about pay (evidenced by their inexplicably fundamentalist focus on flawed metrics like total shareholder return) and to better manage conflicts of interests (which prevent investors from being assertive on behalf of the end-beneficiary clients). Joining projects like the Carbon Disclosure Project is great but no alternative to meaningful stewardship activity (see graph). What is needed is not simply better reporting but actual major reductions.
4. Re-engineer the core investment processes and re-tool the investment supply chain. Long-horizon, highly-diversified investors have no reason whatsoever for using capitalisation-weighted indices which often result in a serious overweighting of dirty energy and heavy energy users. As Sir Richard Lambert, former director general of the
Confederation of British Industry, has said: “It never occurred to those of us who helped launch the FTSE 100 index 27 years ago that one day it would be providing a cloak of respectability and lots of passive investors for companies that challenge the canons of corporate governance.… Perhaps it is time for those responsible for the index to rethink its purpose.”
Of course, the same holds true for S&P and all other index providers. There is an urgent need for a mainstream, climate-savvy index which helps promote better long-term risk-and-reward decisions by shifting capital away from dirty to clean energy companies.
And, similarly, institutional investors should be doing much more to incentivise sell-side and credit-rating agencies to bring climate-related risk into account. The goal should be to avoid carbon-toxic IPOs and bonds, so enhancing the ‘climate proofing’ of their portfolios.
Fund managers and even asset owners have been far too timid in terms of using the obvious remuneration and risk management levers to increase the focus of their investment and sales staff on investing as if the long-term matters. With better leadership, this could change, and change fast.
5. Engage with market gatekeepers – auditors, investment consultants and regulators. Because climate change is now an issue that threatens market stability it should be integrated into investor dialogue with policymakers, financial regulators and commercial gatekeepers. For example, for integrated reporting to work, the rate at which externalities such as climate change are priced is key. If low carbon price assumptions are used, then the base investment models of fossil fuel companies look (misleadingly) attractive. This means they raise more capital, which means investors are reluctant to price carbon as they need the returns – and so on. IAS 36 on impairment of assets allows management, assisted by their auditors, to choose their own externality assumptions. Investors should ensure auditors – who exist to make sure investor needs are met – adapt. Similarly, there is a strong case for asset owners supporting a project to benchmark investment consultants on their own sustainability performance.
6. Evolve from cleantech funds 1.0 to hedging climate risk. Typically, fund managers react to macro issues by developing thematic funds and there is no shortage of green, clean tech, water, agriculture and numerous other vehicles. Like all other active fund management, a few are good, an equal number are bad and there is much in between.
There is no possibility of large institutional investors scaling up these niche funds, nor is there much evidence of the insights from these niche funds being transferred into core investment activity. In many ways, they have served as a distraction away from a systemic response – notice the many press releases about wind farm and solar investments even though they represent a minor fraction of total assets.
What is needed is an aggressive and proactive approach to hedging climate risk. Although bearish on most off-the-shelf green funds, at least in the way institutional investors are using them today, I am bullish on investment opportunities related to the shift to an economy where mitigation and adaptation are taken seriously. This has started but must gather much greater pace. Infrastructure, real estate and bonds are the most obvious asset classes. In all cases, the need for capital requires even the biggest asset owners to actively collaborate. And it requires an active partnership with government to manage risks, as the Climate Bonds Initiative is showing.
7. Model the accountability that investors ask from corporations. Funds need to complete the cycle of accountability by reporting the climate performance of the assets they own as they do the financial performance. They have a duty to their beneficiaries to do this, and are facing increasing external expectations, notably the Asset Owner Disclosure Project.
But more than this, they need to do it to make sure they really are doing everything they can to better address climate change.
All of these seven strategies are important and mutually reinforcing. Today, 90% of investors do almost nothing to be part of the solution, thus enabling runaway climate change. The 10% of investors who are active are making tentative progress on some of the strategies above but few are doing all of them. None are doing all of them well.
Trying to address climate change with today’s investment system is not where any rational person would choose to start. But that is where we are. At a minimum, and given just how influential they are, investors should choose to do no harm – an investors’ equivalent to the Hippocratic Oath. If investors do not take this kind of action seriously and fast, they can expect to be forced into this by civil society and governments as these players, rightly, start to panic about runaway climate change.
Raj Thamotheram is an independent strategic adviser, co-founder of PreventableSurprises.com and president of the Network for Sustainable Financial Markets