Special Report ESG: Carbon Risk, A changing climate

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  • Comparison of the global 2°C carbon budget with fuel reserves CO2 emissions potential

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A few years ago it would have been inconceivable. But last April, the €700bn Norwegian Government Pension Fund Global began considering whether it should sell its holdings in coal and petroleum companies. For the fossil fuel industry, the expert group’s report in December came as something of a reprieve. It found against wholesale divestment, but recommended exclusion on a case-by-case basis for companies that are “severely harmful to the climate”. 

Environmentalists decried a missed opportunity, and denounced the report as “business as usual”. 

“It refutes the idea that large investors have the responsibility to realign their investments with the goal of limiting global warming to 2°C,” says Arild Hermstad of Norwegian NGO Future in our Hands. 

But that one of the world’s largest pension funds – let alone one capitalised with profits from Norway’s oil and gas industry – will now consider “contribution to climate change” as a basis for excluding a company from its portfolio shows just how far the issue has risen up investment agenda. 

“This is a message to the rest of the market that ignoring this issue is no longer an option,” says James Leaton, director of research at the Carbon Tracker Initiative, an investor-focused NGO.


The pressure on investors to start thinking about climate change is coming from two directions. First, an increasingly vocal divestment campaign has emerged from US college campuses. Echoing the anti-apartheid movement of the 1980s and 1990s, it argues that it is “morally wrong to profit by investing in companies that are causing the climate crisis”, as Go Fossil Free, one of the leading campaign groups, would have it.

At a glance

• The impetus behind divestment from fossil fuel companies and other carbon exposures is growing.

• Pressure groups have mounted strong campaigns, but risk managers concerned about the value of ‘stranded assets’ are also influencing the debate.

• Even passive investors are looking for solutions, in the shape of ‘low-carbon’ and other alternatively-weighted or engineered indices, or at least ways in which they can assess the extent of their exposure.

• But divestment is not the only response – some investors emphasise the role of engagement with companies, others stress the importance of investment in clean and renewable energy.

That campaign has had some notable successes, such as Stanford University’s pledge in May to divest its $18.7bn (€16.2bn) endowment from coal companies, and the $851m Rockefeller Brothers Fund’s September decision to sell out of coal and tar sands. 

But the other driver has much wider relevance for the investment community: concern is growing about the risk posed by fossil fuel investments, especially the danger that some assets could become ‘stranded’ – rendered less valuable than expected or even worthless – by efforts around the world to rein-in greenhouse gas emissions.

Put simply, if the world is to meet the internationally agreed target to hold the rise in global average temperatures to 2°C above pre-industrial levels, climate science dictates that the vast majority of fossil fuel reserves will have to remain in the ground. A combination of carbon pricing and falling technology costs will make low-carbon energy sources more attractive, and demand for fossil fuels will, over the coming decades, collapse, taking with it many of the companies that discover, extract and burn them. 

 Comparison of the global 2°C carbon budget with fuel reserves CO2 emissions potential

The Cancun Agreement in December 2010 captured an international commitment tolimit global warming to 2°C above pre-industrial levels. It also noted the potential need totighten this target to 1.5°C. The Potsdam Climate Institute has calculated a global carbonbudget for the world to stay below 2°C of warming. This revealed that to reduce the chanceof exceeding 2°C warming to 20%, the global carbon budget for 2000-50 is 886GtCO2. By2011, the global economy has already used up over a third of that 50-year budget. Calculationsof global emissions published in Nature indicate 282GtCO2 have already been emittedin the first decade of this century from burning fossil fuels, with land use change contributinga further 39GtCO2. This leaves a budget of around 565GtCO2 for the remaining 40 yearsto 2050. This budget could be further contracted if a position is adopted to limit globalwarming to 1.5°C or even lower.The Potsdam Climate Institute also calculated the total potential emissions from burningthe world’s proven fossil fuel reserves, which came to 2,795GtCO2 – nearly five times thecarbon budget for the next 40 years. Consequently only one-fifth of the reserves could beburnt unabated by 2050 if we are to reduce the likelihood of exceeding 2°C warming to20%.Source: Carbon Tracker Initiative, ‘Unburnable Carbon – Are the world’s financial marketscarrying a carbon bubble?’ (2011)

This is a message that is increasingly being heard from within the energy industry itself. Lord Browne, the former CEO of oil major BP, warned a seminar in London in November last year that policies to address global warming pose an “existential threat” to the fossil fuel business. 


So how are investors responding? For many campaigners, the only appropriate course of action is complete divestment of all fossil fuel companies – and a number of endowments, foundations and US city pension funds have pledged to follow that route. However, as with any exclusion policy, reducing a fund’s investible universe will increase the volatility of its returns, and risk introducing underperformance against its benchmarks. 

And there are other arguments against divestment. 

“If we divest, other investors will buy the stock and nothing will change,” says Marcel Jeucken, managing director of responsible investment at PGGM, the Dutch pensions investment giant. “Engaging with companies is the best way forward. We need to work with them to create a new energy system.” 

The engagement of investors such as PGGM, and others via associations such as the Institutional Investors Group on Climate Change (IIGCC), is intended, among other things, to encourage longer-term thinking among energy companies, says Jeucken.

But selective divestment, starting with the most exposed companies, is proving increasingly popular. 

“As the risk of action [on emissions] rises, you start to move along the divestment curve, looking at equities that are at a higher risk from climate action,” says Natasha Landell-Mills, head of ESG research at Sarasin & Partners. Those companies that rely on higher-cost and higher-carbon fossil fuels are first in the firing line: “We are already moving along the curve at an increasing rate.” 

For example, the US coal sector has taken a hammering as environmental regulations in its domestic market and competition from cheap shale gas has hollowed out demand. Some analysts argue that the sector is unlikely to recover. Proposed greenhouse gas regulations from the US Environmental Protection Agency are targeting coal-fired power plants for the first time, while China – which uses as much coal as the rest of the world combined – has unveiled plans to cap its coal consumption by 2020, and its greenhouse gas emissions by 2030, if not sooner. 


A number of investors have announced plans for partial divestment. For example, in July 2013, Norwegian financial services group Storebrand announced it was excluding 13 coal and six oil sands companies over climate change concerns, specifically to “reduce Storebrand’s exposure to fossil fuels and to secure long-term, stable returns for our clients,” according to Christine Tørklep Meisingset, its head of sustainable investments, speaking at the time. In December last year, Norway’s largest pension fund manager, KLP, said it would exclude 27 coal companies, and Sweden’s AP2 says it plans to sell out of 20 fossil fuel firms. 

Other investors are looking for a response to climate risk with broader application than case-by-case divestment – especially for their passive or index-tracking holdings. One solution is to allocate capital towards indices that mirror the performance of benchmarks, but which are tilted towards lower-carbon companies. In September, MSCI launched a family of low-carbon indices that track the equivalent MSCI ACWI universes and promise less than 0.3% tracking error with a 50% reduction in carbon footprint, at the request of the Sweden’s AP4, FRR in France and investment manager Amundi. Both FRR and AP4 are to allocate $1bn to the strategy (see page 52). 

“We are convinced carbon is mispriced,” says Olivier Rousseau, FRR’s executive director. “If you can reduce dramatically your carbon footprint and potentially your exposure to stranded assets, but the expected return is not significantly different, that is very attractive.” 

However, as some investors note, climate risk is not a one-way street, and markets often overreact. 

“It’s often said that carbon risk will only go in one direction – it’s not true,” says Ossian Ekdahl, head of ESG at AP1 in Sweden. “It might be the case that carbon risk becomes overpriced.” The fund, which has commissioned environmental research firm Trucost to conduct a carbon-footprinting exercise, “will look at each company we own and think whether the risk is overpriced or underpriced”. 

Other investors are beginning to shift their portfolios towards asset classes that offer somewhat of a hedge against shifts in value from high-carbon energy companies to low-carbon ones. Clean technology or renewable energy funds promise to outperform as clean energy sources are increasingly favoured, say analysts. 

“There’s a positive story around the massive transformation of the whole energy sector,” says Landell-Mills at Sarasin. “A technological revolution is under way, which is enormously exciting, which will require capital and which offers the prospects of healthy, sustainable returns.” 


For investors starting to consider their responses to growing climate risk, there is no shortage of advice. 

“In the first instance, they should understand the risks, how they might manifest themselves,” says Jane Goodland, a senior investment consultant at Towers Watson. “We think there is merit in investors taking the time to educate themselves about the issue. They should be asking them how they are thinking about the topic, and how they are valuing fossil fuel companies in their portfolio – it’s about starting a dialogue.” 

Will Oulton, global head of responsible investment at First State Investments, says he would be surprised if asset managers were not looking at the potential long-term investment implications of stranded assets. His firm has set up a stranded assets working group, bringing together its responsible investment specialists and analysts covering sectors with fossil fuel exposure, which is set to publish its findings this March. 

“We’re looking at the issue through a risk management lens,” he says. “We’re stewards of our clients’ capital – if this is a long-term risk, we need to understand it.” 

A growing number of investors are taking the next step, and calculating the carbon footprint of their investment portfolio. Such a process is not new; Henderson Global Investors first calculated the carbon footprint of SRI funds compared with the FTSE 100 in 2006. But the practice is becoming more common – indeed, it forms the basis of the Montreal Carbon Pledge, an initiative organized by the Principles for Responsible Investment, which aims to sign up investors managing $3trn by September 2015. 

The initiative is partly intended to add momentum from the investment community to the Paris climate change talks at the end of this year, at which a successor agreement to the 1997 Kyoto Protocol is to be agreed. And this is an area where it is imperative that investors have a voice, argues Jeucken at PGGM. 

“It’s important to engage with politicians. We need a system that brings us to a low-carbon economy and a policy regime that avoids 

shocks to the system,” he says, adding that it will only be with the co-operation of the world’s 

policymakers that the systemic climate risk faced by universal owners such as PGGM can be managed. 


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