Special Report ESG: Carbon Risk, Leaving smaller footprints
It is now three years since the NGO, Carbon Tracker Initiative, published its influential report, Unburnable Carbon, introducing the concept of ‘stranded assets’ to the wider investing world. But the evidence, so far, is that the pensions world is still chewing that concept over.
At the UK railway industry’s scheme, Railpen, investment director Ciaran Barr is reluctant to say whether he thinks the ‘stranded assets’ hypothesis stands up or not. “What I would say is that you’ll find that there’s lots and lots of discussion, but very little actual concrete resolve one way or the other,” he observes. “There’s just lots and lots of chat.”
And this is from a scheme that has given this issue more than the average amount of thought. Back in 2009, it worked with CarbonSense on an audit of its financial exposure to carbon and fossil-fuel prices, before following that up with a 77-question, climate change-impact Risk Audit, drawn up in collaboration with HSBC and Linklaters and sent to more than 40 institutions doing its asset management, investment advice and actuarial work. More recently it has worked with Trucost on similar carbon-exposure assessment projects, and it is also one of the 770 institutional investors signed up to the Carbon Disclosure Project.
Barr says that Railpen accepts that there are basically four ways to think about the impact of ignoring sustainable ownership principles.
“They may make you more money; they may make you less money; they may harm the world your pensioners eventually retire in; or they may harm your reputation and your brand,” he explains. “So you think about stranded assets and everyone gets worked up about it – but what does that actually mean? How could it play out? It’s almost scenario analysis, to some degree – ‘war-gaming’ it, almost. How could stranded assets bite?”
As in all scenario analyses, small variations in input can result in wildly divergent modelled outcomes. CEO Chris Hitchen points out that things “look quite different” with oil at $45/bbl than they did when it traded at $115/bbl, as an example.
• Chris Hitchen and Ciaran Barr, Railpen: UK, £20bn (€26bn)
• Philppe Desfossés, ERAFP: France, €20bn
• Torben Möger Pedersen, PensionDanmark: Denmark, DKK170bn (€22bn)
• Frank Pegan, Catholic Super: Australia, A$6.5bn (€4.6bn)
• Simon Sheikh, Future Super: Australia, A$30m (€21m)
As such, while Railpen has implemented some low-risk or even no-risk measures – making sure its real estate managers take steps to make its properties as energy-efficient as possible, for example – it has not systematically screened out stocks or even re-weighted its portfolios to take account of the carbon-exposure assessments it has done.
“We haven’t tilted our equity portfolio towards or away from high or low carbon producers,” says Hitchen. “I wouldn’t rule that out, but it’s probably fair to say there are different views around our own executive table and there’d certainly be different views around the board as well, because the future is uncertain, we don’t know how it’s going to play out.”
As it happens, the analysis Railpen has done shows, “more by serendipity than design”, as Barr puts it, that the scheme is “slightly below normal on climate exposure and fossil exposure”.
Its situation is therefore rather similar to that at the French public sector pension fund L’Etablissement de Retraite additionelle de la Fonction publique (ERAFP), whose listed equities portfolio is 19% less carbon intensive than its benchmark.
This is particularly impressive, given the fact that ERAFP – a founding signatory to the Montreal Carbon Pledge of 2014 and a member of the International Investors Group on Climate Change (IIGCC) – has never actively focused on cutting down its carbon exposure. It has an SRI process in place, for sure, but the broad environmental aspects only constitute about 20% of it.
“The idea is that our next step is to de-carbonise, and it is something we have already started with one €750m mandate that we have awarded to Amundi,” says CEO Philppe Desfossés. “This will be an experiment in de-carbonising, but we are confident in its success because it is based on a process that has already been implemented at AP4.”
How does ERAFP know that its equities are 19% less carbon-intensive than its benchmark? Because in 2014, in collaboration with environmental data consultancy Trucost (which also works with Aumndi), it became one of the world’s first institutional investors to publish a complete audit of its listed stocks’ carbon footprint.
“Pension fund beneficiaries have the right to know the level of the risk assumed by the managers to whom they entrust their money and among those risks carbon is obviously one of the biggest,” Desfossés reasons. “ERAFP would prefer to invest in companies that register the lowest carbon footprint for every €1m of turnover. Sooner or later there will be a price on the negative externality that is CO2. It is the responsibility of long-term investors to ask for a communication of carbon footprints and it should be on a broad basis: this means that, for banks, we should ask the carbon footprint for every million of net banking income, for example.”
Getting this granular data is important if investors do not want to take the simpler, but very broad-based, sector-exclusion approach to carbon exposure. It would be easy simply to cut out high-carbon footprint sectors like energy or utilities, or sub-sectors like steel production. But ERAFP’s entire SRI process works on a best-in-class basis. There are active sector weights against its benchmark – but Desfossés says that of those 19 percentage points of carbon-exposure reduction, only eight are attributable to these sector tilts.
“It was good to see that we could deliver such a significant result without taking a huge amount of sectoral risk,” he says, as this is the objective of the strategy it is pursuing with Amundi.
The comprehensiveness and quality of data is clearly critical to this exercise. Desfossés says that a lot of companies are now reporting on carbon and that the main challenge now is to go deeper with the analysis, looking beyond the companies in the immediate portfolio to consider their products and their supply chains.
“This throws up all sorts of technical issues and problems, from double-counting onwards, but we have to start somewhere,” he says. “The more that institutional investors join this movement for CO2 reporting – and the Montreal Carbon Pledge is all about that – the more incentives will increase to do the reporting, but also the more academics and commercial organisations will get involved in collecting and analysing the data and the better it will become.”
He adds that the process will also make institutional investors better all-round risk managers and, ultimately, create a virtuous circle whereby commercial businesses will begin to re-think their business models in the light of what their carbon reporting reveals to both themselves and the providers of their capital.
One way the energy and utility sectors might re-think things, he suggests, is to consider spinning off those businesses engaged in developing low-carbon and climate-resilient technologies. This would alleviate a problem faced by carbon-conscious investors – some of the firms with the biggest carbon footprints support divisions engaged in the most significant work to reduce the economy’s carbon intensity. It might also make it easier for those businesses to attract capital from the carbon-conscious.
Desfossés insists that the hard work that it takes to generate meaningful and actionable data across an entire portfolio of assets will ultimately make more of a difference than investments in big one-off clean-energy projects, for example.
“The best-in-class approach is very diffuse, and that’s the problem with it from a PR point of view,” he says. “We understand that it’s much sexier to build windfarms because people actually get to see stuff. Politicians like to be photographed in front of windfarms. But if you take into account the amount of public subsidy that goes towards supporting these transactions and projects, what is the real balance of benefit? What if that subsidy was used instead properly to insulate public housing? As McKinsey identified some years ago, the biggest bang for your buck comes from low-hanging fruit like this.”
He similarly feels that “catchy phrases” such as the ‘clean trillion’ idea put out by the sustainability advocacy group Ceres (the annual investment it claims is required over the next generation to limit global warming to 2°C) would be more meaningful if it acknowledged the efforts of investors like ERAFP to assess and reduce whole-portfolio carbon exposure, rather than simply focusing on big, visible clean energy projects.
“We are convinced that we will only win this war if we are able to persuade all economic agents to change their business models,” he explains. “The positive externalities from research and technology that result from investment in renewables are fine but, objectively, renewables are often very poor in terms of their contribution to solving the big problem. Having 5% of the economy running on renewable energy means nothing if the other 95% is not as sustainable as it could be.
“That’s why I think we need more structural measures, such as more transparency on the carbon footprint of the stocks portfolios of large institutional investors. Including these efforts in initiatives like the ‘clean trillion’ could be the way to reconcile the piecemeal approach – green bonds, projects and so on – and the global one that is less spectacular but much more effective.”
At PensionDanmark, CEO Torben Möger Pedersen has little patience with selling securities in the name of carbon or fossil fuel exposure – whether to disinvest entirely or merely to re-balance for risk-mitigation.
“I think that we should act, as investors, to try to prevent climate change above the 2°C target, not only for the planet, but also to protect the savings and returns of the members of our pension plans,” he insists. “But I don’t think the divestment approach is very constructive. It’s a very defensive approach and does not provide any active investment in renewable energy or other climate-related assets. If I sell our stocks in oil and gas companies, say, they will just be bought by somebody else. That results in zero impact on the climate agenda.”
Instead, he emphasises the importance of “positive” investment programmes in renewable energy infrastructure, energy grids and energy-efficient buildings, pointing to the “very ambitious” plans the UK and Germany have for offshore wind and energy-grid development over the coming decade, and to the €300bn-plus investment plan recently announced by European Commission president Jean-Claude Juncker.
As such, PensionDanmark decided three years ago that all new buildings with which it is involved as an investor must be constructed in line with the highest levels of energy-efficiency standards, and more recently, it has committed to allocating 10% of its members’ DKK170bn (€22.9bn) in assets to direct renewable energy infrastructure. Möger Pedersen says this should result in the capacity to generate green power equivalent to the annual consumption of all 640,000 and more of PensionDanmark’s members.
Just because the fund does not think of climate change entirely in terms of downside risk, that does not mean that it does not see this issue as one of investment risk at all. Rather, investors like Möger Pedersen prefer to focus on upside risk, on the investment opportunity it presents.
For example, he makes the point that energy-efficient building practice is not just good climate practice but also good business practice.
“These high-quality office buildings attract high-quality tenants that are able to see that the total costs of occupying them – rent-plus-energy costs – are actually lower than the costs of occupying an old-style, less-efficient office,” he observes.
More broadly, he sees opportunity in the coming together of two themes in finance.
“Without even taking the climate impact into account we think that pension funds should be exploring these opportunities because the traditional sources of financing have dried up significantly: government budgets are stressed all over the world; utilities are trying to reduce their balance sheets in order to support their credit ratings; and banks are no longer making the same amount of project-financing available,” he explains. “At the same time, all investors face the challenge that bond yields are extremely low and they need to find returns that meet their requirements without the volatility that we associate with equities. We find that there are a group of renewable energy infrastructure projects that do indeed provide us with this kind of attractive risk-and-return profile.”
Turning to Australia, Catholic Super’s strategy regarding climate resilient investments is based on the same risk-and-reward principle as its conventional assets, according to CEO Frank Pegan.
“We believe that there are opportunities out there if you are prepared to take the risk, because there is evidence to suggest that the climate risks will increase the longer there is a delay in implementing carbon reductions at the global level,” he says. “What we find is that there are a lot of opportunities in the green space if you are prepared to do your homework and if you are prepared to follow through.”
The financial crisis of 2008 led many governments to scale back their climate mitigation policies and postpone the introduction of limits on CO2 emissions. Since then, most clean energy funds have underperformed indices such as the S&P500 or NASDAQ100.
Managing A$6.5bn (€4.6bn) on behalf of 80,000 participants within a Christian ethical framework that emphasises the values of “honesty, trust, respect, openness and compassion”, and which includes adoption of the UN Principles on Responsible Investment, Catholic Super currently has about 8% of its portfolio in low-carbon assets. These investments aren’t restricted to any defined geography or asset class. Catholic Super’s balanced risk portfolio has a 27% allocation to Australian shares and a separate 27% to overseas shares. Allocations to property, private equity and growth alternatives are 8%, 3% and 6% respectively, while fixed income, cash, infrastructure and defensive alternatives make up the rest. Among its ‘green’ holdings are a US fund developing PVC solar projects, and the Global Energy Efficiency and Renewable Energy Fund (GEEREF), a fund of funds that is a public-private partnership advised by the European Investment Bank Group. In its real estate investments, Catholic Super invests in buildings with a higher-efficiency rating under the National Australian Built Environmental Rating System.
“By adopting normal investment practices – by taking asset allocation as a key factor and combining that with a risk-and-return profile to which we are working over the medium and long term, we ended with about 8% of our portfolio in climate-resilient assets,” he explains.
Pegan says that its investment in “climate-resilient” assets has helped Catholic Super’s portfolios return between 8% and 12% annually, and he expects the 8% allocation to continue to grow, since it has helped with risk diversification. In addition, he notes that as Catholic Super grows, its investment horizon becomes longer and, as such, climate change and sustainability risks becomes more significant for its portfolios.
“If you invest in a company and its carbon footprint is going to be a risk in the future, then you have to seriously look at it,” he suggests.
Catholic Super has been approached by NGOs with the idea of fully divesting its fossil fuel investments. However, Pegan says the divestment model isn’t Catholic Super’s approach towards investing in carbon-free assets.
“We all want to transition to low-carbon economies but we cannot do it at the expense of my retirees, or the welfare of the communities of the world,” he insists. “We start with the premise – what is the risk and return? If it stacks up and it is investing in a green asset, we will do that. To me, investing is about the planet, the people and profit; all three are needed to transition successfully to a low-carbon world.”
Staying in Australia, but moving to a fund with a very different approach to fossil-fuel risk, we come to Future Super – tagline ‘Fossil Fuel Free Superannuation’ – where the ‘stranded assets’ thesis is taken very seriously on behalf of the A$30m of members’ assets.
“Investing is about attempting to predict the future – and the future of the fossil fuel industry is becoming all too clear,” says founder and managing director Simon Sheikh.
While other strategies adopted by Australian pension funds include divesting from thermal coal exclusively or divesting from companies with more than 20% exposure to fossil fuels, Future Super takes pride in its claim to be Australia’s first and only completely fossil fuel-free superannuation fund. Launched in September 2014, Future Super has seen “huge growth in recent months as part of the popular push for climate action”, says Sheikh.
Future Super’s investment mandate is to redirect retirement savings away from activities that “harm the environment and society”. Structured as a balanced growth fund, it has a diversified portfolio with 70% in growth assets such as shares, and 30% in defensive investments, which include cash and fixed income. Its investment universe includes 120 listed Australian companies approved by an investment committee comprising investment professionals, superannuation experts, and company ethics and sustainability researchers. The investments are managed by Grosvenor Pirie Management, which buys and sells stocks within the approved stock list.
Sheikh points to the fact that more and more fund managers are measuring the carbon exposure of their investments. This includes companies involved in the exploration, extraction, transportation, burning, and financing of coal, gas and oil.
Future Super does not invest in Australia’s big four banks, National Australia Bank, Commonwealth Bank, The Australia and New Zealand Banking Group and Westpac. This is because between 2008 and 2012, these banks loaned at least $6.5bn to coal and gas ports on Australia’s East Coast, many inside the Great Barrier Reef World Heritage Area.
The fund has a small allocation to real estate. Sheikh said Future Super has met with infrastructure managers who are keen to screen their investments to remove fossil fuels and the fund also vets its fixed income, property, cash and listed equities investments for coal, or oil and gas, activities. Future Super also screens out government bonds from states and territories that use public finance to provide significant subsidies to the fossil fuel industry. A positive development for the industry is National Australia Bank’s announcement in December that it plans to offer seven-year Australian dollar notes that comply with international standards for climate bonds. It would become the first of the country’s lenders to sell bonds to fund environmental projects.
“The move for fossil fuel-free investing is active across all major asset classes, from venture capital to property and beyond,” says Sheikh.