President Trump might have decided to leave the Paris climate agreement, but international support for the plan remains robust and has even been bolstered by the cooperation between China and the EU. The question around why we need to reduce greenhouse gases has now moved onto how this will work in practice.
For pensions schemes, questions regarding climate risk are set to become even more prevalent, so adding it to the trustee’s agenda and considerations in a timely fashion is crucial. However, addressing climate risk is rarely simple – and sometimes so daunting, it’s hard to know where to start. So, what to consider?
1. What are your ambitions?
First things first, consider whether the trustees want to actively help support the Paris agreement and make conscious changes to help the world’s environment, or rather just gather insight and understanding of the climate risks of today as an initial starting point. If the former, it is often best to include any ambitions around climate change in your ‘investment beliefs’ or the fund’s sustainability policies and go from there. The valuable insight gained from engaging on climate issues rather than explicitly incorporating them could over time help shape the schemes’ strategic asset allocation and slowly introduce a sustainability element.
2. How do climate risks manifest in your portfolio?
There is no way around it, climate risk is a material issue. We can break the associated risks down into two categories; physical risks such as floods that can endanger business continuity, and transitional risks, such as moving from the use of fossil fuels for transport, which mainly arise as a result of an overly abrupt shift to a lower emissions economy.
But the biggest risk is taking no action at all. It seems that in future it will be impossible to separate climate risk from even the securest investments. If we consider Government bonds for example, an increase in extreme weather conditions would mean more public funding to prevent damage and provide aid, potentially a subsequent decline in the country’s creditworthiness and, inevitably, loss of value.
3. So how do you incorporate climate risks in determining your strategic investment policy?
Trustees should agree the most appropriate way to integrate these elements to develop a climate-aware strategic investment policy for their scheme. With so many uncertainties regarding physical and transitional climate risks, this might seem an impossible area to navigate and can overwhelm even the most confident trustee. But, by providing insight into how climate risks could manifest themselves, we can, through the use of scenario analysis integrate these climate risks into different economic scenarios and help create a more informed investment decision making process.
4. What action is the right action?
When implementing an investment strategy, there are various ways to fulfil your ambitions regarding climate change, through both active and passive strategies. The trustees should look to enhance their existing strategic asset allocation, and this more often than not involves complementary use of both active and passive managers.
Useful elements across both active and passive strategies
· When selecting new asset managers focused on controlling climate risk elements, it’s worth considering how the execution, monitoring and reporting around these risks will be communicated
· Climate engagement: urge companies in which you invest to proactively manage climate risks and bring their activity in line with the Paris Agreement
· Indicate to legislative and supervisory bodies that you have an interest in ambitious action to limit climate change
Passive Investment Strategies
· Consider choosing specific climate benchmarks for equities or bonds, such as the MSCI Low Carbon Target index
Active Investment Strategies
· Consider excluding sectors and/or companies that have low scores on relevant climate metrics, such as their carbon footprint. However – it’s important to note that divestment does not necessarily contribute to an actual reduction in real world emissions and can limit engagement opportunities
· Consider a balanced combination of engagement and divestment – if a company’s response to engagement is insufficient you can then consider exclusion
· You could instruct your asset manager to use positive selection and to overweigh, or even exclusively invest in, companies that score highly on relevant climate metrics. This positive strategy can be expanded by including specific ‘green’ investments such as green bonds and investments in sustainable energy
A point worth bearing in mind is that inaction is a risk in itself when considering risk management in relation to climate change. However, these climate-conscious strategies often end up introducing additional investment specific elements; the market for green investments is not immune to economic bubbles and there is still a question mark around how legislation and a rigorous regulatory framework could develop specifically targeting ‘green’ investments. Finally, while climate risk is becoming a more meaningful element when setting an investment strategy, this should not replace the ‘regular’ sense checking and analysis of all the investment risks in the portfolio, to ensure an effective and well managed investment decision-making process.
Deon Dreyer, UK Managing Director.
