Why should institutional investors be concerned about climate change?

Todd Bridges, Head of ESG Research at SSGA gives his view on why investors need to consider climate change and how to incorporate this into their internal risk management and strategic asset allocation.

Q: Why should institutional investors be concerned about climate change? When should they act?

A: The world’s scientific community has reached consensus that human influence—particularly anthropogenic greenhouse gas emissions driven largely by economic and population growth—has been the primary driver of global warming and changes to the climate system. The IPCC Fifth Assessment Report indicates that “historical emissions have driven atmospheric concentrations of carbon dioxide, methane and nitrous oxide to levels that are unprecedented in at least the last 800,000 years, leading to an uptake of energy by the climate system”  (IPCC, 2016). Many of us believe that climate change presents significant risks to our economic, social, and political systems. Research by The Economist Intelligence Unit estimates the value at risk from climate change ranges from $4.2 to 43 trillion over the course of the 21st century. While it is often assumed to be the responsibility of international agencies and national political leaders to solve the impacts of climate change, we believe that capital markets and institutional investors play a crucial role in any potential set of solutions. In particular, institutional investors through innovative risk management and long-term strategic asset allocation can help play a positive role in climate change solutions—by allocating capital away from inefficient and heaving carbon polluting companies to those that are positioned to take advantage of the multi-decade transition to a low-carbon economy.  

Q: How can institutional investors connect climate science to their internal risk management and strategic asset allocation decisions?

A: Over the last decade, there have been a number of helpful frameworks designed to guide capital markets and institutional investors to align their risk management and strategic asset allocation decisions with the future impacts of climate change. For example, frameworks have been developed by the United Nations Framework Convention on Climate Change (UNFCCC), UNEP Finance Initiative (UNEP FI), United Nations Global Compact (UNGC), Principles of Responsible Investing (PRI), World Resources Institute (WRI), International Energy Agency (IEA), Carbon Tracker Initiative, 2 Degree Initiative, and Mercer. Central to all of these projects is the requirement that asset owners, asset managers, and financial intermediaries need to become aware of their carbon exposure across the total portfolio. As such, the first step in evaluating the potential risks and opportunities institutional investors are facing in the transition to a low-carbon economy is reviewing their carbon footprint—which gives insight into the potential carbon risk or value at risk from climate change. The diagnosis of carbon emissions in the portfolio is a necessary but not sufficient first step to determine GHG emissions from scope 1, scope 2, scope 3 and embedded fossil fuels. The second step is to assess how best to manage these risks imposed on the portfolio (i.e. regulatory risks and stranded asset risks) while staying invested during the long-term transition of the economy. The third step is to assess what options are available for limiting these carbon risks to the portfolio and developing a strategic asset allocation over a sufficiently long time horizon. The final step is to implement the strategic decision into an actual investment strategy or product. For example, asset owners can work with their external managers to design and build an investment strategy that reduces carbon emissions, reduces fossil fuel reserves, increases exposure to the low-carbon “green” economy, and increases exposure to companies that are adapting to the future impacts of climate change.

Q: What existing climate-related products and indices have helped investors make better decisions and improve performance?

A: Climate-related products and indices are still fairly new in the industry.  Only a handful of active managers we know of are integrating climate issues as an explicit focus area in their strategies.  On the indexing side, there have only been a handful of products released to date, mostly focused on reducing carbon exposure. 

As pointed out by Dr. Richard Mattison, CEO of Trucost, there is a general assumption by market participants that low-carbon investment could lead to poor financial outcomes. However, recent research demonstrates that this assumption does not have to be the case if the strategy and indices are designed properly. In fact, low-carbon versions of the S&P 500 were found to outperform their benchmarks over one, three, and five year periods. Our own research has found that not only are their performance implications for firms that are low carbon emitters relative to their sectors in recent years, there are also performance implications for other climate metrics such as those that capture firms’ investments in green technology. The climate strategy we have developed combines different aspects of climate. Specifically our strategy doesn’t just focus on reducing carbon exposure today but identifying those companies which are positioning themselves for climate change in the future.

Q: Where are the biggest hurdles in adoption of sustainable climate strategies by asset owners, and where are the product gaps in the market at the moment?

A: Broadly speaking, the biggest hurdles in the adoption of sustainable investing—both ESG and climate-related strategies—by asset owners are education (assumptions, misconceptions, integration methods), data quality (disclosures, standards, data treatments), and building teams with expertise (ESG, climate, IT). In addition, for climate-related strategies there is also the additional hurdle to provide insights into the complex nature of climate change, the longer time horizons of the associated risks, and role of capital markets to potentially help mitigate the negative impact modeled in the climate projections over the course of the 21st century.

These hurdles directly impact the product gaps in the current market for sustainable climate strategies. In particular, most existing products focus on one parameter of a sustainable climate strategy but neglects other parameter or, potentially, is counterproductive to the full integration solution that aligns with both the mitigation and adaptation that is needed over the 21st century.  For example, there are a number of existing climate-related strategies that have been designed with a methodological approach to remove all carbon emissions and fossil fuels (divestment strategies). The resulting portfolio or index removing huge sectors of the portfolio (energy and utilities) while taking on significant tracking error. Additionally, these divestment strategies do not allow for asset owners to stay invested in those highly efficient carbon emission companies (relative to peers), or those companies in heavy carbon sectors that are moving to more sustainable or new energy production processes. Another existing climate-related product found in the market that potentially leaves a gap for future innovation is that designed around a rules based portfolio construction process. In particular, any rules-based methodology used to manage multiple climate parameters (carbon emissions, fossil fuels, green revenues, etc.) cannot efficiently optimize the risk-adjusted returns for clients. As a global asset manager who holds our fiduciary responsibility as the central duty to our clients, we believe that research and strategy design needs to systematically focus on risk-adjusted returns.

Q: How is State Street Global Advisors helping clients overcome these climate-related risk management and strategic asset allocation decisions?

A: We have created an investment strategy which mitigates climate change issues in an investable portfolio. We have built a sustainable climate strategy from the ground up using the best-in-class climate data to directly align with the latest climate model projections and scenario pathways. The strategy is designed around a “mitigation and adaptation” thesis. The mitigation section of our sustainable climate strategy involves an explicit objective to reduce the flow of heat-trapping greenhouse gases—from carbon and fossil fuels—into the atmosphere and increase exposure to new energy “green” companies. The adaptation section of the strategy involves an explicit objective to increase exposure to companies adjusting to actual or expected future climate impacts (i.e. the physical impacts of climate change). Taken together, mitigation and adaptation are complementary approaches for reducing risks of climate change impacts over different timescales—which aligns nicely with our asset owner’s need to balance short-term risk and longer-term opportunities. The final strategy brings together best-in-class climate data, advanced data analytics, and innovative portfolio construction techniques to achieve the best risk-adjusted portfolio for clients. The strategy achieves significant reduction in the exposure of carbon emissions, emissions from fossil fuel reserves, revenues dependent on carbon-based sectors, and significantly increases exposure to revenues from low-carbon “green” companies who are adapting to the future impacts of climate change.   

Todd Bridges, Head of ESG Research at State Street Global Advisors will be speaking at the Sustainable Investment Forum in New York on the 26 September 2018. To join him and find out more about why investors should be concerned about climate change, visit www.sinvforum.org