Climate change and opportunities in active management
Asset managers are doing more to help investors and clients understand that managing climate change risk in portfolios is beneficial for future returns.
Why should investors care about climate change?
Climate change is the shift in temperatures, precipitation levels and extreme weather due to the greenhouse gases prevalent in the atmosphere. The latest report published by the Intergovernmental Panel on Climate Change suggests that it is now extremely likely that humans have been the main cause of global warming over the past 60 years. Between 1970 and 2010, global greenhouse gas emissions due to human activity increased by 80%. The year 2016 was the warmest on record since the World Meteorological Organisation started tracking global temperatures. These changing conditions will have profound and longlasting consequences for the world population and for its activities. Accordingly, investors should consider how directing capital towards or away from such activities creates risks for investment returns. Investing should be done with as much knowledge as possible of the potential financial implications of climate change.
Although it is very difficult to quantify the time, probability and scale of the impacts from climate change, the range of risks should nonetheless be considered and help inform the various decisions needed to make an investment. The fact that this might need to be done outside the traditional financial analysis framework, and requires creative solutions to be applied, is no excuse to ignore the importance of what is at stake. The effects of climate change disruptions are already being felt, slowly but surely sowing the seeds of change in many economies, industries and companies.
When environmental and social externalities, which too often fail to be priced correctly by the market, are taken into account, then the detrimental effects of climate change can start to be assessed. According to the International Monetary Fund, the ‘true’ costs that people pay for their consumption of fossil fuels include health-related problems, increased mortality, lower quality of life, damage to the environment and money unavailable for investments in other community goods due to hidden costs or the loss of capital invested in stranded assets.
Adapting to climate change could cost up to $500 billion per year by 2050, according to the UN’s Environment Programme, while ignoring its impact potentially poses a threat to sustained economic growth. We expect governments across the globe to increase regulatory pressure in order to address the long-term impacts of climate change and ensure stable economic structures. Companies will need to adapt and demonstrate their climate resilience at both operational and strategic levels.
A fast-evolving international environment
At the 21st Conference of Parties held in Paris in 2015, world leaders agreed that greenhouse gas emissions must be curbed in order to keep global temperatures well below two degrees Celsius above pre-industrial levels. As a result of this meeting, countries have pledged to reduce their greenhouse gas emissions in ambitious national plans. But those plans are only enough to take the world beneath three degrees Celsius of warming. Even with the best intentions, the shortfall is significant. This is an enormous challenge for society. Until recently, the US was an influential proponent of climate change action. Under the Trump presidency, this commitment has since faltered. It is possible that the US, which accounts for nearly 15% of global greenhouse gas emissions, will pull out of the Paris Agreement. This would be a drawback for the international community, but it is unlikely to put a dent in the transition to a lower carbon economy.
If the US seems to waver on climate change, other climate giants like China and India have emerged. Even though both countries count on fossil fuels to meet increasing electricity demand, they are committed to growing the share of renewable energy in the electricity mix, and do not consider this detrimental to future economic growth. India, the world’s third-largest carbon emitter, has put out an ambitious solar plan, with a target to install 200 GW by 2050. Wholesale prices for electricity generated by solar and wind power reached a record low in early 2017. Reforestation and similar initiatives will also help to offset 11% of India’s annual greenhouse gas emissions. China’s 13th Five-Year Plan (2016- 2020) introduces energy consumption reduction targets, and national carbon trading programmes based on a series of pilot schemes will be launched in 2018. It released an updated air pollution law, specifically targeting coal capacity.
Intervention by the international community has traditionally been considered the only way to steer economies on a lower carbon path. While political commitments help maintain necessary momentum, it is the economics of low carbon technologies (such as renewable energies or electric vehicles) that is currently supporting the shift. The technological advances and the cost competitiveness of non-fossil sources of energy should continue to drive change. Companies are also waking up to the notion that physical and regulatory disruptions related to climate change can have profound implications for business operations and may threaten the going concern. The challenge is now to articulate the relationship between climatic and business disruptions.
Making financial sense of climate change
Both the corporate and investment communities are waking up to the financial materiality of climate change; however, making financial sense of it remains an extraordinarily complicated endeavour.
In the UK, Mark Carney, Governor of the Bank of England and Chair of the Financial Stability Board (FSB), stated that the scientific evidence combined with the dynamics of the financial system suggests climate change threatens financial resilience and long-term prosperity. The FSB subsequently established a Taskforce on Climate-related Financial Disclosure. The primary goal of this framework is to facilitate the integration of climate change into traditional financial analysis by encouraging greater disclosure from companies. It also provides guidance on how asset managers and owners can use this information to achieve better investment decisions for the benefit of their clients.
Moody’s, the credit rating agency, recently announced that it would look to assess the credit implications of environmental and carbon transition risks. In particular, this analysis will put negative pressure on the credit ratings of oil and gas companies, many of which face lower demand for fossil fuels over time, combined with rapid technological changes and shifts in consumer preferences. Sovereign ratings were also amended to include an assessment of the exposure and resilience of a country to climate change risk.
Asset owner pressure with regards to climate change considerations is also mounting. A number of pension funds, particularly in Europe, are leading the way on understanding the financial implications of climate change risk. Initiatives like the Transition Pathway Initiative are also moving the needle on the issue and encourage investors to consider climate change risks in their models.
However, the lack of standardised and robust data on carbon usage and emissions makes it difficult to compare companies. Although carbon scenario analysis and stress-testing are turning into the new norm, the vast majority of companies’ management teams are still unable to share how their businesses would fare under different carbon constrained outlooks. This makes climate risk analysis at the portfolio level a challenge, while the variety of fund, asset classes and time horizons render the exercise arduous.
Climate change analysis as a value creation tool for investors
Asset managers can do more to help investors and clients understand that managing climate change risk in portfolios is a financial exercise that can help preserve, or indeed improve, future returns. As active investors at Standard Life Investments, there are number of ways we are looking to influence the wider uptake of climate-related considerations into the investment process. These include:
- improving the climate risk disclosure and publishing results of carbon footprint analysis, both at the asset class and portfolio level
- engaging with fund managers internally on the meaning of carbon analysis
- encouraging the companies in which we invest to recognise climate change risks and opportunities, as well as demonstrate to investors how they inform the business strategy.
In our view, these actions will help preserve the value of investments and deliver improved performance at a time when the transition to a lower-carbon economy is likely to cause significant disruptions to many business models. Only by assessing and measuring exposure to climate change issues at investee companies and in portfolios will investors be in a position to manage the risks, identify the opportunities and ultimately be better placed to achieve superior risk adjusted returns.