Opportunity and risk

While few people would challenge the assertion that climate change is a real and growing threat, most pension funds have not begun accounting for the risk it poses to long-term asset value.

Those venturing into green investments have predominantly been return rather than risk focused, taking a thematic, satellite approach.

However, experts have called for environmental considerations to be moved to the core of portfolios as no asset class can remain untouched.

“The physical and regulatory risks of climate change are accelerating,” says Insight Investment head of responsible investment, Rory Sullivan.

“Schemes’ risk exposure is therefore growing, but investment practice and risk management do not appear to be following suit. Some promising signs have, however, begun to emerge. Mercer associate in the responsible investment team Rebecca Dixon says the volume of signatories to the UN Principles for Responsible Investment is encouraging. 

Despite this, few schemes have taken decisive action against environmental risk. According to Fortis Investments head of sustainable and responsible investment Stewart Armer, there are indications that a few large schemes are starting to think about practical measures to protect themselves over the longer term. “But this is the exception, not the rule,” he says.

Green funds have become increasingly popular in recent years, driven by growing public and political awareness as well as improving returns.

According to Sullivan: “There has been much more interest in investing in clean technology and alternative energy. The drivers have included regulatory changes, the strengthening scientific evidence and the high media profile of climate change.” Sullivan believes that while many mainstream asset managers were sceptical of green labels, the seriousness of the threat presented by climate change and government determination to take action, means it will be a long-term driver of performance and a major source of risk.

Armer believes the thematic, return-focused satellite approach to environmental investments needs to be reconsidered.

“These investments are often marginal and treated like any other theme, but this is a very different kind of problem. It is a major structural technological shift.

“Assets are being managed to benchmarks that are locked in the unsustainable past. Long-term liabilities will need to be met by the sustainable economy of the future. Environmental investing should not be seen as a marginal alpha source, but rather this technological transition should be built into the core of a portfolio.” He urges schemes to review all asset classes on environmental factors.

“We’re not talking about responsible investment, we’re talking hard economics. It makes financial sense to put these issues at the heart of long-term portfolios,” says Armer.

So far, equity has been a pension funds’ dominant investment route.

According to Schroders fund manager Simon Webber, climate change will have a profound effect on most industries. “In many instances, it will have a fundamental impact on profitability, cash flows and therefore on the valuations placed on businesses,” he says.

“Within individual sectors the impact will also be dramatic,” Webber adds.

“Climate change will create winners and losers, which is already apparent within the auto and energy sectors.” The price of carbon is now a crucial return driver for all European power generators, and has led to significant outperformance of clean generators (renewable energy, hydro, nuclear), according to Schroders.

“This is also likely to become important in the US, as they move to implement a cap-and-trade scheme,” Webber says.

Sustainable Asset Management chief investment officer Christian Werner says: “In general, only those companies most exposed to the debate are addressing climate change. Those who have not, will be hard hit.” According to a Carbon Trust report, tackling climate change could add as much as 80pc to a company’s value. On the other hand, for poorly positioned companies or laggards, up to 65pc of company value could be at risk.

Sullivan thinks a fundamental re-think of business models is essential, but has not yet materialised.

“So far,” he says, “many corporates have established carbon-footprint policies, but business targets still assume an increase in greenhouse gas emissions. Operating in an increasingly carbon-constrained world is not yet being built into corporate strategies.” 

He points to just-in-time production and geographically dispersed supply chains as examples. “We are starting to see some consideration given to climate change-related risks but, as yet, there has been no fundamental rethink, which would be expected in the face of such a permanent new reality.” 

Armer says: “Property also entails enormous climate risk. The regulations are going to tighten and environmentally efficient buildings will suffer much less, making them more attractive long-term investments.” The trouble is, he says, today’s prices look expensive. “Factoring in future costs, the calculation looks quite different and schemes should consider making the shift now.”

Changing the paradigm

Even though many schemes recognise the issues, Sullivan says this is not translating through to mandates. “Dealing with the physical impact of climate change requires a longer term investment time horizon.

“Schemes should view their assets and liabilities as long term, but since they encourage their managers to invest on a much shorter time horizon, there is a fundamental disconnect.” 

Pictet Asset Management head of business development in Continental Europe, Udo von Werne agrees: “Pension funds generally focus on a 12-month artificial horizon, due to regulatory constraints. Long-term themes are therefore often ignored or schemes are not perseverant to implement an SRI approach on a sustained basis.” Ongoing confusion about discount rates, something raised by Lord Nicholas Stern, is also to blame.

According to Armer, the financial industry requires a fundamental conceptual shift to deal with climate change: “Financial markets tend to struggle with very long term issues,” he says. “Conventional valuation models tend to de-emphasise the future. A sustainability perspective would weight the future equally. We need to develop approaches that square this circle.” Short term, performance-focused investment also raised concerns over schemes’ commitment to environmental investments.

Sullivan says: “A lot of companies in this space are small or mid caps.

“There is a danger that schemes could withdraw their investments based on short-term performance, notwithstanding the compelling long-term case for such investment.” The current downturn adds weight to this view. “While the returns have been good,” Armer says, “the risk profiles of environmental small and mid caps are not favourable in a market crisis.” 

Dixon stresses that while schemes might historically have focused on shorter-term performance, there is growing pressure to reassess this and take a longer-term view.

She continues: “It is unfair to put all the blame on pension schemes.

“Climate change is increasingly being recognised as both a risk and an opportunity that does need to be prioritised.

“Although a new concept to a number of smaller and medium schemes, who typically have fewer resources, the larger, better-resourced public pension funds have already begun to address the risk and opportunities that climate change poses to their investments.” Armer calls for more innovation from asset managers: “A lot more process and product development is needed, but this is a chicken and egg situation. Innovation won’t come without demand. The more debate there is, the quicker things will move.” 

Asset managers and schemes alike have started encouraging debate by engaging with companies they are invested in.

According to Universities Superannuation Scheme co-head of responsible investment David Russell: “Addressing this issue is not just about investing in new products, it is also about ensuring that the assets in which the fund invests are preparing for a low carbon future and the potential physical impacts associated with climate change. This means pension funds need to be active owners and engage with their investments.” 

However, Werner questions whether many were ready for engagement. “Some have started already, but many schemes are still struggling with their overall approach to climate change and are not yet at a stage where engagement is realistic” he says.

Armer says engagement is not a sufficient solution: “An engagement overlay will not add as much value as having the right underlying investments. There is not the evidence to say that it can force enough change to badly-positioned companies.

“Engagement can be used as an excuse for not doing anything in investment portfolios. It is not an alternative to investing in companies that are better positioned to deal with the environmental challenges,” he stresses.

Russell argues, however, that pension funds are increasingly investing in this area – as witnessed by significant asset growth. “That said, there is still a long way to go and many opportunities for funds to invest and make returns,” he says. “Labelling such allocations as ‘green’ is not necessarily helpful though: they are just good investments.” 

Sullivan believes schemes are not currently taking enough advantage of these opportunities. “They are putting their investments at risk by not doing so as the changing environment will impact mainstream and ‘green’ assets.

“Pension funds have a fiduciary responsibility, which obliges them to look seriously at environmental risk,” he argues.

“Energy, pollution, waste and other environmental issues are so important that schemes would be remiss if they were not accounting for them in their risk management, asset allocation, monitoring and engagement policies.”

Emma Oakman is a freelance journalist