Carbon is fast becoming something pension funds need to pay attention to, whether as a potential investor in a carbon trading fund, or a shareholder looking to engage with companies on environmental issues. Dorothee Gnaedinger explains
When you add to this the fact that the US$6trn a year energy sector needs investors to pay for a rapid and total transition to low-carbon technologies, it is evident carbon is set to play a big role in pension fund portfolios, according to Craig Mackenzie, director, carbon benchmarking, at the University of Edinburgh Business School.
A spokesperson for APG Investments, the asset management arm of the giant Dutch fund ABP, which was one of the early movers in carbon emission rights fund investment, outlined the attraction for pension funds: "We invest in these assets because we expect low correlation with commodities [or the other] investments we already have. We think the world is serious about its intention to reduce greenhouse gases and therefore expect an investment in emission rights to offer attractive returns over a longer period."
Lionel Fretz, CEO of Carbon Capital Markets, supported ABP's view: "The carbon trading market is pretty much independent to anything else. Therefore, if people are looking for uncorrelated returns that are long term in nature, then investing into this area is a pretty good bet."
PKA, Denmark's largest pension fund, is currently mulling over carbon-related investments, to go into either its private equity or infrastructure programme.
How large an investment it would make is still to be decided, but Claus Jorgensen, head of equities, was able to say: "We have a target of 7% of total assets for our private equity programme, and we have up to 4% of total assets for infrastructure. Our investment into carbon would be a part of these programmes."
In terms of the type of investment, PKA will opt for investment in by-products, which is the form of carbon trading investment most popular with pension funds. "We are particularly keen to look into investment projects to get emission rights more as a by-product," continued Jorgensen. "We are looking to combine economically sound investment with something that would fit into our own guidelines of SRI. Carbon trading naturally would fit quite well into this." Mackenzie elaborated on PKA's point: "Some pension funds have decided they want about 5% of their assets in a fund that invests in wind farms, solar panel companies and renewable technology businesses. This is partly because they think it is good for investment reasons and also because of their desire to be doing something about climate change."
In line with this, most of the pension funds investing in carbon trading are signatories of the UN Principles for Responsible Investment.
While SRI may not be the overriding reason for pension funds to look to investment in a carbon themed fund, with players stressing instead the potential for outperformance, they will have to accept the wider role they must play in reducing carbon emissions and, in turn, the impact of carbon emissions on their overall portfolio.
Mackenzie explained: "One other important role pension funds will fill is to accept they are big shareholders in companies. As big shareholders they have an opportunity to influence the company's management of carbon issues."
A number of big pension funds are already beginning to up their shareholder activism on carbon-related issues a notch, as part of their wider climate change agenda, with the Carbon Disclosure Project being a prime example.
Mackenzie added: "The Carbon Disclosure Project is an example of this willingness from pension funds to ask companies to explain their carbon performance and to engage with them to encourage performance improvement."
While pension fund awareness of carbon-related issues is undoubtedly growing, carbon trading itself, projected by some economists to have the potential to become the biggest commodity market in the world, is facing an uncertain future.
"Carbon trading depends on the existence of carbon permit systems, carbon pricing systems and also the clean development mechanism. Those, in return, depend on the Kyoto Protocol," explained MacKenzie.
The Kyoto Protocol was signed by 161 countries in 2005, although famously not by the US and Australia. Spurred on by the Kyoto Protocol, the European Union (EU) then created its own Emission Trading Scheme in 2005, which aims to dramatically cut carbon emissions from Europe's five most heavily polluting industries.
However, the Kyoto Protocol is due to expire in 2012 and the European Emission Trading Scheme has, thus far, not proved to be enough to help climate change. Fretz stated: "The EU is showing a good lead but actually, in global terms, it is by no means good enough to impact upon the huge emissions of China and the US which are the world's two biggest emitters."
In a nutshell, an appropriate international post-2012 agreement is urgently needed. Mackenzie furthered the argument: "It used to be the case that China and India emitted a relatively small amount of carbon dioxide; so climate change was viewed as all the fault of the industrial world. Yet China is already probably the world's biggest emitter, and within a couple of decades China and India may exceed the total emissions emitted over the last 150 years by the developing world, based upon the current rate of growth."
All hope for a new protocol is now fixed upon the Climate Conference in Copenhagen, due to take place in December 2009, where governmental representatives from more than 170 countries will come together to work on the post-2012 climate era.
"The conference in Copenhagen will hopefully produce a new framework. If it does, the new framework will most likely contain a significant carbon trading environment, which will make it possible to do carbon trading on a massive scale," suggested Mackenzie.
However, securing a framework is not the end of the story: an adequate agreement in terms of ambition level will be essential; furthermore, a deal that is badly enforced will be of little use. "We saw very patchy implementation with Kyoto.
Therefore, even if you get a deal in Copenhagen that is sufficiently ambitious, you need to make sure governments effectively implement this," warned Kate Hampton, head of policy at Climate Change Capital. "So we need this combination of strong international agreement and strong national implementation in order for Copenhagen to be a success."
For the Copenhagen Conference to be a success, ongoing support from the US is crucial. The absence of the US in the international negotiations is believed to be the largest obstacle for progression so far, as a number of countries were hiding behind the inaction of the US as an excuse not to do anything themselves.
Hampton stressed: "The US has huge potential to contribute to the solution on climate change. The US is already a key geography in terms of technological development and early stage financing. Furthermore, the US could benefit hugely from an international carbon market. If the next US president identifies these opportunities and pursues them, the US could unlock progress towards an ambitious international deal."
Despite the (lack of) international developments, there is a consensus carbon trading will take off as an investment for the future. "The volume of trading has increased dramatically in the last year. The carbon market now is bigger, much more liquid and public," explained Fretz.
A number of countries are introducing carbon trading, the most recent of which are Australia and New Zealand. Japan and the US are also considering it.
"I think it is pretty clear that carbon trading is becoming more and more mainstream in more and more parts in the world. It is inevitably going to be mainstream in the energy sector and in energy intensive industries," explained Hampton.
In terms of pension fund engagement on carbon issues, Mackenzie said he planned to develop benchmarks that identified which companies were managing carbon well and which ones were not to enable pension funds to manage their risk better. "We are already seeing significant changes to the share prices of carbon intensive companies. There is some evidence that, in the last few years, the price of the most carbon intensive electricity utility companies has underperformed the share price of the least carbon intensive -' so the most carbon efficient electric utility companies -' by 16% a year."
He continued: "There will be more opportunities for pension funds to invest in carbon trading, whether that's investing in carbon trading businesses or buying carbon instruments as a commodity. Carbon trading could become a very large commodity market and pension funds have recently shown some desire to invest in commodities."
The Pensions and Lifetime Savings Association (PLSA) is in the process of convening an industry-wide group to take forward the work of the Institutional Disclosure Working Group (IDWG).
The Transfers and Re-registration Industry Group (TRIG) has given its support to an initiative which aims to complete occupational pension transfers within three weeks.
Scottish Widows has completed a bulk annuity deal for the Hitachi UK Limited Pension Scheme.