In this blog, Claire Jones focuses on the investment aspects of climate-related risks and provides some recommendations for trustees.
Climate-related risks are increasingly recognised as relevant to companies’ financial performance and Mark Carney has warned that they pose a potential threat to the stability of the financial system itself. The Cambridge Institute for Sustainability Leadership concluded that nearly half of the investment risk is “unhedgeable” and warned that short-term shifts in market sentiment could cause “substantial losses in financial portfolio value within timescales that are relevant to all investors”.
There are two main types of climate-related risk:
- physical risks from the climate itself, such as disruption of global supply chains by floods and storms, and changes to rainfall patterns which affect agricultural yields; and
- transition risks from measures to prevent climate change by significantly reducing our use of fossil fuels through improving energy efficiency and switching to renewable energy sources.
In the shorter term, transition risks are likely to be more significant than physical risks.
There are also various opportunities arising from climate change adaptation and mitigation: cost savings through resource efficiency and alternative energy sources; innovation in products and services; access to new markets; and developing resilience to climate change. Significant investment will be required in sustainable infrastructure, with much of the capital expected to come from private sector investors such as pension schemes.
Our new guide for pension scheme trustees provides more detail on these risks and opportunities, drawing out the implications for investments, sponsor covenant and funding, and suggests some actions trustees can take. In the rest of this blog, I focus on the investment aspects.
In issue 4 of LCP Vista I wrote about the considerable uncertainty that climate change policy poses for investors. Since then, the Brexit vote and the election of Donald Trump have created yet more uncertainty, even though most global leaders are standing firm on their climate pledges.
Many critical questions remain, including: how far and how fast will climate policies seek to reduce fossil fuel use? How will the detailed policies affect individual sectors and companies? And how will asset prices respond to these developments?
Few trustees will want to, or feel able to, form a view on these questions. But you don’t need to. For both DB and DC schemes, what you need to do is:
- Recognise that climate change poses risks to all of your investments, including in the short term. The nature and extent of the risks and opportunities vary considerably between asset classes, sectors and individual companies. In particular, the energy, transport, materials and agricultural sectors are likely to be most affected.
- Consider your investment portfolio’s overall exposure to climate risks and opportunities, particularly when reviewing asset allocation and manager appointments. Equities typically have a higher exposure than, say, fixed income, and the exposure is strongly influenced by the choice of index to track or use as a benchmark.
- Select managers that have the skills and resources to integrate climate factors appropriately into their investment processes. This can include macro-level decisions (particularly in multi-asset products), stock selection decisions (for actively managed funds) and shareholder engagement (for equities).
- Oversee the way managers are managing climate factors on your behalf, noting that their approaches differ widely. You should satisfy yourselves that your managers’ approaches are suitable for your scheme and are being implemented as expected, and be prepared to challenge them if not.
The big challenge is to obtain sufficient information on your managers’ approaches to climate risks and opportunities and, in turn, for them to obtain sufficient information on the companies they invest in. Fortunately, climate-related disclosures are improving rapidly. Various initiatives are seeking to increase the extent, quality and consistency of disclosures. Foremost among these is the Task Force on Climate-related Financial Disclosures (TCFD) whose final recommendations were published in June. These recommendations apply to asset owners such as pension scheme trustees, as well as investment managers and investee companies (see Pensions Bulletin 2017/28). We expect them to drive improvements and harmonisation in disclosures across the globe.
Make sure you understand the implications of climate-related risks for your scheme. Our new guide on this is a good place to start