Both the physical risks from climate change and the potential policy risks from mitigation actions will have repercussions for markets that are unlikely to be priced in today. Investors need to take note, and spend more time thinking about the risks climate change poses to investments, as well as options for adaptation.
As fund managers, we can design products that channel financial resources towards mitigation and adaptation, but the challenge also goes beyond changes we can make at the fund level. Climate change poses such a significant threat it needs to be considered as an issue of strategic importance by asset allocators.
This is why fund selectors should be placing increasing emphasis on understanding the extent and effectiveness of the engagement activities their fund managers are undertaking on their behalf. Are your fund managers engaging directly and meaningfully with companies on climate change?
Tools to use
Engagements will be most effective if they are evidence-based. Institutional investors and their advisers must start taking concrete steps to ensure they are integrating climate analysis into their strategic investment frameworks. Asset allocators will also want to consider whether their fund managers are able to independently evaluate company performance against climate targets.
One such tool is value-at-risk, which estimates the extent of climate risk to company valuations under different scenarios. For example, how would an oil company’s share price evolve if the economy were to transition away from oil towards cleaner fuels and the company were to be taxed on every tonne of CO2 it emits?. This measure is very useful in starting conversations around what the company could do to mitigate or adapt to these risks.
Another is temperature alignment, which helps us assess the future trajectory of portfolio companies according to different emissions pathways, to evaluate whether they are on track to contribute to a world where we limit global warming to 1.5-2°C. This asks of companies: do your past carbon performance and future emissions targets indicate a meaningful commitment to limiting global warming to, for example, 1.5°C? The result allows us to engage companies directly on their impact on the climate, based on their own data. It highlights to them the importance of continuous improvement in carbon performance and the setting of ambitious but credible targets.
A third is carbon analytics, which measures a portfolio’s emissions intensity of revenue or enterprise value. In combination with the other metrics above, this allows us to illustrate the importance of going beyond carbon intensity.
Although many companies such as utilities are highly emissions intensive compared with technology companies, they have a crucial role to play in a low-carbon transition. They may face low climate risk if they are greener than their peers and may be aligned with below-2°C temperature outcomes if they have a track record of emissions reductions and credible future targets.
As COP26 draws near, the science could not be clearer: governments and companies must act now. They cannot wait until more and more extreme climate events force their hand. To generate momentum as investors, we need to start by understanding the materiality of climate risk to power our investment decision-making and our engagement with companies.