On 22 April 2016, also known as Earth Day, the Paris Climate Agreement was officially signed in New York. After months of negotiations the year before in the Le Bourget area of northeast Paris, representatives from 196 states had reached a historic consensus – to limit global warming to below 2 degrees Celsius above pre-industrial levels.
Capital allocation has become a core focus of this commitment with pension funds under pressure to leverage the influence they have on the assets they manage. Most recently, pension funds and asset managers have begun to set out plans to reduce or offset their carbon dioxide emissions to become ‘net zero’. But what does this mean for end investors?
Pricing in net zero
Ethical motivations aside, when announcing net zero commitments many pension funds have cited the long-term investment argument behind these changes in policy. Willis Towers Watson head of sustainable investment Adam Gillett says climate change represents a material long-term risk to capital markets and the global economy.
“Being strategically ahead of a low-carbon transition will, in our opinion, significantly improve risk- adjusted returns for our clients,” he said. “This will come from two sources – better beta due to more effective stewardship, and alpha as the mispricing of climate issues is resolved.
“We also think tha t understanding this transition will be one of the biggest sources of alpha across all asset classes and that this opportunity is likely to be greatest in the next few years as the data is not yet well understood and prices have not yet fully reflected the likely path for the world.”
The perception that net-zero targets will detract from performance is being batted away by many advocacy groups, with Make My Money Matter – an organisation dedicated to bringing about positive climate change investing across the pension industry – pointing to comments made by former Bank of England governor Mark Carney that climate risk is an investment risk.
“Members’ best interests will also be met when they can retire into a better world, and this should also be considered by trustees,” says MMMM’s senior finance adviser, Huw Davies. “At the moment most pensions are driving the climate emergency and destroying the world people will retire into. By considering both returns and a habitable planet, trustees will properly serve their members.
“The general idea that investing sustainably means lower returns does not hold true. In fact, research from Morningstar revealed that sustainable funds have, on average, outperformed their traditional counterparts over the past 10 years, while pension industry giant Nest consistently reports that its ethical fund is one of its strongest performing options.”
The Pensions Regulator is also of the view that climate change poses a significant risk to pension funds and has pushed strongly for trustees to put this high up their agendas.
Making a pension net zero
There are many ways for a pension scheme to become ‘net zero’. Trustees can choose to divest from polluting sectors, engage with companies to encourage positive change, and fund climate solutions
through allocations to renewable energy assets. Some pension fund managers, such as Scottish Widows, are using third-party guides such as the Net Zero Investment Framework developed by the Institutional Investors Group on Climate Change (IIGCC).
“This framework acts as a blueprint and a how-to guide to help investors change their approach to governance and strategy, asset class alignment, stewardship, and policy advocacy to embed climate change considerations both to reduce [their] greenhouse gas footprint in the portfolio and the real economy, but also to support finance flows into climate solutions,” explains Scottish Widows head of pension investments Maria Nazarova- Doyle. “We anticipate that the traditional two-dimensional risk/return view of portfolio construction will naturally evolve into something balancing risk, return, and carbon reduction.”
Some groups have begun exerting their influence through the threat of voting sanctions and, ultimately, divestment. However, this surge in activity from pension schemes to meet net zero targets has concerned some critics who argue that a rapid transition to net zero could compromise trustees’ overarching fiduciary duty to deliver retirement benefits for members.
On the other hand, some experts argue that the net zero targets are actually crucial to fiduciary duties. Kempen Capital Management head of global sustainable equity Richard Klijnstra explains: “A net zero pledge is an advantage for trustees and [independent governance committee] members as it allows portfolios to adjust and take into account the risks and opportunities of the transition to a net-zero society.
“Evidence of this can be seen in how several of our fiduciary management pension fund clients implement a Paris-aligned benchmark to be net zero by 2050 across their portfolios.”
The role of regulators
Policymakers are increasingly requiring pension funds to take non-financial issues into consideration, and Nazarova-Doyle says this is leaving less room to hide for climate change laggards. “Those companies that fail to amend their businesses to be less carbon-intensive are at risk of being caught out by mounting regulations, leading to significant falls in their value or facing the risk of becoming stranded assets,” she says. “Regulations play a very important role, alongside other factors, in influencing the investment landscape. Asset valuations are partially driven by evolving regulations and the pace of change will depend on the nature, extent and speed of policy response in this area.”
These kinds of rules have been brought in under greater pressure from environmental groups, politicians, and changes in public sentiment. RisCura head of research Faisal Rafi concedes regulations have an important role to play in introducing change, but warns that pension fund managers’ hands should not be tied.
“We strongly recommend governments against dictating on… artificial deadlines,” says Rafi. “While it is important to reduce the carbon footprint of these industries, they will have a carbon footprint for a long time to come. Similarly, fossil fuels are still required to keep the world going, at least for now.”
This nuance could present challenges for investors as fossil fuel companies still deliver an important investment return and income for many pension funds. This could lead to conflict for some investors in the short term, as Carlota Garcia Manas, head of engagement at Royal London Asset Management, concedes.
“Investors will go where they can find a good return. In the short term there will be return in some areas of the market that are perceived as ‘brown’ or ‘dirty’, but we think the longer-term trend towards sustainability is quite clear,” she says.
“A more interesting question is whether net zero pledges by countries will leave the current generation better off, or it will take one or half a generation to reap the benefit. This is because the upfront cost may be steep, it is the levelized cost – the cost over an asset’s lifetime – which may be more competitive. We are internalising the past cost of decades of emissions.”
Early days
Net zero investments are still relatively new, and many pension funds are at the initial stages of steering their portfolios towards this commitment. Evidence is emerging that this is attainable, without compromising returns – but there is still a long road ahead for trustees.
“This is a very new area with methodologies still being developed, so we don’t have a long history to draw on,” says Manual Adamini, responsible investment strategist at BMO Global Asset Management. “A net-zero pledge is exciting, its implementation often feasible, but the devil is in the detail.
“It is important for asset owners to be aware of the range of implementation options available. There is no single ‘right’ answer, and to speak to their advisers and managers about the impact on their investments.”
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