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Understanding the rising tide of climate change legislation

Insurance Consulting and Technology|Investments
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By Gareth Sutcliffe | October 3, 2019

Legislators are starting to compel companies to pay attention to climate change. If good intentions alone are no longer enough, then where will this leave the investment industry in years to come?

It is good practice to consider climate change risks alongside every other risk. This has become self-evident in recent years, but there is another, more basic truth that should win all arguments for investors. It appears that regulators are now going to make institutional investors consider climate change much more directly and much more carefully, which takes this matter from the status of good practice to a hard requirement.

How should investors respond to this regulatory action? By going through an active planning process that involves thinking through scenarios for how the rise in temperatures, together with the projected increases in frequency and severity of a number of climate hazards, might affect your business, and planning for them in detail. While any scenario you choose is unlikely to correspond to the way the world unfolds, the mere act of planning and thinking through the detail of the effects on your business and investment portfolios will improve your ability to respond. Perhaps Dwight D. Eisenhower put it best when he said "plans are worthless but planning is everything".

A new risk taxonomy

When discussing climate change risk and investing, it useful to define terms at the beginning. In particular: traditional, responsible, sustainable and impact-driven investing. A traditional way of investing would be the interest in making money. Further down the scale, responsible investment has this 'finance first' mentality, but avoids investments that cause harm to stakeholders. Sustainable investment incorporates both of these, but the investments should be actively beneficial to these stakeholders.

Then you get into impact investing. There are various flavours of this, such as making investments that consciously contribute to solutions to ESG problems, but there are also some forms of impact-driven investment where you have a high tolerance of loss.

Once the investment approach has been chosen, there are other risks that need to be assessed. The two key risks in climate change space are physical risk and transition risk. A transition risk is the risk arising from of cost a transition to a lower carbon future, which will be expensive and which will involve a range of other economic drag factors.

Physical risks are more direct. These are typically the kinds of risks that come to mind when thinking about climate change, specifically, the physical impact of rising temperatures, such as storm damage. It also includes more complex phenomena, such as a concept called 'water stress,' where places which are already hot and arid become still hotter and there is not enough water to carry on economic activity. There is also the flood risk that comes with rising sea levels. That will have important impacts on certain property investments. Florida could be particularly affected, but we have also seen increased flood risk in the Midwest of the US and around the Mississippi.

Transition risks include things such as stranded assets. The idea is that if governments bring in policies that mean it is harder to use fossil fuels, then those fossil fuels will stay in the ground and companies that make their money out of them will become less valuable. It makes for some difficult investment choices. An oil company that is linked to fossil fuels might be a significant investor in renewables, so simply excluding fossil fuels is not the answer.

Finding opportunities and building scenarios

Probably the best way of understanding the risk exposure and potential opportunities that stem from climate change is through scenario construction. There are a number of building blocks to this and, within each of those blocks, there are several underlying scenarios such as the climate model, socioeconomic model, climate policy and asset model.

To take one of those, the socioeconomic model, we mean changes in demography, changes in economic structure and also changes to social norms. That could be things such as the extent to which voting populations pressure governments to make climate policy changes, but also the fact that climate change is a global phenomenon and would be best solved by coordinated action between countries. If we have more nationalistic governments, we may see less coordination.

While any scenario you choose is unlikely to correspond to the way the world unfolds, the mere act of planning and thinking through the detail of the effects on your business and investment portfolios will improve your ability to respond.

This feeds through into the technical levers that governments can pull in relation to climate policy. Reforestation may be useful, as may be changing the way we do agriculture so that it is less CO2 intensive. In one of our hypothetical scenarios, we pulled 90% of these levers, and in the other we pulled 30%, and those were related to how we expect climate to change over time.

Finally, there is an asset model, because all those things together will have impacts on GDP. That model translates those GDP impacts into changes in asset class by sector. It is vital that you consider the time horizon, because we might not expect much to change over a short-term horizon, but by 2100 a lot will change. Even in the medium term, you still might see some significant developments.

There are two scenarios that we've been working on with our clients. One shows global, coordinated action, which is the one with 90% of policy levers pulled, and the idea is that that gets us down to a temperature rise of no more than two degrees above pre-industrial levels by 2100, in line with the Paris accords. There is another scenario, in which we see a four-degree (or more) temperature rise which is projected to happen if we carry on as we are.

There are investment opportunities that arise from climate change. The most obvious is renewable energy. There has already been investment in wind and solar, while electric vehicles are less obvious than others. An example is Rolls-Royce, who have bought the electric planes division from Siemens. The idea is that because aviation contributes around 4% to CO2 emissions, it will come under growing pressure to move to a lower carbon future. As jet fuel is 60 times more energy dense than an electric battery, making a plane engine 60 times heavier will also make it harder to fly and much less economical. As can be seen, some investments are closer to technological reality than others.1

Bottom up analysis

In addition to 'top down' scenarios bottom up analysis can reveal in more detail where risks and opportunities lie. Some sectors will do poorly, others will fare better. One sector likely to perform poorly is coal, whose decline may be hastened by policies coming in that increase the likelihood of it being a stranded asset.

But once coal is identified as a poorly performing sector, these can lead to further insights. In 2011, there was the Fukushima nuclear disaster in Japan. Angela Merkel responded by switching off all of Germany's nuclear reactors and replaced them with lignite, which is the dirtiest form of coal, so German manufacturing industry is now disproportionately dependent upon a particularly carbon dioxide intensive form of energy. You might expect German equities to have a greater impact from carbon dioxide from policy changes than some other equities.

Taking further steps to understand risk exposure

We can show some GDP changes for different countries in the two different scenarios. Emerging markets are expected to be more affected than developed markets and the reason for that is that they are less well prepared and have less money to spend on being resilient. Australia fares badly in our scenario projections. The country is already hot but maintaining water resilience in rising temperatures will be difficult.

Transition costs tend to be borne by equity investors rather than credit investors. What you see in the credit space is that companies find they have extra risks, and therefore may be subject to a greater rate of downgrades, but the equity investors will ultimately be the ones who pay. The drags on returns are also projected to be higher in equity space than in the fixed interest space under our scenarios.

Having gone through an exercise of constructing a scenario, there are further steps that investors might want to take. The first thing is establishing where you are now. This would involve doing things such as scoring your portfolio against certain criteria, assessing your exposure, which means conducting scenario and stress testing, and evaluating your response.

It's good to talk

You need to communicate what you are doing to your stakeholders. A lot of big asset managers stress the importance of regular engagement, including Legal and General and BlackRock who are vocal about how much they engage with the firms they invest in, because they own so much of the market. It is generally a good thing to be able to do and makes it easier to steer investments towards where you would like them to go.

If you did an analysis of your portfolio, subjected it to an ESG rating, scored it, and decided that you were holding too much risk, then the obvious thing to do would be to cut some of that out by divesting. We see a lot of this in the insurance industry. Many insurance companies will no longer invest in companies that make more than 30% of their revenue from coal. As an alternative, you could engage in offsetting, so you move towards the opportunities.

There are some differences in the way that these ideas are implemented in different asset classes. While asset managers have their own ways of ESG scoring, they all offer different policies whose scoring mechanisms are different. This is initially confusing, but as they tend to be the leaders in this area, you can make use of their systems to see whether those scores are getting better or worse over time and to use them to carry out an equity tilt. Index providers like MSCI or FTSE provide you with ESG tilted indices, which reduce your risk, and you can exclude stocks for ethical reasons.

Illiquid investments provide an opportunity for climate-aware investing because you do diligence for every illiquid asset individually, so you have a much greater ability to understand what the ESG impact of that investment should be without a score from an external provider. Sometimes you will be funding some of the development of that asset and will be able to shape the asset in a way that will be climate aware.

In the liquid credit space, the same kind of ESG scoring techniques are available as they are in equity. It is possible to get scores on a universe of names you might want to invest in, but there are some extra complications. It is harder to engage in stewardship, because you do not run into management as a bondholder as much as you would as an equity holder, and scoring for a government is harder than for a company.

Conclusions

Whatever class your investments are and whatever your exposure, understanding the legislative framework that is rapidly being built around climate change is a good starting point, as is understanding the effects of rising temperatures. And then, to return to Eisenhower's dictum, the planning can begin in earnest and corporate knowledge can progress to the next level.

Scenarios are the next stage of the process, as is understanding how these scenarios have been put together. Whichever scenario you choose, it is almost certainly going to turn out to be wrong, but the process of planning for that scenario will give you a much better understanding of what to do. Whether the temperature increase is kept to the level stipulated in the Paris Accords or a more daunting prospect lies ahead, planning now may help avoid catastrophe tomorrow.


1 FT.com article: “Aviation/climate change: plane speaking” 19 June 2019

Author

Gareth Sutcliffe
Head of Insurance Investment Team

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