Institutional investors - those responsible for superannuation, insurance, endowment or other wealth funds - collectively manage trillions of dollars globally. They each have varying objectives and portfolio allocations and function within different regulatory requirements. However, they are all exposed to climate change as long-term investors.
Financial regulators are increasingly setting the expectation that climate-related risks are financially material and, therefore, must be considered and managed in accordance with fiduciary duty. However, for a growing cohort of investors it is not just regulation driving action, they’ve already moved beyond minimum standards and are now focused on getting ahead of the risks and opportunities created by the transition momentum.
There are two parts to climate change considerations: the transition to a low-carbon economy and the physical damages that come with temperature increases we’ve failed to avoid (the magnitude of the latter depending on the speed of the former).
Transition comes with change in technology and policy to transform the economy away from fossil fuels, invariably creating risk in some sectors and opportunities in others. Physical damage from an increasing frequency and severity of storms, wildfires, floods and droughts will also generate higher risk exposure in sectors most closely connected to real asset exposure – property, consumer staples and telecoms – but create new adaptation opportunities as well.
The expected financial materiality of these risks is evidenced in Mercer’s “Investing in a Time of Climate Change” report (2015) and The Sequel (2019). The findings in Mercer’s reports support the view that it is in investors’ best interests - and consistent with fiduciary duty - to actively support the low-carbon transition to avoid the worst physical damages.
This view is reinforced in reports by The Bank of England, the G-20 Financial Stability Board, The Economist Intelligence Unit and an increasing number of reports within the investment-industry.
As awareness of the financial materiality of climate-related factors has increased, regulators have moved to clarify and legislate their expectations of investors, particularly those responsible for retirement savings and insurance.
Europe has led the way; for example the 2016 EU directive, gradually captured within country laws, that requires pension trustees to document how they take account of environmental, social and governance (ESG) factors and climate change.
During a recent four-year period working in Mercer’s London office, I saw first-hand how these new expectations drove changing priorities for consulting colleagues and our clients. And that was before the Task Force on Climate-related Financial Disclosures (TCFD) recommendations, the central banking Network for Greening the Financial System (NGSF), the Sustainable Finance Action Plan and the Shareholder Rights Directive.
There is movement in key Asian markets, mainly on stewardship, and regions in North America and Canada as well, while the current US administration and Department of Labour seem to be heading in a different direction.
More locally, the NZ Sustainable Finance Forum (linked to the Aotearoa Circle) commissioned a legal opinion from Chapman Tripp which concludes that “directors and scheme managers must assess and manage climate risk as they would any other financial risk”. Further, KiwiSaver default funds are soon to have a fossil fuel exclusion requirement.
In Australia, the Sustainable Finance Initiative is soon to release recommendations, and regulatory bodies Australian Prudential Regulation Authority and the Australian Securities and Investments Commission have flagged their expectations on climate change, to be formalised later this year (industry has been calling for these updates to the 2013 Prudential Practice Guide since at least 2016).
These developments only strengthen the legal arguments and avenues where investors fail to keep pace. Litigation is primarily being targeted at companies for failure to mitigate, adapt or disclose, but there are examples of litigation against governments and, most recently, superannuation funds.
As signals from regulators become stronger and/or more investors take action, those who fail to consider, manage and disclose their potential portfolio-specific risks may be susceptible to legal challenges in the future.
At the other end of the spectrum, there is a growing group of investors who, rather than waiting for regulation or threats of litigation, are instead taking the lead.
They have already followed the TCFD guidance and undertaken scenario analysis and carbon footprinting, and joined collaborative initiatives like Climate Action 100+. That scenario analysis has told them it is in investor best interests for a transition from our current 3°C temperature increase trajectory to 2°C or ideally 1.5°C (consistent with the Intergovernmental Panel on Climate Change’s scientific consensus and the 2015 Paris Agreement ambition).
With this in mind, there is now the Net Zero Asset Alliance of 27 investors and the Science based Targets initiative on the financial sector, committed to net zero emissions by 2050, actively working on the methodology for specific metrics and targets over the next decade.
The investor groups on climate change across Europe, Pacific and North America are also agreeing guidance to support their members to set transition action plans. Not surprisingly, Mercer is also now ready to help investors to build on scenario analysis and create a transition plan that sits within investment process decisions, including setting emissions baselines and calculating reductions targets across a total portfolio.
The methodology on how to account for emissions throughout the supply chain, and account for growth and meet investment objectives while achieving emissions reductions, are works in progress. However, the first steps for the initial years are actually fairly clear.
Forecasting exactly how a transition scenario might play out also isn’t simple, especially anticipating market pricing. It could be a gradual, orderly transition, but Mercer also stress tests sudden scenario shift over the next decade. A transition, of some description, as the most likely direction of travel is fairly clear.
It’s up to all of us – investors, companies, governments, individuals – to decide if we are intent on achieving the 2050 net zero target and the road we take to get there. Perhaps the current global pandemic will help focus our minds on systemic risk impacts and the benefits of coordinated action sooner rather than later. We might even find positives in the transition, and avoid the worst of the negatives that we can no longer ignore.
Jillian Reid, senior responsible investment specialist at Mercer, Marsh and McLennan companies.
The article is featured in the August/September issue of Boardroom magazine.