Finance in the frame post-COP26
We saw some important developments coming out of COP26, and the latest government targets now mean that 88% of carbon emissions and 90% of GDP is now covered by net-zero carbon targets. But looking beyond COP26, it is clear that existing promises by countries need to be translated into binding actions not just to decarbonise, but also to build resilience and adapt to the physical impacts of climate change. And the ambition of those commitments needs to be increased as 2030 pledges currently only put us on a 2.4°C alignment pathway.
A positive aspect of COP26 was the emphasis on the crucial role of the finance sector.
Tackling climate change requires trillions of dollars in annual investment. Public- and private-sector collaboration will also be important, with the right incentives and infrastructure to accelerate the transition to net zero. For that reason, a positive aspect of COP26 was the emphasis on the crucial role of the finance sector.
For example, the UK government announced that it would become the world’s first net-zero-aligned financial centre. This will require all UK-based financial institutions to produce credible transition plans, develop solutions to meet net zero and adopt best practice. The Glasgow Financial Alliance for Net Zero has been established to provide a forum for financial institutions to accelerate the transition.
Focus for the finance sector
The finance sector needs to focus on four key areas, detailed below.
Improve the quality of reporting and the level of disclosure
Adequately assess the resilience of companies to climate risks
- Ensure that net-zero transition funds are in place and credible
- Increase the flow of private finance to drive the transition
In making these changes, the sector must overcome two key problems: dealing with the uncertainty about how and how quickly the energy transition will progress; and the need for transparent disclosure that quantifies both the climate change impact of investing and on investments themselves.
To help address some of these challenges, we conduct a forward-looking quantitative assessment of potential impacts using climate-scenario analysis. This examines the financial outcomes for companies under a range of policy and technology pathways which result in differing transition risks. These include changing demand for fossil fuels and renewable energy, carbon taxation, as well as physical impacts.
We combine ‘off-the-shelf’ scenarios (to enable comparison with minimum standard approaches) with our own research-led bespoke scenarios (which include the realistic variation between sectors and regions). This provides us with asset-level and portfolio insights which informs stock-level research, feeds into the construction of climate-resilient products and informs our corporate engagement activities.
The impact on pension fund trustees
Pension schemes are playing a significant role in financing the necessary transition to a low-carbon economy by moving capital away from where it can continue to do damage to the environment and towards where it can do good. Increasingly, trustees are asked to make sure that they account for risks relating to environmental, social and governance (ESG) issues and climate change in their investment strategies.
Consideration of these issues is absolutely aligned with trustees’ fiduciary duty to act in scheme members’ long-term interests, as well as with members’ expectations that providers are investing their pensions responsibly.
Pension schemes face risks, though. There are reputational risks from taking inappropriate action. There are also risks from failing to comply with new regulations on reviewing and assessing climate change using the framework of the Taskforce for Climate-related Financial Disclosures. This currently only applies to the larger schemes. However, next year, it will extend to pension schemes of £1 billion-plus and probably eventually to smaller schemes. Additionally, the pension regulator’s new single code of practice will include new requirements for trustees to consider climate change in their overall governance systems. The government has also announced its new roadmap to sustainable investing.
Steps towards a greener future
Pension schemes have a massive opportunity to participate in future economic growth driven by sustainability. The following steps are useful for pension-fund trustees considering a greener investment future.
- Undertake training to fill in any gaps in your understanding so you can clarify the trustee group’s beliefs and priorities in this area.
- Set a policy around ESG and climate change.
- Work with your investment consultant, so you engage with your managers to ensure they are aligned with your desired approach.
- Consider switching your investments into more sustainable alternatives that have objectives consistent with your future strategy.
An increasing focus on ESG and climate change should lead to more robust risk management of pension schemes and, hopefully, more secure outcomes for members.
Making investment portfolios more sustainable
Investing more sustainably is easier said than done. There are transition risks (such as increased regulation and lower demand for carbon-intensive products) to consider, along with physical risks from global warming and severe weather events. However, there are also significant investment opportunities, especially in areas like renewable power, energy storage, electrification and energy efficiency.
We use various tools to help integrate climate considerations into our investment portfolios. This includes looking at the carbon footprint of companies to get a sense of their transition risk. As already mentioned, we apply our climate-scenario analysis to see how companies might perform under different scenarios. By engaging with companies, especially high carbon emitters, we can encourage them to disclose their emissions, see if they are in line with their targets, and promote best practices generally.
We consider three pillars in our climate-change investment frameworks.
- The leaders: high-emitting companies or companies in high-emitting sectors with ambitious and credible decarbonisation plans.
- The adapters: companies that are helping address physical risk issues, such as water stress or wildfires.
- The solution providers: companies that help third parties to decarbonise. For example, a wind-turbine manufacturer or home-insulation provider might have high emissions, but their products are essential to help the world decarbonise.
Investment opportunity of a generation
By looking at high-emission sectors and picking companies that are on the right track, we can provide the capital they need to support real-world change and reduce emissions in the real economy.
For example, a few years ago the UK utility company, SSE, had one of the highest emissions intensities of power generation in Europe. Investors looking for a quick way to decarbonise their portfolios would likely have sold SSE without having any impact on real-world emissions. Such a move would have failed to support SSE’s subsequent rapid decarbonisation. A build-out of wind and solar, alongside the retirement of coal assets now puts SSE among the cleanest utilities in Europe. This is why we prefer to take a forward-looking assessment that prioritises real-world emissions reductions when it comes to climate change.
Investing in sustainability and green energy is part of the next industrial revolution and represents the investment opportunity of a generation. For pension-fund trustees, it’s a question of simultaneously reducing investment risk and addressing climate change to pivot their portfolios towards helping achieve long-lasting real-world benefits.
Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.