This year started with fires of unprecedented magnitude ravaging Australia and The World Economic Forum citing climate change as one of the main risks that businesses are facing. With climate change dominating the headlines, 2020 started right where 2019 – yet again one of the hottest years on record – had ended.
For investors, the multiple challenges translate into ever more scrutiny on how they are approaching the topic. Regulators are honing in on investee companies. One example is the European Union’s Non-financial Reporting Directive that requires companies to disclose their material impact on the climate. Investors are being drawn into the regulatory focus as the EU, Canada, Australia, the UK, and China introduced green and sustainable finance initiatives and transformation roadmaps for the financial system.
California’s Senate Bill 964, for example, requires both the California State Teachers’ Retirement System (CalSTRS) and the California Public Employees’ Retirement System (CalPERS) to provide regular reports on climate risks. The first round of reports were published recently.
Not surprisingly, investors are embracing the issue quite forcefully, and BlackRock’s CEO Larry Fink is a prime example. In his letter to CEOs on January 14, Fink put climate change on top of the agenda for the world’s largest asset manager’s when he wrote, “Climate risk is investment risk”.
It is therefore timely that the United Nations Principles for Responsible Investing (UN PRI), the largest international network of more than 2,500 investors working on sustainability in finance, has made numerous climate-related questions in its 2020 annual reporting cycle mandatory for signatories.
With a focus on climate risks, the UN PRI embraced the recommendations of the Taskforce for Climate-related Financial Disclosure (TCFD) for its survey. Established by the Financial Stability Board in 2015 and chaired by Michael Bloomberg, the TCFD developed recommendations for corporations and financial institutions to establish what constitutes good disclosure on climate-related matters. The emphasis is on those elements that could have material financial impacts on asset managers and owners.
UN PRI signatories have until March 31, 2020 to report how they are identifying and addressing climate-related risks and opportunities, who in the organization is responsible for the topic, and whether and if so, how they have conducted a scenario analysis. (A complete guide to the new mandatory questions and how to answer them is available here). In other words: There are currently more than 2,000 asset owners and asset managers who should be identifying and reporting on their investment climate risks.
The costs of reaching the stated climate goal of 196 governments to reduce greenhouse gas emissions that will limit global warming to below 2° Celsius compared with pre-industrial levels might be high, but the risks of inaction are much higher. At the same time, global greenhouse gas emission levels keep increasing, and a scenario where governments react with sudden and drastic “catch up” measures to slow down or reverse global warming becomes more likely.
Possible steps include the sudden phase outs of fossil fuels, the introduction of high carbon pricing levels, and abrupt shifts in consumption patterns, all with potentially strong effects on company valuations. The UN PRI coined this scenario the “inevitable policy response.” Some policy steps are already being taken. Germany committed to phasing out coal until 2038, and several European countries established sales targets for electric vehicles.
Are investee companies prepared for that seismic shift? The analysis results are often staggering. Based on ISS* ESG proprietary analysis, of the over 2,900 companies in a basket of global titles, only 6% are considered well positioned to mitigate climate risk and seize opportunities related to the transition to a low-carbon economy while 46% are considered climate laggards.
When analyzing those same companies to measure alignment of their corporate greenhouse gas (GHG) emission trajectory with the climate goal as recognized in the Paris Agreement reached during COP21, a visible gap emerges. Instead of contributing to limiting global warming to 2°C, those companies support a 4°C world. A world with 4°C warming compared to preindustrial levels could be daunting: Wildfire risks would be projected to change substantially in many areas, extensive biodiversity losses would be highly likely, and economic damage related to climate change could reach 10% of gross domestic product (GDP) in the United States by the end of the century (PDF).
In working with investors globally, we at ISS learned that there is more to a TCFD report than just another reporting burden. Aside from obtaining insightful results, it can even help reduce costs. If done properly, a TCFD exercise can help identify key areas of climate risk inside portfolios that can be subsequently addressed. It can lead to creation of new sustainable investment offers to address the expectations of millennials, given that 90 percent of them stated they want to direct their allocations to responsible investments in the next five years, according to FactSet’s HNWIs’ Vision for Wealth Management Industry in the Information Age.
And it can even save resources. Some investors learn from their TCFD report that internal divisions may have built parallel capacity or purchased different climate-linked data sets so the exercise helps streamline expertise and procurement costs.
So what should be on top of every CIO’s mind when thinking about “acting on climate”?
- Get the lay of the land: For any type of climate-linked portfolio de-risking, the key is to establish the baseline first. Where are the relevant climate risks in my portfolio? This is no longer a challenge as there are now tools available that can highlight these climate risks in seconds. Risks that come with the physical effects on climate change such as floods and those relating to a low-carbon transition of economies can both be tracked with the latest tools.
- Be smart about your focus: It’s a marathon, not a sprint. Investors embarking on the journey need to build internal capacity, identify hotspots, and choose an approach that suits their organization. Whether reducing exposure to coal or focusing on companies producing climate adaptation solutions, climate change poses both a risk and an opportunity, and approaches to both are as plentiful as there are investors.
- The power is yours: Making equity investments into companies means taking ownership. An ownership stake can be leveraged to support lagging companies in addressing the topic of climate change by putting sound governance structures into place and laying out plans to identify how a company addresses climate risks and opportunities. From voting on a few select companies based on detailed in-house analysis to implementing rules-based approaches to large portfolios – voting options are available to suit the needs of different investors.
The topic of climate is here to stay. As the World Economic Forum noted, “Climate change poses an urgent threat to economic progress, global food security, our natural systems, and individual livelihoods.” If nations transition successfully to a low-carbon system, businesses will operate in a different economy and energy system. If countries fail to rise to the challenge, a booming adaption industry should be expected with companies and societies scrambling to climate-proof their activities. In both cases and given all that is at stake, CIOs should pay heed.
* CIO is an ISS Media brand.
Viola Lutz is Head of Investor Climate Consulting at ISS ESG where she is responsible for supporting public and private sector clients with developing and implementing solutions to address climate impacts and risks within financial institutions. She is a co-author of several studies for governments and investors on climate risks and of financial actors’ impacts on climate change. Viola holds an MPA from the Paris Institute of Political Studies and a BA in Economics from the University of St. Gallen, Switzerland.