INSTITUTIONAL INVESTORS GENERALLY DON’T MINE coal, make
cement or indiscriminately strip large forests. But the companies in which they
invest might be engaged in such activities that experts say will prove
incompatible with the shift to a lower-carbon world. And, they add, a
retirement plan’s holdings of these at-risk investments could have negative
consequences for plan participants.
Plan Exposures
Climate change risks can affect plans in several ways, says
Therese Feng, vice president of research for The Climate Service, a climate
risk analysis firm in Durham, North Carolina. Physical climate risks such as
droughts, fires and rising sea levels can result in both market and credit
losses in a portfolio. For example, imagine that drought conditions continue to
worsen in California, which accounts for almost 15% of the U.S. economy. At
some point, the lack of water and resulting rationing conceivably could
constrict the state’s businesses, particularly agriculture, and reduce
employment levels. The resulting slowdown to such an important component of the
U.S. economy could then affect national business conditions and stock market
values.
For corporate and government instruments, losses from
physical damages and diminished asset values can lead to lower instrument
values, increased return volatility and increased credit risk, Feng says.
Instruments collateralized by physical assets, most notably mortgages, carry
increased credit risk due to physical climate risk.
Investors also face climate transition risk, she adds.
Transition risk is the potential financial impact of the economic transition to
lower greenhouse gas emissions, which includes a shift to using lower-carbon
energy sources and increased use of lower-emission technologies. To date,
investors have focused more on transition risk than on physical risk due to
access to data and methodology, says Feng. “But institutional investors need to
be knowledgeable of how both physical and transition risks can affect their
strategies, both in the near- and medium-term,” she cautions.
Additional Exposures
Adam Gillett, global head of sustainable investing at Willis
Towers Watson in London, says institutional investors also should consider
regulatory pressure related to climate change. For example, a blog post from
law firm Dentons’ UK-based associates notes the United Kingdom’s Pension
Schemes Act 2021 “allows the government to make regulations that impose climate
change governance and disclosure requirements on trustees of large trust-based
pension schemes (whether defined benefit [DB] or defined contribution [DC]
schemes).”
“It wouldn’t surprise me at all if other regulators from
around the world who had a similar agenda looked at [the UK’s Act] and thought,
‘Well, let’s do something similar,’” says Gillett. “‘Let’s put in similar
instruments, in whatever context, to accelerate action.’”
In fact, the United States might not be too far behind the
UK, he adds. On May 20, President Joe Biden issued an executive order on
climate-related financial risk that called for “consistent, clear,
intelligible, comparable and accurate disclosure of climate-related financial
risk … including both physical and transition risks.”
On an agency level, in June, the Government Accountability
Office (GAO) issued a report criticizing the Federal Retirement Thrift
Investment Board (FRTIB), which oversees the $735 billion Thrift Savings
Program (TSP) for federal employees, for not taking “steps to assess the risks
to TSP’s investments from climate change as part of its process for evaluating
investment options.”
Sources note that it’s still unclear how
climate-benchmarking risk concerns will influence companies’ DC plans. Sponsors
control plan lineups and could increase the presence of environmental, social
and governance (ESG) funds, but participants still choose their own
investments. DC plans, and the way they’re set up with a menu of options,
present a slightly different challenge than DB plans, in which the sponsor can
take a holistic portfolio view, says Gillett. It’s perhaps harder to assess
risk looking at an individual investment offering or option, because each
investment might have different roles in that menu’s structure of options, he
adds.
TCFD 101
The UK’s regulations and the GAO’s report both reference the
Task Force on Climate-Related Financial Disclosures (TCFD)’s recommendations.
TCFD’s supporters believe the recommendations will benefit investors,
particularly those with a longer-term focus like plan sponsors, by providing
“clear, comparable and consistent information about the risks and opportunities
presented by climate change.” Per the report: “Compounding the effect on
longer-term returns is the risk that present valuations do not adequately
factor in climate-related risks because of insufficient information. As such,
long-term investors need adequate information on how organizations are
preparing for a lower-carbon economy.”
The TCFD recommendations form a voluntary framework for
climate-related disclosures, covering governance, strategy, risk management,
and metrics and targets, explains Joost Slabbekoorn, senior responsible investment
and governance specialist at APG Asset Management in the Randstad, Netherlands.
“The TCFD can be used by corporates as well as asset managers and asset owners.
Right now, the TCFD is a voluntary framework but elements of it have already
surfaced in regulation, for example, in the EU Sustainable Finance Disclosure
Regulation [SFDR],” Slabbekoorn says.
And the TCFD recommendations are gaining global acceptance.
The Financial Stability Board’s 2020 “Status Report” states that more than
1,500 organizations have expressed their support for the TCFD recommendations
and nearly 60% of the world’s 100 largest public companies support the TCFD,
report in line with the TCFD recommendations, or both.
Scenario Analysis
The GAO and TCFD also both cite the need for organizations
to conduct scenario analysis, which is an analytic technique for projecting the
possible impact of climate-related change.
“Scenario analysis is trying to ask, in the future world,
when we do respond to climate [change] and we have the policies in place that
respond to it, what does that actually do to your business?” says Laura Zizzo,
co-founder and CEO of climate-risk consulting firm Manifest Climate in Toronto.
“For instance, if we can no longer run internal combustion engines, what does
that actually do for my business?”
Sarah Bratton Hughes, head of sustainability, North America
at Schroders in Brooklyn, New York, says Schroders has built its own toolkit
for scenario analysis, but she warns there is “no silver bullet” or perfect
scenario analysis.
“We’re focused on assessing [companies’] physical risk,
their transition risk in our carbon value-at-risk model, which is essentially
stress-testing portfolios for carbon pricing, and we’re focused on
understanding stranded asset risk—how exposed they are to what we would
consider climate growth around a technological perspective,” she explains. “And
the next area that we’re really focused on is climate alignment: How aligned is
this company’s future trajectory with a one-and-a-half-degree world, which is
essentially the same thing as being net-zero?”
The Benchmarking Challenge
Investors can choose from a range of benchmarks to track
their investment results and operational performance. Benchmarking a
portfolio’s investments for climate change risk is more of a challenge,
however.
Zizzo says she believes the problem arises because
traditional financial benchmarks are not risk-adjusted for climate change. “I
think we have to think about that and figure out how we risk-adjust our
financial benchmarks for climate change, because we are seeing contraction of
GDP [gross domestic product] based on physical risk alone that is not factored
into the benchmarks,” she says.
Current fund benchmarking focuses on assessing fund impacts
on the environment, Feng explains. “The converse––benchmarking for the climate
risk of investments––is nascent, as risk methodologies to estimate climate
impacts continue to evolve to represent both physical and transition risk, and
physical asset data become more reliable,” she says.
Feng reports that The Climate Service has recently
calculated the climate-related financial risk for the S&P 500 within its
Climanomics platform, allowing users to benchmark and compare global industry
classification sectors. “By year-end, we will have climate financial impacts
for major U.S. corporate bonds and global listed equities, followed in 2022 by
coverage of sovereign and municipal bonds,” she adds.
Is It a Fiduciary Duty?
Even if an institutional investor agrees that including
climate-change risk analysis in its investment management makes sense, does its
inclusion rise to the level of fiduciary duty?
Thomas Tayler, a senior manager in London-headquartered insurer
Aviva Investor’s Sustainable Finance Centre for Excellence, says he believes it
does. Fiduciary duties require investors to act in the best interests of their
beneficiaries and to take all material factors into account when making
decisions, he explains. Climate risks are financially material risks to the
investments that sponsors or their delegated asset managers make on behalf of
their beneficiaries and therefore should be taken into account alongside any
other risk with the potential to have a material impact.
“The longer term the investment horizon, the more likely it
is that climate will not only be a material risk, but the most material risk,”
Tayler maintains.
Feng expresses a similar sentiment. In the absence of a
legal redefinition under the Employee Retirement Income Security Act (ERISA) by
the Department of Labor (DOL) of fiduciary duty to include ESG factors, at the
most fundamental level, sponsors need to assess if climate change has an impact
on fund solvency and the ability to pay benefits, Feng says. She believes that
in the same way a corporation’s failure to disclose risk or mitigation means it
is difficult to assess the impact on share price, a fund’s lack of
understanding and disclosure of climate risk make it difficult to assess the
impact on portfolio performance and for plan participants to be fully informed.
Looking Ahead
The sources interviewed all agree that market and regulatory
forces are aligning in support for greater inclusion of climate-change analysis
in retirement plan management. And, given the Organisation for Economic
Co-operation and Development (OECD)’s estimate that pension funds held more
than $35 trillion of assets worldwide at year-end 2020, the result could be a
profound impact on global capital flows.
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