It seems as though every week there is news reiterating the risks and threats posed by an overexposure to carbon assets for funds and investments. In March, the Bank of England became the first central bank to acknowledge the risk of climate impact investment risks in its One Bank Research Agenda Discussion Paper. The chapter entitled “Response to Fundamental Changes” considers how physical changes in the environment and resource scarcity translate into financial impacts. Similarly, it highlights how public policy on environmental risks might affect the economy or financial system. It specifically points out the risk “that carbon-intensive assets may become ‘stranded’ as part of a low carbon transition”.
In 2014 nearly 350 global institutional investors representing over USD 24 trillion in assets signed the Investor Statement on Climate Change. Swedish pension giant AP4 led the announcement of the Portfolio Decarbonisation Coalition, a multi-stakeholder initiative to decarbonise USD 100 billion of institutional equity investments. The Montreal Carbon Pledge saw the world’s biggest institutional investors commit to the public disclosure of investment portfolios before the 2015 United Nations Climate Change Conference in Paris, COP-21.
Stranded asset, litigation and regulatory risks
The main investment risks associated with carbon are stranded assets, litigation risk, regulatory risk, and reputational risk. The most attention has been on stranded asset risk. Stranded assets are assets that have suffered unanticipated or premature write-downs as a result of certain risks. Investors are becoming more aware of the risk that fossil fuel resources used for energy generation may be restricted from earning their full economic return. The main risks are changes in the market and regulatory environment associated with the transition to a low carbon economy. Regulatory risk is a broader term that includes stranded assets; the risk that a change in laws and regulations might materially impact the investment. The new and rapidly expanding carbon pricing mechanism in China is a perfect example of how regulation can influence company value and performance: added expenditure reduced company earnings.
As local and global laws and regulations take shape around climate change, litigation risk comes into play. Litigation risk is the likelihood of being taken to court for environmental reasons. This is already happening. The Illinois Farmers Insurance Company filed nine class action lawsuits against nearly 200 local governments in the Chicago area last year, for failing to do more to prevent damages linked to climate change. Finally, there is reputational risk from funding carbon-intensive organisations. This reputational risk is particularly an issue for fund managers whose clients are universities and faith-based investors, who have been very forthright about their commitment to mitigating its climate impact investment risks.
Solution: understand, diversify and divest
In Australia, carbon investment risk management appears to have traction amongst the responsible investment circles, but less so from Australia’s Chief Investment Officers and Fund Managers. One of the main roadblocks has been the availability and quality of solutions.
The first step towards understanding these carbon risks is to quantify the carbon that can be directly or indirectly attributed to the activities of the invested organisation. The best metric is usually carbon dioxide equivalent emissions (CO2e) per annum. This is a good basis for diversifying or divesting, as well as reporting and positioning investment products to stakeholders.
The investment world has been deeply familiar with diversification and modern portfolio theory since the 1950’s. Fund managers might find themselves overexposed to carbon-related risks, and require action to ensure the right balance of low, medium and high risk holdings.
More popular has been divestment, completely withdrawing from carbon-intensive sectors or companies with poor climate policies. KLP, Norway’s largest manager of pension funds with USD 84 billion in assets under management, decided to sell off all equity holdings that derived 50 per cent or more of their revenues from coal based operations. The South Pole Group (of which Climate Friendly is part) assisted in calculating these coal-based related revenues and provided further company-specific analysis. Some fund managers are able to capitalise on its moves with marketing and public relations. Future Super has gained popularity from a fossil fuel free message. The decision of the heirs to the Rockefeller oil fortune to divest from energy-intensive industries gained significant public recognition.
In Australia, carbon investment risk management appears to have traction amongst the responsible investment circles, but less so from Australia’s Chief Investment Officers and Fund Managers. One of the main roadblocks has been the availability and quality of solutions. But these are rapidly improving - online screening and reporting tools, data feed integration services and solutions, portfolio analysis work and forward-looking impact assessment consulting work – offered by organisations in the responsible investment space such as South Pole Group. With these solutions now increasingly available, hopefully Australia’s finance and investment sector does not become stranded itself, and can follow the rest of the world in this burgeoning trend.