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Building Climate Aware Portfolios

Climate change is a systemic risk. Here's how to handle it.

With climate change being increasingly recognised as a systemic risk, the investment community is becoming more focused on supporting the transition to a net-zero-emissions economy and establishing sound transition plans.  

The announcement by Cbus Super is the most recent example. Last month, the $54 billion building and construction industry superfund launched a new Climate Change Roadmap targeting a 45% reduction in its portfolio emissions by 2030, and net-zero emissions by 2050. An estimated 45% carbon reduction from 2010 levels is needed to have any chance of limiting warming to 1.5 degrees, which is in line with the aims of the Paris Agreement. The fund has already done significant work to understand its holdings’ physical and transition risks, and has embarked on reducing or removing the assets with high climate-change risk exposure. Concurrently, Cbus has been investing further in renewable energy and climate solutions. Cbus has adopted a ‘whole portfolio’ approach, as this allows more flexibility for asset allocation. It had previously set net-zero emissions targets for its property sector (by 2030) and infrastructure (by 2050.) Under the new roadmap, pathways to achieve this portfolio target will be developed for each asset class, including equities.

Two other Australian industry funds made similar announcements in the last three months. The $120 billion First State Super committed to reducing greenhouse gas emissions in its listed equities portfolio by at least 30% by 2023. From October this year, it will divest its equity holdings in thermal coal. As part of its Climate Change Transition Plan (CCTP), HESTA, a $52 billion super fund, has stated it would reduce the absolute carbon emissions in its investment portfolios by 33% by 2030 and move to net-zero by 2050.  

  • NZ Super, probably the most progressive fund on the climate change front, launched its climate change strategy in 2017 after spending several years developing it. It established four workstreams (Analyse, Engage, Reduce, and Search) to consider climate change issues and its impact on portfolio investments. In one of the interviews earlier this year, NZ Super discussed the challenges in developing the climate change strategy and pricing climate change. These are some of the key learnings:  

    • It is essential to take a long-term view; 
    • Climate change investment strategy sits across the whole of the portfolio and is owned by the Board; 
    • The climate change strategy should be embedded within the organisation; 
    • Progress on climate change work has been built into the team’s KPIs; 
    • Being cognisant of climate change risks and pricing them are two different things; 
    • True risks posed by climate change are still not well understood nor fully priced by the market;
    • It was not possible to produce a prescriptive “how-to” price-in/value climate change framework due to the complexities of climate change and the uncertainty around climate scenarios.  

    The above are valuable insights for those considering having more climate-aware portfolios. However, while most institutional investors are actively discussing climate change, they struggle with the magnitude of the challenge with no coherent plan on how to tackle climate change.   

    Using the Principles for Responsible Investment (PRI) framework, State Street Global Advisors (SSGA) has summarised a list of issues/questions that climate-aware investors should consider to determine their investment policy and strategy and start repositioning their portfolio. These issues are categorised into four broad groups: Context, Principles, Objectives, and Strategy.  

    Context: Framing the relevant factors and dynamics that should be considered in the organisation’s approach to climate aware-investing. The aim is to align all internal stakeholders on their environmental, social and governance (ESG) vision and mission for the firm. 

    Questions to ask are: 

    • What is the organisation’s view on climate investing? Are there conflicting viewpoints? 
    • What is the organisation’s current understanding and knowledge on climate change and critical issues like regulation, social and environmental trends? 
    • Is the business responsible solely to members, or is there a dual objective to contribute value outside the organisation? 
    • What level of resources can the organisation dedicated to climate change integration? 
    • Are there clear lines of responsibility within the organisation?

    Principles: Articulating a specific set of investment principles/beliefs that will inform the organisation’s asset allocation and be the basis of all climate-related investment decisions. 

    Questions to ask are: 

    • Will the climate principles be applied to the entire portfolio, or will there be different principles for specific groups of assets? 
    • Do you consider the impact on people and/or the planet? How would these considerations be translated into investment decisions? 
    • Are your firm’s principles/beliefs based on external principles, codes and/or regulations? (eg. UN PRI, UN Global Compact)

    Objectives: Reflect the organisation’s beliefs, goals, and preferences related to climate change. The objectives’ breadth plays a vital role in determining the final strategy, whether it be an exclusionary approach, integration, impact investing, etc. 

    Questions to ask are: 

    • Do you view climate change as a material investment risk and/or opportunity within the portfolio? Are there any sectors, industries, or geographies that should be avoided/preferred. 
    • Which climate factors do you want to integrate into your portfolio? (e.g., climate emissions, fossil-fuel reserves, brown revenues, “green” revenues, climate adaptability)
    • Is positive real-world impact an explicit part of your primary objective for investment results?
    • What are your objectives on transparency and reporting of climate goals? 

    Strategy: Identify an investment strategy that fits the organisation’s objectives, investment principles/beliefs, and capabilities. 

    Questions to ask are: 

    • Does the firm have resources to manage the strategy inhouse or will it be outsourced to an investment manager? 
    • What are your investment parameters/objectives? Factors to consider include: asset class/sector/benchmark selection, risk and return targets, and investment horizon. 
    • Investment vehicles to be used? Consider expected costs, mandate size, and the number of exclusions to be included. 
    • Active/indexed solution, or a combination? 
    • What quantifiable benefits do you want to create for the beneficiaries other than financial returns e.g., CO2 emission reduction, member engagement on key climate-related issues? 
    • The use of voting rights? Is responsibility for climate-related engagement/voting owned internally or externally? 
    • What are the leading climate performance indicators that all involved parties/internal stakeholders need to report against regularly?  

    Addressing the questions above should help investors formulate specific plans and start the journey towards building climate aware portfolios. As Paul Dobbs, a financial risk expert at consulting firm Sionic says, “Coronavirus is a crisis, climate change is a catastrophe. COVID-19 will impact the global economy for months if not for years. Climate change will impact the global economy over years and decades, if not centuries.”  

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