Getting to grips with climate
Paul LeeHead of Stewardship& Sustainable Investment Strategy
Sustainable investing, it’s the word on every investor’s lips. So, to ensure you’re well-versed with the latest happenings in this space, we’ll be speaking to a member of our Sustainable Investment team each quarter and sharing their responses via Investment Edge.
This quarter, we spoke to Paul Lee, our Head of Stewardship & Sustainable Investment Strategy, about whether climate change is an investment issue and what wealth managers should be doing about it.
Is climate change an investment issue?
Climate change is an inescapable issue in all parts of our lives, including our investments. Each week, we see fresh physical impacts from the excess of carbon dioxide in our atmosphere – at around 415 parts per million (ppm), we’re about as far above the 280ppm level in the pre-industrial era as the ice ages were below that level. If we think about ourselves entering the opposite of an ice age, that definitely has implications for us and our investments. World temperatures have already risen 1.2 degrees above those seen in pre-industrial times and we’ve baked in further rises.
The world’s scientists argue that emissions must be reduced rapidly from current levels simply to stop the atmospheric concentrations of greenhouse gases, such as carbon dioxide, from rising further. That means that every company on the planet will need to transition from our current carbon-intensive model for business to something different. The entire world economy will need to be re-engineered. It’s the sort of shift we saw over centuries in the agricultural revolution and over decades in the industrial revolution. Scientists say that the time we have to deliver this is short – perhaps only the next 30 years or so.
Some companies will navigate that transition better than others. Some won’t survive the process at all.
This presents both an investment opportunity and a challenge. We’ve so far seen fine words but limited actions from most world governments, but as the threats imposed by climate change become harder to ignore, the political pressure for change will likely grow rapidly, and the economic shift may become more abrupt.
Investors prosper by being ahead of shifts and by limiting the downside risks of them. A wise investor will be working to position their portfolio to reflect possible changes as politics and economics respond to these scientific facts and the real-world impacts we’re seeing.
Is there a framework for measuring the impact of climate change on investments?
The Task Force on Climate-related Financial Disclosures (TCFD) is the main framework for investors to understand their climate exposures and get to grips with the climate risks and opportunities associated with their investments.
The TCFD was a body set up by the world’s central banks to advise on how financial institutions and companies might best report on the risks and financial implications of climate change. It set out a framework for thinking about climate – although it can actually be applied to almost any risk area. The framework uses four pillars to help shape reporting: Governance, Strategy, Risk Management and Metrics and Targets.
Governance calls for climate to be considered from the top of the organisation, insisting that it’s a board-level issue that must be reflected in all decision-making. It needs, TCFD argues, to be built into Strategy and used to help shape all long-term thinking. For an investor, it needs to be embedded in all planning for strategic asset allocations and should be reflected in the analysis of the possible impacts of potential climate scenarios for portfolios. Climate should be an integrated part of all Risk Management, built into systems with appropriate oversight. Finally, Metrics must be captured and assessed, and Targets set against one or more of these metrics in order to assess progress against the change that is needed. Among the most used metrics are backward-looking ones, measuring the level of carbon emissions from a portfolio now, and forward-looking ones, estimating the trajectory of the portfolio towards the future decarbonised economy.
This reporting framework is slowly being applied across the world and the global economy.
Does this apply in the wealth world?
Oddly, in the UK, pension schemes were the first entities to be asked to comply with TCFD. Only more recently have companies been required to do so – helping to provide some of the data that pension schemes and other investors need to understand their investments.
These disclosure requirements don’t apply to wealth managers – at least not yet. But it’s clear that the FCA and others have these issues in their sights and expect reporting like TCFD from the entire investment value chain over time. In requiring fund managers to report against TCFD standards, the FCA said, “Our aim is to increase transparency on climate-related risks and opportunities and enable clients and consumers to make considered choices.”
The regulator went on to say, “Our work supports the UK’s commitments to implement the TCFD’s recommendations and its wider ambitions for sustainability disclosures. The Government has committed to work towards mandatory TCFD-aligned disclosure obligations across the UK economy by 2025.”
So it seems likely that TCFD will be heading your way soon too.
It sounds like compliance. Is that how we should be thinking about it?
As ever with regulation, you could simply approach it as compliance; wait until the rules are set and deliver precisely against them. But, as is the case with most regulations, in doing so, you risk missing a trick.
The way TCFD is framed aims to encourage institutions to consider it throughout top-level decision-making and strategic thought. That’s why the framework starts with Governance and Strategy, and sets all the other expectations within the context of both. The aim is to get boards thinking differently, not just get their organisations to tick a box.
You’ll find that when you start including climate in your risk analysis and gathering those climate metrics it’ll help you to think differently and ask different questions. How much of the overall portfolio is at risk in likely scenarios, and how could we reduce that? Why’s this portfolio emitting so much more carbon than its peers? What’s that manager doing to try to ensure more of the companies it’s invested in align themselves more effectively to the climate transition? Why’s it that these investments seem to match with a world heating by four degrees above pre-industrial temperatures rather than the two degrees or less that we need?
Having the data at hand to ask these questions means that you’ll likely want to ask them, and once you start asking them, you may well find yourselves taking different decisions too. Like food labelling, TCFD disclosures will likely nudge you to different approaches.
Communicating this information to your clients may nudge them to behave differently too.
I’ve long argued that ESG disclosures are key to energising individual investors about their investment portfolios. Not many people get excited by a numerical analysis of performance, but most will be intrigued when they understand how their investments interact with the world around them. As increasing numbers of people worry about climate change, communication about the climate impacts and readiness of portfolios will become in greater demand.
Getting ahead of those expectations, not waiting simply to comply with TCFD requirements when they become a necessity, could prove a wise investment for wealth management firms. We help some of the UK’s largest pension funds make the most of TCFD, and there’s a real chance to learn from their experiences. They’ve already had to face up to this challenge and begun to reveal its opportunities. So, if you’re ready to get ahead, we’re here to help.