Michael Sher sets out the option savailable to investors who are looking to improve their portfolios’ climate credentials
Investors are increasingly focusing on climate risk, whether for internal or external reasons, and whether they are driven by wanting to protect assets from climate risk or to benefit the planet. What are the options open to them – and you? Stepping into the shoes of an active portfolio manager and the trustees of a fictitious pension fund as an example, we explore just that.
- Engage intensively with material individual holdings to reduce high emissions and improve the data they publish
- Divest from material individual holdings that have high emissions
- Investment strategies – Change strategic asset allocation by excluding or tilting away from certain regions and/or sectors
- (Pension) buyout – Anticipating funding improvements, prepare for full buy-out, which will wind down the fund and associated responsibilities.
Engagement that works will result in improved portfolio metrics and fewer real-world emissions from the companies engaged with. It may also pressure competitors to reduce emissions, producing a greater real-world impact than investors’ own metrics show. A further advantage is that engagement does not change overall risk-return characteristics, except for the reduced exposure to climate risk. This simplifies things, as no changes to strategy are needed to stay within risk appetite or investment mandate guidelines. However, the timing and degree of success gained through engagement can be uncertain.
Divestment and investment strategies
Divestment rapidly improves portfolio metrics, but there is debate over whether this induces companies to improve real-world emissions and published data. One argument is that customers and investors will shy away from companies that don’t reduce their emissions and produce credible data. A counterargument notes the existence of indifferent investors and customers, shown by the rise in profit and share prices of energy and fossil fuel companies due to the Ukraine war. (For example, Thungela Resources, Anglo American’s coal-focused spin-off, has seen its share price rise by more than 1,000% since June 2021.)
Intentionally changing your strategic asset allocation – for example, by tilting away from certain sectors and markets – has similar effects and considerations as divestment. However, its broader, less-targeted approach and inherent lack of direct engagement can reduce investors’ impact on a given company.
Both divestment and changes to strategic asset allocation can have notable impacts on risks relative to risk appetite, as well as key aspects of portfolios. These impacts may include:
- Less diversification across sectors and regions, and fewer holdings
- Changes in the timing and size of expected cashflows
- Changes in risk and expected returns.
A completed pension buy-out will see all pension scheme assets and liabilities transferred to an insurer and the scheme wound down, with all trustee responsibilities ceasing – including those around climate risks. However, trustees can still select an insurer whose approach to environmental, social and governance factors is aligned with theirs.
In fact, a scheme’s transferred funds can produce greater impact post-buyout, since insurers may find it easier to invest at scale in the more risky early stages of ‘green’ investments. This is because insurers are not subject to the Pensions Regulator’s guidance, which encourages well-funded pension funds to de-risk their investments.
What would you do?
Most of these options and considerations are relevant for a range of asset owners, including family offices, insurance companies and private equity investors. Which apply to you? What can you do once metrics and targets are in place?
You may be a trustee, sponsor, member or adviser; a general partner, portfolio manager or regulator; even an interested member of the public. Whichever stakeholder you are, you have a mandate to contribute to the mitigation of climate risks and improved outcomes for your beneficiaries, your clients and your future.
Michael Sher sits on the Board of the IFoA Sustainability Volunteer Group and leads a small team in building a user-friendly asset liability climate model
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