Challenges and opportunities to invest along the goals of the Paris Climate Agreement
Sustainable investment is gaining massively in importance among providers of occupational pension schemes - albeit starting from a very low level, even by international standards. The reasons for this increase in importance, especially among open pension funds, are on the one hand the wishes of the investors, i.e. the companies and ultimately the employees. On the other hand, legal and regulatory requirements provide more transparency with regard to ESG aspects. Not least the EU Action Plan, the introduction of fossil-free climate benchmarks and the EU Disclosure Regulation (SFDR), which has come into force in March 2021, will provide a further boost here. The most important motivation, however, is the realisation that ESG and especially climate risks have become a non-negligible factor in capital investment itself. What is more, in addition to pure risk avoidance, for example through exclusion strategies, it is becoming increasingly clear what investment opportunities lie in the fossil-free transformation of national economies.
The consideration of the ecological, political and, above all, financial impacts of global climate change on investment portfolios and, consequently, a consistent orientation towards the goals of the Paris Agreement on Climate Change are therefore rightly increasingly becoming the focus of pension funds.
Aligning a portfolio with the goals of the Paris Agreement is a complex task. There are many reasons for this: incomplete and inconsistent corporate emissions data, evolving climate science and scenario analysis, and the limited availability of robust and plausible rules to measure corporate and portfolio performance. For these reasons, a best-effort and mandate-specific approach that uses transparent reporting metrics and climate science depending on the nature of the portfolio and the asset class in question makes sense. Scenario analysis is important as a measurement and portfolio benchmarking tool. However, there is a danger that the investment industry is trying to find a highly simplified, binary solution to climate risk assessment. For example, integrated climate models are very sensitive to discount rates and assumptions about future technological developments. For example, a high discount rate suggests that we can meet the goals of the Paris Agreement while still emitting CO2 into the atmosphere for many years to come. The models assume that Carbon Dioxide Removal (CDR) will be available largely through Carbon Capture and Storage (CCS) technologies in the second half of the century with very large capacities and at a low price. However, although the technology exists, its viability on large, industrial scales is still unproven. Emissions data are considered relatively robust for direct emissions (Scope 1 and 2). However, much of the data used for ratings and optimisation is estimated, especially the life-cycle emissions included in Scope 3.
Systematically constructing portfolios based on reported carbon emissions without checking for data gaps or using broader climate-related inputs can lead to sometimes counterproductive outcomes and high, unintended risks. Investments in so-called "green solution providers" can be disadvantaged compared to "dirty" industries. For example, a lack of full life-cycle emissions data may lead to a solar panel manufacturer being judged in the same way as a car manufacturer in terms of its carbon footprint.
Scope 3 emissions are notoriously difficult for companies to report, but their impact is particularly important in certain industries and sectors. Data shows that Scope 1 and Scope 2 emissions from the energy sector are lower than emissions from the materials and utilities sector, for example. However, Scope 3 emissions from the energy sector dwarf all other categories. This has implications for the construction of indices optimised on Scope 1 and 2 emissions data and shows why some "low-carbon" funds include oil and gas companies among their largest holdings. Failure to consider entire value chains can lead to inefficient reallocation of carbon exposures and hide risks rather than effectively reduce them. If we consider the goals of the Paris Agreement to be essential and achievable and want to align ourselves with them, there are companies we can avoid to minimise the risk of stranded assets and limit transition risk or hidden carbon risks. For this reason, climate-smart strategies should be fundamentally fossil fuel free.
The success of such a climate-smart investment strategy depends, on the one hand, on access to high-quality data and, on the other hand, on an understanding of where the data gaps are. This is especially true for a systematically managed portfolio. Here, reliance on limited emissions data can lead to some unintended consequences in portfolio construction, such as hidden climate risks and other market-related risks like sector or country biases. Given the plethora of climate funds and indices available, swapping a market cap-weighted equity index for a low-carbon solution is an active choice. Recent research by Carbon Tracker has highlighted that none of the major oil and gas companies can be considered parity compliant. In 2019, the oil and gas industry spent 99.2% of its capital expenditure on fossil fuel development, compared to 0.76% on renewables and 0.04% on CCS. The fossil fuel industry is not expected to transform into the renewable energy giants of the future. Because of the huge investment opportunities, the Paris agreement focus should extend to investing in climate solutions, not just avoiding risk. The MSCI World Index is not suitable for this from a climate risk perspective. Investment approaches that only focus on this benchmark cannot deliver a successful Paris alignment due to the high share of fossil business models and the extensive lack of green solution providers. By mixing in climate-conscious investment strategies, a weighting of such green solution providers that is up to 20 times higher than the MSCI World can be achieved. The focus here is on stronger allocations to renewable energy technologies such as solar and wind power. However, this should be done in a diversified, risk-managed manner that is aligned with the risk budget of the respective pension fund in order to control or limit deviation and liquidity risks.
Despite numerous declarations of their commitment to sustainability, the large passive asset managers continue to vote against many climate-related proposals, even though they could have influenced the vote in most cases due to the size of their participation. When managing climate risks, we therefore believe that the choice of manager is as important as the choice of product. When passive equity exposures are replaced by index-tracking, climate-aware solutions, it is essential to question whether the manager takes responsibility for product construction rather than merely replicating an ineffective index. In addition, it is imperative to consider his engagement, voting practices and corresponding outcomes.
To avoid greenwashing, the fund manager should be able to accurately explain the carbon risks underlying its strategy and demonstrate environmental integrity in portfolio construction, organisational culture and its engagement activities. Traditional portfolio management techniques are proving ineffective for managing climate risk. We believe that climate science expertise is required to ensure robust portfolio alignment with the low-carbon transition.
If you want to find out more about Storebrand's fossil free MSCI tracker Storebrand Global ESG Plus or the SDG solutions fund Storebrand Global Solutions please refer to https://www.storebrandfunds.lu/ or contact us on
e-mail: michel.ommeganck@skagenfunds.com
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