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Why climate change matters for long-term investors
For custodians of long-term capital, strategic action around the current and future impact of climate change should be a priority. Climate change will occur over a long timescale and delays in taking action raises the risk of those extreme scenarios where our options to deal with this threat to the global economy will be few1
Long-term asset owners can play a prominent role in transitioning to a low-carbon economy. The risks and opportunities accompanying climate change, for institutional investors, can be addressed with carbon management initiatives. Asset owners not only have a fiduciary duty to invest accordingly, but also to engage companies, regulators and their clients, if a global shift to integrating carbon management into long-term business strategies is to take place. Governments also have an important role to play in facilitating financial sector initiatives towards decarbonisation, through providing a supportive policy environment and accurate economic data. This is particularly the case for carbon analysis in sovereign fixed income investing, a critical area which up until now has been neglected.
The financial sector seeks action on climate change
The Belgian economic think-tank, Bruegel, has urged financial institutions to measure their exposure to ecological imbalances, and encouraged policymakers to develop and implement standards for this. The push for improved carbon management has been supported by investor initiatives such as the UN Principles for Responsible Investment (UNPRI), the investor-led Global Investor Coalition on Climate Change (GIC), and the Carbon Disclosure Project (CDP). The insurance industry has been working hard on carbon management issues for many years. In October 2016, Moody’s Investor Service set out how it now captures the credit implications of physical climate change for sovereign issuers. In December 2016, the governor of the Bank of England, Mark Carney, and the chief executive officer and founder of Bloomberg, Michael Bloomberg, called for financial disclosure of climate change exposures to be regarded as material risks.
The challenge, though, is maintaining momentum and commitment to decarbonisation. Some countries either made big commitments, which continue to be delayed, or have reversed policies when a new administration comes into power. Therefore, governments are critical when providing a supportive investment environment for long-term asset owners committed to the sustainability transition and decarbonisation.
Our positioning for the sustainability transition
At Investec Asset Management, we have made several commitments that we hope will enable us to harvest the opportunities of the green transition. Our Climate Change statement2 further outlines our commitment to act in four key areas: engagement; measurement; reallocation of capital; and advocacy. But besides mitigating transition risks, we are vigilant for opportunities.
Over US$34.3 trillion is needed to invest into new power generation projects required to meet the climate change targets set out in the Paris Climate Agreement. Our Emerging Market Fixed Income (EMFI) team has also been exploring a potential framework of analysis for carbon exposure in sovereign fixed income, an area that to date has been neglected by investors.
Infographic: What is the price of decarbonisation?
Carbon considerations in sovereign fixed-income investing
There are a number of reasons for the lack of a coherent framework for carbon exposures in sovereign fixed-income investing. Bondholders are not owners. It is thus a moot point as to what extent they are financing carbon emissions. Moreover, is a government bondholder financing state emissions only, or economy-wide emissions as well? It is also much easier for equity investors to engage and influence company management. As for disinvestment, it is generally a non-starter, given the need for low-risk yield, and the relatively small universe size, particularly in developed markets. However, given the potential impact of carbon development on global economies, the time is fast approaching where investors must consider carbon trends in their sovereign investments. This is particularly important in emerging market debt, given emerging markets’ formative stage of development and greater susceptibility to climate change.
From an investment perspective there are two key risks regarding climate change: transition risk and physical risk. Transition risk refers to the risks inherent in moving to a low carbon world. Physical risks are somewhat different – this is the risk of financial impact from actual climate change, which today is widely believed to be directly impacted by the increase in carbon in the atmosphere. Asset returns will be driven by the magnitude and immediacy of these risks. Given the intrinsic uncertainty around both these elements, this is still some way from having an impact on assets, but this will inevitably change in the future. For those investors seeking to shape the transition to a lower carbon world there are also many opportunities.
For instance, it is an unfortunate irony that many of those countries most at physical risk from climate change are least responsible for the increase in greenhouse gas emissions, particularly many African countries. While there is uncertainty about the magnitude and immediacy of physical risks, governments can take steps to ensure their economies are resilient and on a sustainable trajectory to manage these risks. Similarly, transition risks can be mitigated through prudent and strategic climate policy. Environmental sustainability extends quite naturally to fiscal prudence, economic diversification, and accountable and responsive governance. As such, we believe there is a strong link to long-term investment return potential. There is scope for institutional investors to incorporate sustainability biases in their portfolio construction, to reward those countries doing the right thing with lower borrowing costs at the margin, while not necessarily at the expense of lower investment returns.
The green bond market3 is another area of opportunity. Indeed, in our emerging market corporate strategies, we already own a number of green bonds. The sovereign green bond market is very much in a nascent stage, but has the potential to expand quickly.
- Fiona Morrison, 20 October 2015. ‘Transition risk is real and needs to be addressed’, Financial Times: https://www.ft.com/content/dc49a75e-7658-11e5-933d-efcdc3c11c89
- Climate change statement can be found: http://www.investecassetmanagement.com/international/professional-investor/document/pdf/Investec-Stewardship-Policy.pdf
- Green bonds are debt instruments where proceeds are used exclusively to fund qualifying green investments.