The UN Framework Convention on Climate Change delivered a successful outcome at the Paris negotiations. This Agreement will have far reaching implications for the companies and assets that pension funds invest in. So how should managers and trustees of pension funds respond to the theme of climate change and the outcomes of the Paris Agreement?
There are three important messages that I, personally, would like to convey to other pension fund investors.
My first point is this: treat climate change risk like you would any other significant risk.
Climate change risk is not going to go away soon. 195 world leaders did not turn up in Paris on a whim. They turned up to debate their individual and collective responses to the risk. And that’s what I urge you to do. Work out what your scheme’s response is going to be. Any personal views you might have on the causes of climate change, or even whether climate change is happening is of secondary importance. What matters is that the collective belief around climate change risk is going to influence inter-government policy and the development of alternative energy sources for decades to come.
There’s a parallel here with liability risk management. Individually we have no influence on the level of interest rates that determine pension liability valuations. The setting of interest rates is down to the collective wisdom of central banks and secondary bond markets. What we control is our response to that risk, i.e. how much liability hedging we put in place within our portfolio. The same is true for climate change risk - we control the response, not the underlying risk.
My second point is to say, when debating the subject at trustee meetings, focus on the financial arguments rather than the emotional ones.
As a private citizen I appreciate that the world is tackling the issues caused by global warming. But that’s not the focus of my day job as a CIO of a UK pension fund.
Sadly, climate change continues to be regarded by many in the investment industry as an ethical investment or SRI issue, and therefore gets prioritised as one. I think that’s a financial mistake. Fortunately, there are signs that this is changing. In a speech last year for example, the Governor of the Bank of England, Mark Carney highlighted the impact that climate change risk was already having on the insurance industry. His focus was on the potential impact to financial stability, not the more emotional ethical considerations.
That’s all very well, but how do you do this? How do you build a framework for assessing the financial arguments? For my third and final point, let me offer a simple model:
Test the financial basis behind any portfolio proposal by asking yourself whether it’s going to make money or avoid losing money.
It is likely that climate change risk will impact some sectors and asset classes more than others. In my view, understanding the dynamics behind climate change risk is something more likely to be handled better by an active fund manager than within passive index funds.
A simple example is the so-called stranded asset theory. The idea goes that some stock valuations are dependent on fossil fuel reserves held deep underground that will never be extracted and sold profitably. Being left as an owner of such stocks means losing money at some point in the future once this risk is fully priced-in by the markets. I think active fund managers, those who themselves understand climate change risk, are better placed to profit from this.
So let me leave you with this question. What’s your response to climate change risk; are you going to make money, or lose money?
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