Sustainable investing in a time of climate change

As of mid-2019, three years after the Paris Agreement was adopted, and not quite two years since this landmark effort to combat climate change was ratified by a majority of the world’s governments, the global community is still in the early stages of determining how to best share the burden of responsibility for reducing the greenhouse gas (GHG) emissions that are the primary driver of climate change.

The attention of governments, companies, and investors is centering on the global temperature targets that scientists have identified as must-win battles for humanity and the planet. Under the Paris Agreement, this entails limiting the global average temperature increase to less than 2.0°C, or—significantly better if much more difficult to achieve—1.5°C above preindustrial levels. We also know much about the likely environmental, social, and economic impacts of climate change at +1.5°C, +2.0°C, and +3.0°C (or higher) temperature scenarios, which range from bad to dystopian. But as communities, corporate entities, investors, and governments, we have yet to clearly map how we can or should share responsibility for mitigating the effects of our rapidly worsening climate catastrophe. Recent initiatives that Manulife Investment Management has been involved with may give hope that the investment industry is increasingly ready to play its necessary part.

Asset managers continue to weigh how this gradually unfolding global disaster might affect their responsibility to generate returns for their clients. It’s commonly accepted in the investment industry that the fiduciary duty owed to clients, whether institutional or retail, broadly entails asset managers acting in their clients’ best interests, abiding by the terms of their investment mandate, and suitably calibrating exposures to different forms of asset and investment risk in the pursuit of attractive risk-adjusted returns. The concept of fiduciary duty hasn’t yet, under most legal regimes, formally incorporated climate risk management. However, the concept is set to be tested by legislators and courts, as there’s now arguably sufficient evidence available to support the idea that forward-looking climate risk analysis is an integral part of understanding the true scope of asset and investment risk.

Consider some of the well-known headline risks concerning the impacts of climate change. In October 2018, the U.S. federal government provided a fairly provocative outline of its domestic predicament:

• “Climate change creates new risks and exacerbates existing vulnerabilities in communities across the United States, presenting growing challenges to human health and safety, quality of life, and the rate of economic growth.
• Without substantial and sustained global mitigation and regional adaptation efforts, climate change is expected to cause growing losses to American infrastructure and property and impede the rate of economic growth over this century.
• Climate change affects the natural, built, and social systems we rely on individually and through their connections to one another. These interconnected systems are increasingly vulnerable to cascading impacts that are often difficult to predict, threatening essential services within and beyond the Nation’s borders.”¹

Climate risks, which are macroeconomic in scope but will be intensely experienced at the local, microeconomic level, are material considerations that are projected to worsen over time based on our current trajectory. For institutional and retail investors alike, these risks are therefore urgent and pervasive.

Consider the distributed nature of economic exposure in a diversified investment portfolio: Where do its climate risks cluster or appear less material, and can these risks be mitigated without changing the nature of the portfolio’s asset allocation? Or think about the long-term framework of the typical asset-liability management plan: If exposure to climate risks worsens over time, how does that intensification change the basic understanding of any mismatch of assets and liabilities? Put more simply, is there any security in saving and investing for retirement when the world we know today may in a few decades become much less safe, prosperous, and habitable? The closer we look, the more we find that questions of climate risk are relevant to investment vehicles and strategies used by investors at all levels of size and sophistication.

What adds complexity to applying climate analysis to global investing is that there’s no one-size-fits-all approach. Climate analysis needs to be responsive not only to different scenarios of climate change, but also to the variable effects of those changes on geographies, sectors, and individual companies.

In a research report we co-published with two organizations based in Asia, we found that long-term risks to investors with exposure to Asia are particularly acute due to the rapidly compounding effects of climate change on key resources such as water.² With vast cities in 16 Asian countries and territories clustered along 10 key rivers—all of which are fed by the seasonally melting snowpack of the Hindu Kush Himalayan mountains—rising global temperatures are literally drying up the single most relied on water source in the world. And even as this water capacity is disappearing as the atmosphere heats up, rising urbanization rates in Asian cities are putting ever greater pressure on the same shrinking water source, precipitating hard choices about agriculture, industry, and regulation.

We’ve also documented how climate risks will multiply sector-specific risks, such as waste management and storage in some areas of the global mining sector.³ As the frequency and intensity of rainfall rise in locations such as the state of Minas Gerais in Brazil, that spells trouble for both active and inactive tailings dams—fortified storage pools of toxic mining waste—which increasingly run the risk of catastrophic failure due to accelerated erosion. As we know from recent disasters in this region, the loss of human life, property, and agricultural capacity—not to mention civil liabilities that arise from these events—can substantively affect company valuations. It’s hard enough for a mining company to run a profitable business given declining ore quality and strengthening environmental regulation; when you layer on the multiplicative uncertainties of climate change, the total risk mosaic may seem to threaten the sustainability of specific companies’ growth.

While the complexity and interconnectedness of climate change pose a unique challenge to asset managers, standards and best practices for taking action are beginning to take shape. One of the goals of our ESG integration efforts is to manage climate risks in investment processes in order to improve the climate resiliency of portfolios. To sharpen our methods and get ahead of this critical investment issue, we recently participated in a year-long pilot program convened by the United Nations Environment Programme Finance Initiative (UNEP FI). The pilot involved 20 investment institutions from around the world and focused on developing guidance for implementing the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures recommendations.⁴

The group’s objective was to operationalize a methodology of climate risk assessment developed in collaboration with Carbon Delta, a data analytics firm that quantifies investment risks for more than 30,000 companies under numerous climate change scenarios by modeling vast amounts of data, including weather projections and operational locations, among others. The output is used to identify and rank companies based on exposure to climate-related risks or adaptive capacity to mitigate that risk. The pilot demonstrates, for the first time ever in a coordinated manner, how a group of institutional asset managers can effectively collaborate to create a new bottom-up method of fundamental analysis on an ESG theme of critical importance.

Using Carbon Delta’s Climate Value-at-Risk (CVaR) model, our aim for Manulife Investment Management was to understand how climate risks can be assessed at the level of individual securities and at the aggregate portfolio level to inform portfolio construction and how distinct geographical exposures can be identified and managed through asset allocation.

In comparing a portfolio of Canadian equities with a portfolio of Asian equities, we obtained several notable results.⁵ First, we found that the Asian equity portfolio is subject to greater relative transition (i.e., policy) risk under all three climate scenarios—+1.5°C, +2.0°C, and +3.0°C—as well as a greater potential opportunity from technological innovation. Notably for both portfolios, we found that the total cost for companies to transition to a lower carbon future (1.5°C) increased by several multiples of what it would cost for a less restrictive, business-as-usual 3.0°C scenario. Similarly, the company-level business opportunities of climate change—such as clean and alternative energy, greener technologies, and climate adaptation innovations—also become larger in a nonlinear fashion as economies move in the direction of climate resilience.

However, while we found that tech opportunities between these two geographically focused portfolios can vary substantially, it appeared unlikely that the transition risk for either would be canceled out by its corresponding technological opportunity. This asymmetry is important to bear in mind for climate-conscious investors: Even for a diversified portfolio, we believe intention and focus in both asset allocation and security selection are required for the technological opportunity of climate change to outweigh and potentially hedge the negative impact of climate transition and physical hazard risks. Armed with issue- and portfolio-specific VaR modeling, asset managers are in a better position to shift exposures and asset allocation models in favor of harnessing climate opportunity rather than purely mitigating climate risk.

Being able to apply CVaR analysis to identify company-specific risk and opportunity in turn opens up promising avenues for active engagement with company management—both to improve disclosure transparency and to discuss strategies for improving the actual mitigation of climate risks.

There are two common misconceptions about engagement that are worth addressing in the context of this discussion. The first is that asset managers go into climate-related conversations with companies with an adversarial or politically activist agenda, which aims to put high carbon companies out of business.⁶ Aside from the fact that precipitating company failure would contradict the aims of the vast majority of investors, the purpose of engagement is rather to exert influence on corporate strategy to ensure alignment with investor interests. That means engagement is about partnership—about asset managers building trust and credibility with investee companies and emphasizing how climate risk mitigation, for example, is a shared responsibility that’s in everyone’s best interests.

Engagement as a partnership is an iterative process; like any relationship, it involves care and attention. Company management is less inclined to hear an asset manager’s concerns if the latter betrays unfamiliarity with their business, industry, or the particular challenges a company may have to grapple with in connection with climate risk mitigation. Of course, where an asset manager can’t know, for example, the physical location of plants, factories, facilities, or related logistics because these elements aren’t effectively disclosed, then that may become a useful topic for enhanced disclosure, which in turn can support more effective planning and target setting.

The second misconception is that engagement is an ineffective channel of influence that merely sponsors asset managers’ greenwashing of their own response to climate change and sidesteps the call for divestment from high carbon-emitting companies raised by some quarters. This view can fundamentally misconstrue the nature of the investor-investee relationship, particularly in the context of share ownership, where active managers can and are forthrightly bringing climate into regular discussions held with companies in which they’re invested.

Further, if engagement as a tool is used legitimately and on the basis of shared interests, it can be a potentially powerful lever for supporting companies to transition to a lower carbon business model, and can counterbalance the pressure for corporate decision-making to pursue short-term profits at the cost of long-term sustainability. Our focus at Manulife Investment Management on long-term issues in our company engagements is reflected in the fact that we engaged with companies on climate change-related issues most frequently in 2018 (20% GHG emissions and 4% climate vulnerability among all issues engaged on), and this has continued in 2019 year to date (20% GHG emissions and 12% climate vulnerability).

Through collaborative ESG engagement with other investment institutions, our experience is that asset managers can amplify their global impact on the companies, industries, and markets in their collective orbit of influence. And for the companies engaged with, collaborative efforts reduce the noise of numerous points of view, helping focus on goal setting and making consensus part of the conversation from the start.

Among the various initiatives we’re a part of, Manulife Investment Management is a steering committee member of Climate Action 100+, a five-year initiative led by investors to engage systemically important GHG emitters and other companies across the global economy that have significant opportunities to drive the clean energy transition and help achieve the goals of the Paris Agreement.

This initiative is helping to shape a global approach to managing climate risks, calling on companies to improve governance on climate change, curb emissions through adopting targets, and strengthen climate-related financial disclosures. The response from certain key GHG emitters to these three specific requests has already been swift and significant, and includes major emissions-reduction commitments from Royal Dutch Shell and BP, and new commitments to align business strategy with the goals of the Paris Agreement by oil and gas major Equinor, global mining giant Glencore, and the world’s largest shipping company, Maersk.⁷ Climate Action 100+ is proving that collective action brings structure to difficult and urgent conversations and gives meaning to the Paris Agreement while also improving visibility of companies’ intrinsic valuations over time.

Climate risks are increasingly recognized as urgent and globally significant, with almost daily reports on how different facets of climate change are bringing worst-case scenarios for future generations into sharper view. As part of the interconnected ecosystem of stakeholders grappling with these risks, we’re committed to being nimble in our response to evolve and adapt in the way we do business.

We believe this requires rapid and extensive innovation—in the realms of analysis, portfolio management, and active ownership practices. We believe asset managers must act in the vanguard of collaborative efforts and do what they can to support companies to run their businesses in harmony with our natural ecosystems. In this way, sustainable investing is redefining our collective ability to make a positive contribution to society that transcends financial performance.

1 Fourth National Climate Assessment, Volume II: Impacts, Risks, and Adaptation in the United States, U.S. Global Change Research Program, https://nca2018.globalchange.gov/, October 2018. 2 “Are Asia’s pension funds ready for climate change?” Manulife Investment Management, China Water Resource, Asia Investor Group on Climate Change, manulifeam.com, May 2019. 3 “Dam failure: addressing risk management challenges in the global mining sector,” manulifeam.com, April 25, 2019. 4 “Changing course: a comprehensive investor guide to scenario-based methods for climate risk assessment, in response to the TCFD,” unepfi.org, May 2019. 5 As noted in our case study, the Canadian portfolio invests primarily in large-cap Canadian equities, benchmarked against the S&P/TSX Index, while the Asian portfolio invests in equities with primary interest in China, benchmarked against an aggregated MSCI China/Hong Kong Index. The methodology used for scenario analysis is only focused on Scope 1 (direct) emissions and doesn’t consider the impact of climate change risks on Scope 2 and Scope 3 (indirect) emissions. 6 See, for example, “Corporate Climate Coups Averted,” Wall Street Journal editorial board, June 2, 2019. 7. See http://www.climateaction100.org/ for specific announcements.