Managing climate risk in portfolios

Written By: Frédéric Samama Frédéric Samama Amundi Asset Management

& Mats Adnersson CEO AP4

& Patrick Bolton Professor of Finance and Economis Columbia University

Frédéric Samama of Amundi with Mats Andersson and Patrick Bolton introduces and explains the benefits portfolio decarbonisation can bring to investors

Most of society agrees that climate change is real. But climate change isn’t just risky for society; indeed, a growing number of investors are taking climate change seriously. They perceive that climate change-related risks are not appropriately priced. So, based on their fiduciary responsibility to maximise returns, they are reallocating capital away from carbon intensive companies that can be either polluting companies or those exposed to stranded assets.

This reallocation is important in the context of moves to address climate change because it requires no negotiations or agreements between governments, and no binding treaties. And these “green funds” have proven successful track records that hedge the risk of future regulation at no cost, while paving the way for higher future returns. Carbon-intensive holdings could become liabilities, risking investor returns. And delaying carbon divestment may be as costly for investors as it will be for the environment. It would be irresponsible for fund managers not to act, recognising these mounting threats to investors.

Investors should approach climate change as a risk management problem. Up to this point, the divestment movement simmering on college campuses has been motivated by the desire to be a good citizen. But it is not only about doing good, but also persuading asset owners to do good, while maintaining their fiduciary responsibility to their ultimate beneficiaries. We have developed an investment strategy to accomplish both – to invest in green without sacrificing returns. If any investor were to do this on their own, it would be a nearly impossible task, which is precisely why investors should engage with the decarbonisation index providers now available. Investors and asset managers need only to obtain the decarbonised index from the index providers to make their asset allocations. They don’t have to do any of the work involved in investing “green”.

For example, AP4, one of Sweden’s largest pension funds with over US$30 billion under management, has gradually decarbonised its equity portfolio over the past two years, without sacrificing returns. Similar experiments exist around the world, ready for prime time and the mainstream, but still not well enough known among asset owners. This is the reason why AP4 and Amundi, together with CDP and the United Nations Environment Program and Finance Initiative, have formed a not-for-profit coalition of investors, the Portfolio Decarbonisation Coalition (PDC) which is taking further action on climate change.

The PDC’s main target is to bring together institutional investors who are committed to decarbonising at least $100 billion in assets. After a few months of existence, $45 billion has already been committed. This illustrates to other asset owners that portfolio decarbonisation is real, feasible and scalable.

As impressive as these numbers may sound, they still only represent a drop in the ocean compared with the $10 trillion of assets under passive index investment management worldwide, which includes pension and university endowment funds, and more. It only takes 1% of passive investors to replicate AP4’s decarbonisation strategy to achieve the $100 billion objective of the coalition.

We detail in our paper Hedging Climate Risk how much decarbonisation can be achieved without sacrificing returns. It turns out that despite a 50% reduction in its carbon footprint, the decarbonised S&P500 index that AP4 put together has outperformed the S&P500 by 14 bps since its inception in November 2012. And the MSCI Europe Global Low Carbon Leaders Index launched in September 2014 also outperforms the MSCI Europe index (and similarly in the US).

In summary, a free option on a mispriced asset is generated because at the time when climate change mitigation policies are enacted, the decarbonised portfolio will significantly outperform the benchmark. This alternative to divestment meets the constraints of most mainstream investors and therefore can unlock vast pools of assets. It will also create competitive pressure to reduce carbon emissions, as the selection of stocks is annually assessed. We believe that this will accelerate the transition towards a low carbon economy.

This is only one approach among many other possibilities. At this stage we must encourage one hundred flowers to bloom and the sharing of best practices is key. This is one of the fundamental reasons for the establishment of the Portfolio Decarbonisation Coalition: to create a platform where asset owners can pool their knowledge in order to bring prototypes to the mainstream level. Governments can and should create strong policies to leverage this shift in investor awareness by providing clear commitments on future carbon pricing. This will send the right signal to both investors and polluting companies. At the same time, it will help guide investments towards renewable and green infrastructure.

But governments can also help in a much more straightforward way by introducing mandatory disclosure of the carbon footprints of public pension and sovereign wealth funds. This policy has no cost: pension and sovereign wealth funds already communicate on all risks (interest rate exposure, equity market risk, etc.) except for this one. Greater transparency on climate risk will by itself encourage action: what gets measured eventually gets managed.

We urge investors to move towards lower carbon investments today. We now know enough to act. We have the market testing, we have scalable solutions, and we have the investment capabilities. Delaying portfolio decarbonisation will be costly for investors and for society.