ALL STAKEHOLDERS PUSH FORWARD
Within the broader investment topic of environmental, social and governance, climate is right at the top in terms of impact and importance,” according to Sarah Bratton Hughes, head of sustainability forSchr oders in North America. “For many years, it has been integral to how we think about the investment landscape. But now, increasing pressure is translating into corporate action. As a consequence, it’s an unavoidable issue for asset managers and asset owners. That’s not to say other areas of ESG aren’t also important. But climate is both imminent and pressing — demanding an immediate response.”
The push toward disruptive change and a net-zero economy is happening at the political level, the corporate level and the social level, she said, adding that it has gathered significant momentum over the past couple of years. About two-thirds of the world’s emissions come from countries that have made commitments to net-zero carbon emissions over the next few decades; and the past 12 months have seen about a 50% increase in the number of companies making commitments to the Paris aligned-decarbonization targets.
“A growing universe of stakeholders is pushing companies towards being more sustainable and more climate aware,” said Matt Lawton, a sector portfolio manager in the fixed income division of T. Rowe Price. “That includes bondholders, shareholders, regulators, employees and customers. If companies don’t credibly respond to these secular pressures, they will be disadvantaged from a capital markets, competitive and, ultimately, an economic returns perspective.”
The key issue, according to Maria Elena Drew, T. Rowe Price’s director of research for responsible investing, is that, historically, companies have polluted the atmosphere without significant repercussions. They can no longer take that stance today. Carbon markets are increasing in size and number and, in particular, China’s new carbon market will cover an enormous portion of the world’s current carbon emissions. So investors need to take a different view of climate opportunity and risk going forward, compared with how they treated such issues in the past.
“The other important point here is that climate considerations are not just about carbon, nor even just about greenhouse gases,” Drew continued. They’re “also about biodiversity and considering how companies use land and water resources, because [how] they impact biodiversity levels and deforestation … has a very big impact on climate.”
“Companies on the wrong side of change will ultimately have to confront increasing cost of debt capital and higher refinancing risk,” added Lawton.
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SUSTAINABILITY AT THE FOREFRONT
“The global energy system is undergoing a seismic transition from one based primarily on fossil fuels to one based primarily on renewable sources,” said Carlo Funk, head of ESG investment strategy for Europe, the Middle East and Africa [EMEA] at State StreetGlobal Advisors. “And this is going to happen, full stop.”
Funk said he believes the world is at a tipping point where ignoring climate change is no longer an acceptable option, and climate-related developments, such as increased regulation and more commitments from the private sector, are accelerating. He pointed out that a couple of decades ago, a chorus of industry experts doubted Germany’s then-announced renewable energy goals, claiming that the ambitious program couldn’t be supported by the country’s infrastructure. However, last year, Germany surpassed 50% renewable generation.
“Right now we’re seeing a lot of pledges, but little has happened as yet,” Funk said. “Eventually those companies will have to live up to those promises — and what happens then? Then we will likely see massive capital repricing and reallocation, leading to climate-centric investment risks and opportunities. Financial market participants will be held accountable, and those are fundamentally governments, corporations, pension plans and the banking and financial sectors. So, while the transition to a low-carbon economy won’t happen overnight, if you don’t act now to prepare, it could be too late.”
“Environment is foremost among ESG factors in terms of driving interest in ESG investing overall, and it’s been that way for a good while,” said Reid Steadman, head of ESG indexes at S&P Dow Jones Indices. “We expect that will continue to be a driving force within sustainable investing not just for the near future, but far into the future.”
That’s part of the reason S&P DJI is expanding its climate-specific indexes, covering broader swaths of the market. For example, the S&P Paris-Aligned and Climate Transition (S&P PACT) Indices tend to be broad and offer a benchmark-like risk and return profile, instead of looking at a very narrow selection of companies.
“We want our indices to reflect current reality, but we also keep an eye toward the future trajectory of markets,” Steadman said. “The environment and, specifically, climate are growing in prominence as a driving force within sustainable investing.… And while there was a time when chief investment officers saw great career risk in sticking their necks out to incorporate climate into their investment strategies, I think we may have crossed a threshold, where there’s risk in not leading. With the arrival of larger and more complex data sets, stakeholders are increasingly looking to providers such as S&P DJI to be thought leaders, to steer the conversation and to be leaders in action — making a significant impact on these kinds of major issues.”
BOTH RISK AND OPPORTUNITY ARE BROADENING
“Climate impact isn’t just about carbon,” said Hari Balkrishna, portfolio manager for the Global Impact Equity Strategy at T. Rowe Price. “Investors need to be focused on things like methane, [nitrogen oxide] and [fluorinated]-gas type refrigerants, which in some ways are much more harmful than traditional [carbon dioxide]. And the risks and opportunities stretch well beyond the energy and transportation sectors to encompass changes in sustainable agriculture, bioplastics and replacing petroleum products with green hydrogen for industrial applications and heavy transportation.”
“Climate factors have to include things like energy transition or the amount of physical climate risk a company has, their biodiversity impact, whether or not they’re contributing to circular economies, and how they’re using land and water resources,” said T. Rowe Price’s Drew. “We also look at how companies handled past controversies, which can be a good indicator of how well they’re managing environmental issues. We consider climate and ESG issues very broadly across every single portfolio because these issues, to some degree, are going to affect the financial outcomes of all of our investments.”
Such a broad-brush approach to defining “climate” relevance is increasingly becoming the norm. As a result, Balkrishna said that within his impact strategy, about 42% of investments are leveraged to the climate-and-resource impact theme. In fact, when one considers the inputs and knock-on effect of climate change, there’s hardly any industry left untouched. (See graphic on climate change impact by sector.)
TAKING AN INCLUSIVE VIEW
“The ESG investing trend, particularly with climate, is toward greater breadth,” said S&P DJI’s Steadman. As an example, he pointed out that “the S&P 500 Carbon Efficient index contains nearly the full portfolio of the S&P 500 index. There’s a reweighting methodology that tilts the constituents toward companies that are doing better from a carbon efficiency standpoint. But rather than focusing on exclusions, as ESG investing has done in the past, the trend now is toward being as inclusive as possible. That is, capturing a broader universe of opportunity and then modifying capitalization weights to reflect ESG principles and priorities.” (See graphic on sector composition of indices.)
According to Steadman, broad, climate-centric indexes tend to reflect the general market more so than narrow, exclusionary indexes. Performance deviations from the market beta are fewer, and the composition offers diversification more in line with the market.
“Through that shift, index users can seek beta exposure as well as express what one could call values alignment,” he said. “These indices also aim to incentivize companies to act in a way that we hope would mitigate climate change.”
What we’re talking about in terms of policy action is reversing a process that has played out over centuries and doing it in less than a generation,” said Andrew Howard, Schroders’ global head of sustainable investment. “The idea that climate issues will just impact a few small parts of the market doesn’t really make sense. This disruptive shift will impact all areas of the economy.”
According to Howard, investors can no longer view climate exposure as a choice —whether or not to invest in climate change, or whether or not to be exposed to climate change. Every asset class, of every type, is now to some degree impacted by climate change.
“The only question today is, How are you managing climate exposure?” said Howard. “This is a disruptive force that will rewrite the rules of success to varying degrees in every sector. So, investing on the basis of what has made companies historically successful is unlikely to work in an environment where those drivers are significantly different.”
AN INTEGRATED APPROACH
“Climate issues are integrated into every single asset class that we are managing here,” said Schroders’ Bratton Hughes. “The fundamental question is, How do we understand and protect shareholder value and find the opportunities created by an inevitable and imminent transition that is moving very, very quickly?”
“I tell investors not to think about climate change just in terms of Big Energy incumbents,” said SSGA’s Funk. “Greenhouse gas emissions are embedded in every economic sector, and there are so many potential technology inputs for climate remediation, from electro-fuel to zero-carbon cement, zero-carbon steel and zero-carbon fertilizer.”
That’s why Funk believes investors should consider climate investing approaches that go beyond exclusionary screening, which often mainly aims to reduce exposure to the biggest carbon emitters. Such approaches would necessarily target materials, energy and utilities. We need a sector like energy, he pointed out, adding that we just need an energy sector that is more carbon-efficient. In the same way, we need a materials sector to build our houses and offices and stores; we just need a material sector that is more carbon-efficient, he said.
“Climate risk is embedded in every sector. So if you really take it seriously, one of the best ways to consider climate is to allocate large pools of capital, as in a core allocation, to support your goals,” he said. “It’s a very, very powerful way to reallocate capital.”
Source: S&P Dow Jones Indices. Data as of April 30, 2021. Charts are provided for illustrative purposes.
STRUCTURAL DISRUPTION: WHO WILL WIN?
“Big Energy incumbents have an advantage because they understand the entire infrastructure and how to bring a unit of energy to the end consumer,” Funk said. “But within that universe, there will be winners and losers. The winners will be those that adapt more quickly and drive the bulk of innovation.”
He likened the coming energy shakeout to the trajectory of digital technologies. Innovation will come from large incumbents, but new emerging players will also tap into the value chain to help bring the world to net-zero emissions. That value chain stretches beyond energy to include steel, cement, fertilizer, plastics, pure thermal energy, thermal storage, agribusiness, construction materials and textiles. Funk argued that winners are likely to be those that have a favorable carbon footprint or those than can rapidly reduce their exposure to climate-related costs. (See graphic below on how winners could emerge with carbon pricing)
“These will be the biggest structural changes since the industrial revolution, and there will be no shortage of very, very interesting companies and opportunities out there for investors to consider,” Funk said.
“Slowing climate change will require the mobilization of huge amounts of capital, something on the order of $2 trillion a year going forward,” said Schroders’ Bratton Hughes. “But pure climate opportunities are a relatively small part of public equity markets today, and those company valuations have increased. That points to the importance of having a disciplined, well-structured investment process, one that can help identify the next generation of leaders.”
A HOLISTIC PERSPECTIVE
Schroders argues that investors should be thinking about the climate issue holistically, both from an alpha and a beta perspective, across their entire portfolio. That could include broad-based core solutions as well as satellite opportunities to add alpha around a theme, such as energy transition or climate change. But she cautions that investors should not be too narrow in their focus.
“Electric cars and windmills are important,” she said. “But don’t write off important industries traditionally thought of as ‘dirty,’ such as aluminum, which will be instrumental to light-weighting transportation, a crucial component of an energy-efficient future. Likewise, about 70% of the companies launching new climate-related technologies are private. There’s potentially a significant amount of alpha to be found in private markets, where potential mispricings are more common. And potentially a huge amount of government investment will be required to address climate issues, which will have a big impact on sovereign and municipal markets, both in terms of risk and issuance.”
Fixed income, in fact, potentially offers some of the most attractive climate-targeted investments. “From a fixed-income perspective, climate is traditionally viewed as a risk that needs to be mitigated,” said T. Rowe Price’s Lawton. “While that still holds true, we believe there are also capital appreciation opportunities by investing in companies on the right side of this secular trend”
DEMAND FOR GREEN BONDS
Lawton sees two areas of opportunity. The first is green bonds, which grew to $136 billion in issuance in the first quarter of 2021, a 100% increase over the first quarter last year, and he expects that growth to continue at a healthy rate.
“There are also pockets of value among hybrid capital securities from issuers at the forefront of the renewable-energy movement,” Lawton said. “These securities typically offer attractive valuation relative to senior unsecured bonds from the same company. Capturing incremental yield while directing capital to long-term climate winners is an appealing proposition.”
However, he offers a cautionary note on green bonds: The market is wrestling with high sector concentration, price distortions and greenwashing — the risk that investments presented as green really aren’t, once you look under the hood. About 80% of corporate green bonds originate from just three sectors: utilities, banks and real estate. Over time, Lawton said, diversification should improve as new issuers enter the market. In addition, investors may have to navigate price distortions given increasing demand from climate-focused bond funds. Lastly, he noted, it’s important to go beyond the green label to research the underlying projects being financed. “Not all green bonds are created equal. Investors need to understand [that] relative climate benefit varies by bond,” said Lawton.
State Street’s Funk also offered a caution that relates to green bonds, as well as social bonds or other sustainable debt. “Make sure that the bond proceeds are targeted and spent on projects that are actually ‘green’ or ‘climate-related,’” he said. “This raises the issue of data. If you want to move the dial on climate, you need a specific focus within ESG on the climate element, and you need to look at different and potentially additional data points to confirm that any given investment proposition is truly focused on climate.”
“For us, 2021 is really the year of Paris-alignment,” said S&P DJI’s Steadman. “We’re seeing incredible interest in newly launched climate-focused indices as a lens through which we can have discussions with asset owners, and as a departure point for all kinds of index investment strategies.”
DATA GETS MORE GRANULAR
Underlying that work is a commitment to comprehensive, transparent data that has a wide range of uses. For example, Steadman pointed out that low-volatility strategies can be concentrated in carbon-intensive industries and good data helps asset owners put a climate lens on a strategy that is not precisely ESG or climate. Data is essential in addressing the question of greenwashing, he noted, and it is also critical in measuring risk in specific industries and in comparing companies within their peer groups. (See chart on carbon pricing risk exposure.)
“In 2016, S&P Global acquired a company called Trucost, a recognized leader in the field of environmental metrics,” Steadman said. “We combined Trucost’s capabilities with ESG scoring and analytical tools from a Swiss company [that] S&P Global acquired called SAM, which is now also part of S&P Global, to create Sustainable1, an S&P Global ESG research, data and analytics hub. When it comes to environmental data that Sustainable1 produces, there’s a checking [process] that takes place, where we start with public disclosures and then model our own estimates for climate impact. That validation step is critical because there can be widely different levels of reporting rigor when it comes to emissions and other environmental metrics. So it’s important to publish indices based on consistent, sound data.”
Finally, climate data needs to go one step further than just reporting on the current climate profile of a company or investment. To present a true picture of future risk, opportunity and competitiveness, data has to be forward-looking, according to Schroders’ Howard.
“Ratings are inherently backward-looking,” Howard said. “We also need data that tells us how a company intends to change going forward. How are we going to hold them accountable? And what benchmarks are they giving us to measure their progress?”
THE POWER OF ENGAGEMENT
To have an impact on climate, or to attempt to mitigate climate risk in an investment portfolio, the first thing that asset owners and investment managers need to do is engage in the issue — on multiple levels.
Steadman said he believes that momentum toward climate engagement is likely to accelerate in the U.S., particularly in the second half of this year, and that climate indexes, particularly the S&P 500 Paris-Aligned Climate index, will be major benchmarks and a standard in their own right.
“As we build our different products, we very much have in mind that there will be certain asset owners that are expressing their worldview through the prism of an index,” said Steadman. “They’re perhaps using an index as a tool for investing in line with their institution’s values. Climate-focused indices offer a comprehensive vehicle that institutional investors can use with passive management, thereby potentially rewarding companies for positive progress on ESG generally, and climate specifically.”
“For us, the question is, how can we use our influence as active managers to facilitate change in companies, and help those companies transition toward more sustainable businesses and business models?” said Howard. “That’s really the role of engagement and ownership, and using our voice and our leverage to achieve that.”
“We believe in the power of engagement, which is why, in the context of climate, we put engagement right up to the top priority,” said State Street’s Funk. “If you divest, you lose your ability to engage and vote. So this is something we always keep in mind: Exclusionary approaches rob you of a seat at the table. In addition, divestment may open the door to opportunistic investors to take your place, and they likely won’t have the same climate priorities that you do. However, for certain climate strategies and ESG strategies, it is common to apply exclusions, provided companies cross previously defined lines of business behavior.”
LAYER IN FIDUCIARY DUTY
Going beyond influence, asset owners and investment managers also need to think about engagement through the research and portfolio-construction process.
“No company is going to escape climate impacts,” said Howard. “So from an investment perspective, we need to engage in the issue from the point of view of risk, opportunity and fiduciary duty. Our aim is to identify those companies with strong business models that will not only survive, but thrive, because management has taken steps to ensure the organization’s sustainability.”
“The thing with climate is that a completely holistic ESG approach is not going to have much of a climate impact,” said Funk. “For example, a broad-based ESG portfolio will never be Paris-aligned. To reach that goal, the investment methodology needs to be refined with additional data points, metrics, overlays and other approaches. ESG and climate principles are not mutually exclusive, but if you want to really move the dial when it comes to climate and climate change, you need to engage specifically with the climate issue, and climate should be embedded as the dominant analytical factor.”
“I think climate-focused investing is important from two angles, one moral and one financial,” said Balkrishna at T. Rowe Price. “On the moral side, I think it is our duty to allocate capital to incorporate a company’s true impact. We can all agree that climate change is something that we’ve got to solve for, while we live in an era of inequality and social issues as well. Allocating capital to good actors and taking capital away from the bad actors is probably the most efficient way to address some of the world’s pressure points,” he said.
“And then on the financial side, as investors, we’re numbers people too,” Balkrishna continued. “So we’re not simply investing in something just because it has impact. We’re investing in it because it also has the potential for financial performance. We invest in companies that generate positive impact because we believe those companies will also have more sustainable growth prospects and, as a result, better financial performance over time.”