Climate-related investing gets hotter among institutional investors

Institutional investors are beginning to incorporate climate change risk factors into their asset allocation processes, and leading funds are contemplating a bevy of environmentally friendly investments.

Major funds such as the Swedish buffer fund AP1, the British Columbia Investment Management Corp., the BT Pension Scheme and the Environment Agency Active Pension Fund already have invested billions in environmentally friendly assets and are planning to expand their investments.

But while leading funds already have made climate-related investments part of their portfolios, the move to incorporating climate change into their asset allocation processes or understanding how climate change risks affect them at the total portfolio level is just beginning.

A recent report from consultant Mercer seeks to speed that process.

Investors need to broaden their strategic investment approaches to include an awareness of risk factors as well as diversifying into climate-sensitive asset classes, such as infrastructure and private equity, according to Danyelle Guyatt, principal and global head of research, responsible investment at Mercer.

“There is an increased source of risk from climate change, and it could be material,” Ms. Guyatt said at a recent client conference on the report in London. Investors should “embed an early warning system” into their risk management processes, specifically by having trustees view and discuss climate change as a strategic risk. “It should be looked at not as a nice, tree-hugging thing to do, but as part of a prudent risk management process,” Ms. Guyatt said.

At AP1, the 218.8 billion Swedish kronor ($33.9 billion) fund that provides buffer funding for the government's pay-as-you-go social security system, officials “started to (use factor-risk analysis) in 2010 as part of the (Mercer) project ... and will use it now in the future,” said Ossian Ekdahl, head of communications and corporate governance at the Stockholm-based fund. “It's a bit early to say, but we will explore the possibility” of allocating directly to climate change risks in the future.

AP1 also has increased its exposure to climate-sensitive asset classes and is considering investments in timberland and infrastructure. In 2010, the fund boosted its real estate exposure to 5% from 3.3% at year-end 2009 and made new private equity commitments of 1.8 billion kronor.

“Of course we make a very broad analysis before we move into a new asset class, and climate change sensitivity is just one factor behind that,” Mr. Ekdahl noted.

British Columbia Investment Management Corp., with C$85.4 billion ($86.7 billion) in assets, is one to two years away from having a total-portfolio understanding of its climate change investments, Doug Pearce, CEO and chief investment officer, said in an interview. “There's a lot more work to be done on that,” he said, adding that the fund will likely keep allocating capital to climate change investments in the meantime.

The Victoria-based bcIMC oversees pension and trust funds for public entities in the Canadian province. As of Dec. 31, 4.3% of assets were classified as strategic investments and infrastructure. The fund is working to incorporate environmental, social and governance factors into all of its investments and does not isolate green-only assets, spokeswoman Gwen-Ann Chittenden said in an e-mail.

Mr. Pearce hopes to expand the fund's allocation to infrastructure, and fund executives are looking into sustainable agriculture investments as a way to take advantage of rising food prices.

“This story is just beginning,” Mr. Pearce said. “Our industry is stepping out and coming to grips with where our long-term capital should be deployed” to manage risks of and take advantage of opportunities in climate change.

Helene Winch, director and head of policy at the £34 billion ($54.8 billion) BT Pension Scheme, London, said at the Mercer conference that climate change “is part of (the) strategic asset allocation work we do.” Fund executives will use scenario models created for the report in their allocation decisions to alternative assets, which the fund is adding to boost diversification and lower overall risk, she said.

BTPS executives are considering increasing their infrastructure allocation, and are devising a way to make their passive equity investments able to take advantage of climate change. Infrastructure is part of a 20% allocation to alternatives, according to the fund's 2009 annual report; more current information was not available.

“A lot of our equities are passive, and by that we would have exposure to high-carbon stocks that we don't necessarily want,” Ms. Winch said. “We are working with Trucost Data (PLC) and FTSE (International Ltd.) to help us allocate to a different index ... which helps tilt us toward more carbon-efficient stocks.”

The Environment Agency Active Pension Fund, Bristol, England, has about 12% of its £1.7 billion investments in “green” assets, Howard Pearce, head of environmental finance and pension fund management, said at the Mercer conference. And green assets are expected to take on a greater portion of the portfolio over time, he said.

“By 2015, we think 25% of our fund will be invested in contributing to the greener economy,” Mr. Pearce said.

The fund is about to begin a strategic asset allocation review, and the Mercer report will help trustees incorporate climate change risks into those decisions, Mr. Pearce said: “That will cause some changes to our asset allocation, probably some derisking, and probably a bit more diversification. That's the general direction we'll be heading.”

The Environment Agency fund, BT Pension Scheme and British Columbia Investment Management were among 14 institutional investors worldwide that worked with Mercer to develop the report. Investors provided asset allocation data, and received a tailored report on recommended changes.

In its tailored report to the Environment Agency, Mercer recommended the fund diversify into climate-sensitive assets such as agricultural land, timberland, green bonds and infrastructure, Mr. Pearce said.

The public report, “Climate Change Scenarios — Implications for Strategic Asset Allocation,” took about 18 months to complete and is available as a free download at www.mercer.com/climatechange.

Climate change research has looked at many investment subjects, but “one of the things that hadn't been touched upon was what climate change might mean on the total portfolio level for institutional investors,” said Simon Dietz, deputy director of the Grantham Research Institute on Climate Change and the Environment and principal at Vivid Economics Ltd., London, said at the conference. “I'd argue that it's a groundbreaking report in its focus on exactly that.”

Grantham and Vivid developed four climate-change scenarios as part of the report. By overlaying asset allocation data from participating funds on the climate-change scenarios, Mercer was able to show how certain environmental and policy variables might affect investments over the long term. In the most likely scenario, institutional investors will be rewarded for investing in climate-sensitive asset classes, according to the report.

In the report, Mercer found that over the next 20 years:

• climate change policy risk could boost portfolio risk by 10 percentage points;

• the impact of climate change on the environment, health and food security could cost $4 trillion, and policy changes worldwide could boost the cost of carbon emissions by as much as $8 trillion; and

• investments in low-carbon technology could reach $5 trillion.

The report emphasized the need for institutional investors to engage with policymakers worldwide as part of a risk management approach. “The longer the policy delay, the higher the impact costs will be for investors,” according to the report.

And some funds engage directly with companies they invest in. Because huge funds need to invest broadly — and often passively — in public companies worldwide, they see active ownership as the best way to improve efficiency and climate-change practices throughout markets and industries, thereby lowering risks to their fund.

Tom A. Fearnley, investment director at the Norwegian Ministry of Finance, said the 3.15 trillion kroner ($543 billion) Government Pension Fund-Global, Oslo, is simply too big to invest in most climate-sensitive asset classes, which tend to be capacity-constrained. “Instead, we have opted for engagement with companies,” Mr. Fearnley said. “For a fund of our size and influence, we believe that is the most effective way” to manage climate risks.

Like the Norwegian fund, Danish fund ATP has no plans to incorporate climate change into its strategic-level decisions.

“For us, it's about (internalizing climate change risk) not about asset allocation; it's about the risk to the individual investment,” said Ulrik Dan Weuder, head of investment structuring at the 476 billion Danish kroner ($86.7 billion) ATP, Hilleroed. Within each industry, “there will be winners and losers,” he explained. “We'll still be driving cars in 30 years. The question is what types of cars will we be driving and who will be producing that car.”