Rivista Corporate Governance ISSN 2724-1068 / EISSN 2784-8647
G. Giappichelli Editore


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Is it time for asset allocators to address climate risk as investment risk? (di Gregorio Saichin)


1. Introduction - 2. Climate Risk and Global Actions - 3. The Impact on Asset Allocators - 4. The Rise of ESG-Compliant Financial Instruments - 5. Outlook and Conclusions - NOTE

1. Introduction

In a race against time to stabilize emissions the world is moving at different speeds when time is of the essence. The scientific consensus has established that the world can only burn 1200 Gigatons on CO2 until the year 2100 to prevent global temperatures from rising above 2 degrees Celsius, This boils down to the ongoing geopolitical zero-sum game on emissions that determines who keeps the highest share of that budget going forward. This global fight has stunted an agreement on mandated national emission targets and leaves the initiative to curb emissions at grassroots levels. This lack of top down action is manifest in big large developed countries that are dominant on the back of the existing legacy model (i.e. U.S.A.) or the big developing nations that feel they have not been able to reap the development rewards afforded by emitting on a par with developed nations (i.e. India, China, Indonesia etc).

2. Climate Risk and Global Actions

Global Finance’s quest for sustainability has developed with a keen eye on risk as the scientific consensus on climate change signal dire economic consequences that are relevant to the viability of insurers and fund managers. The number of insurers unwilling to invest in coal related assets has steadily grown over the last five years and calls grow for companies, banks and investment funds to disclose the carbon footprint of their balance sheets and portfolios. There is gathering momentum behind the TCFD (Task Force on Climate Related Financial Disclosure) with a purported support of $135Tn in assets held by financial agents across the globe to aim for carbon neutrality at balance sheet and portfolio levels by 2050. To get to this point the global community has settled for a voluntary carbon neutrality pledge and a naming and shaming system for noncompliance of voluntary reporting on issuers’ ESG (Environmental, Social and Governance metrics) performance. It is in this climate that BP (also known as British Petroleum), a hydrocarbon industry giant, has pledged to be carbon neutral by 2050, but without disclosing how it will achieve this feat. In early January 2020 fund giant Black­rock joined Climate 100+, a concerted effort by the Fund industry to bear pressure on asset owners to address climate change. Blackrock has also recently pledged to make its portfolios more sustainable by reallocating up to $2Tn of its $7tn (excluding sadly its ETF product range) in sustainable assets over the next ten years. In its letter to investors Larry Fink, Blackrock’s CEO, stated that “Climate risk is Investment risk”. Is too early to say whether there are real teeth in this statement of intentions, but Blackrock remains a lone voice in sustainability as the other titans of the sector in the US – i.e. Vanguard, State Street, T Rowe Price etc. – are yet to articulate a strategy around sustainability.

3. The Impact on Asset Allocators

As time goes by, the stakes are getting bigger for asset allocators. In simple terms, to avoid a total environmental (and economic) catastrophe the world must achieve carbon neutrality by 2050 and decarbonize by 2100 to hit an imperfect target of 2 degrees Celsius. To get there, the world can burn up to 1200 GT (Gigatons) in CO2 emissions (only 464 GT if it is to meet a more ambitious 1.5C target-Inter Governmental Panel on Climate Change – IPCC sources [1]), and some of this budget HAS to be used towards building non emitting assets (such as solar and wind farms, achieve sustainable agriculture, housing, etc.). That will leave coal, oil and gas with stranded assets to different degrees. Under a 2 – degree Celsius limit only one quarter of current coal reserves can be burned. Oil and gas would fare a bit better with 71% and 92% can be burned under this budget –. Whilst it is true that cheap gas has displaced coal in thermo generation, should national governments decide in future years that emission targets have to be tightened the amount of stranded oil and gas assets will rise. This is already showing in enterprise valuations as the value of coal miners has plunged 74% since they peaked in 2011 (Bloomberg index of global coalminers). Valuations at IOCs (International Oil Companies) have fallen half as much as coal valuations since 2011. A downward recalibration in valuations of the top 13 IOCs on the back of proven reserves consistent with a 2C ceiling would signal further write offs from present levels to the tune of $360bn, rising to $890bn should the target be tightened to 1.5 degree Celsius [2]. For asset allocators, the continued investment in hydrocarbon assets can hide a toxic value trap with a limited exit window timeline and dire consequences for LDI investors. Other high emitting industries (i.e. cement, steel, aluminum extrusion, etc) could soon find themselves under scrutiny from asset allocators in the absence of a concerted strategy to mitigate sector emissions. While IOCs have the cashflow to reinvent themselves, National Oil Companies (“NOCs”) will be in a tight spot, subject to their production costs, long term reserves, and government dependence of NOC’s contributions to national budgets. This is ominously in evidence in developing countries where NOC’s of countries such as Venezuela, Azerbaijan or Saudi, for example, account for 75-90% of national GDP. With [continua ..]

4. The Rise of ESG-Compliant Financial Instruments

For the last ten years the Fund industry has heeded investors demand for sustainable assets by designing funds with ESG criteria that showcase a superior adherence to higher standards. The lack of consensus around a reasonable ESG rating framework, the voluntary nature of ESG reporting and the absence of ESG covenants are obstacles to scale up allocations to sustainable investments. Green bonds, and now SDG bonds (UN Sustainable Development Goals framed bonds) carry a use of proceeds language, but money being a fungible medium could easily be used temporarily in high carbon footprint and/or socially inequitable projects muddled in dubious governance. At best, ESG framed investments are focused in rear mirror behavior and hence lack the potency to drastically affect future issuer/borrower behavior when time is a rare commodity. A better framework at achieving behavioral change is in private debt and equity, where the funding party retains some degree of decision making in the asset and can impose or demand impact targets that can be measured ex-post as a result of that investment. The problem for global finance is that these investments are normally bespoke and cannot be easily scaled up to absorb the gargantuan volume of capital needed to stem the challenging environmental degradation trend.

5. Outlook and Conclusions

For Global Finance to become more effective in the future it needs at least one out of three events to happen: a) At a global event, such as COP26 due in Glasgow in November 2020, national governments must agree and commit to their emissions target contributions and strategic plan to achieve carbon neutrality consistent with at least a 2C target around 2085. Countries must subsequently legislate how they will spend their emission budget resulting from this undertaking. This will provide a clear signal to capital where the new risks and opportunities lie. b) In the absence of a global carbon tax, mandating local or state carbon taxes that price the cost of emitting will provide investors with better signals to invest regionally or locally, understanding the full economic impact of issuers’ carbon footprint without relying exclusively on ESG metrics. c) Global investors must collectively push to convert the voluntary code of disclosure of climate risk instituted by the TCFD into a mandatory one. Once this is achieved, investors will have reliable data on issuers’ ESG performance that can mobilize capital more rationally, albeit still looking at a rear mirror picture. We can conclude that climate change presents serious risks to traditional asset allocation strategies and investors must address climate risk as investment risk