12 February 2016 | By Mark W. McDivitt, Managing Director-Head of US Alternatives at State Street Global Markets, and Tim Nixon, Managing Editor of Sustainability at Thomson Reuters
“What was once unthinkable is now unstoppable. The private sector is already investing increasingly in a low-emissions future. The solutions are increasingly affordable and available, and many more are poised to come, especially after the success of Paris.”…. Ban Ki-moon, Secretary-General of the United Nations.
Did the Paris Agreement on Climate Change really change anything? The short answer is absolutely yes. The immediate results are mostly aspirational, but momentum will pick up in months to come as the 195 member-states follow up on their Intended Nationally Determined Contributions (INDC) to reduce carbon emissions. In addition, increased awareness and related commitment by the global investor community will prove to be among the main drivers that start to mitigate global warming. The Paris Agreement, unlike Copenhagen, Kyoto, and other COP gatherings, drove home the point that the private sector, partnered with individual Country INDCs, will be the impetus needed to start to limit overall global warming to less than 2°C.
Within the global investor community, this will not be just limited to “playing defense” with negative screening and divestiture away from carbon intensive assets, but it will also be about “playing offense” where asset owners, asset managers, endowments, insurance companies and hedge funds will utilize this new growth sector, “ESG (Environmental, Social & Governance) Finance,” to drive above market returns. One important example of this movement is the Portfolio Decarbonization Coalition, representing a diverse collection of investors with the dual aim of earning a competitive return while at the same time supporting the ethical and social goals of COP21.
ESG Finance can be defined multiple ways, to include:
- Algorithmic ESG: Utilizing environmental, social and governance factors within algorithmic tools to help measure risks as well as identify commercial “alpha generating” opportunities
- Standards Investing: Rewarding specific business practices or standards that integrate ecological concerns with social and economic factors (standards include, i.e. Fairtrade, SA8000, Sustainable Palm Oil)
- “Impact” Investing: Deploying capital with the intention to generate a specific measurable, social or environmental impact while producing a positive risk-adjusted return for investors
So what does it mean to play Climate Defense or Offense within this new ESG Finance space?
Playing Climate Defense
Asset owners and asset managers such as pension funds, endowments, insurance companies and hedge funds are already taking steps to implement appropriate strategies to play defense against two new-found risk categories to their portfolios:
- Stranded Assets: Exposure to fossil-fuel intensive assets as part of a portfolio’s overall value
- Carbon Intensive Operations: Scope 1, 2, 3 GHG emissions from business infrastructure activity and related holdings across supply chains and stakeholders
These two overarching risks can be broken down into a list of latent risk factors which can and do emerge to impair the value of portfolios. These risks also tend to reinforce each other, as they become extant within a portfolio. For example, an increase in “reputational risk,” (e.g. a major oil spill) can also increase the risk of divestment, regulatory notice and sanction, and/or litigation.
These factors include:
- Regulatory: Intervention such as a tax or price on carbon, financial penalties like what we are seeing with Volkswagen and BP, and the potentially stranded assets of companies heavily dependent on fossil fuel reserves which may be prohibited by regulation from full monetization in the marketplace
- Operational: Damage or disruption to business infrastructure and global value/supply chains by socio/political forces (e.g. strike or social movement), or to increasingly extreme or unpredictable weather and climate conditions from climate change itself
- Emerging Legal: Risk as exemplified by the recent court decision in the Netherlands in favor of citizens demanding a government response to climate change or by the efforts in U.S. Courts to hold carbon intensive industries liable for damages from climate change
- Reputational or Brand: Reputational risk through being perceived as responsible for the increasingly dire consequences of climate change, as established by the Intergovernmental Panel on Climate Change (IPCC) and global scientific consensus on required greenhouse gas reductions
- Divestment and Fiduciary: Risk of divestment or activism by asset owners as exemplified by the growing number of entities like universities, pension funds and governments seeking less carbon intensive portfolios, and the emerging view that fiduciary care extends to consideration of ESG broadly, and climate-related risk factors specifically
Playing Climate Offense
In addition to defensive, risk mitigating strategies, there is increasing evidence that investors may be able to outperform their benchmark by integrating (ESG) factors into their investment strategy and decision-making process. Evidence for superior performance while avoiding fossil fuel intensive investments is growing rapidly. The below chart documents as such:
New funds are rapidly emerging with strategies that look to optimize returns while mitigating the above-mentioned risks leveraging “big ESG data” to identify attractive risk-adjusted returns. Arabesque, a new Quant fund out of the UK, is one example of a fund playing offense as it relates to the environmental finance space. Since inception from mid-2014, Arabesque Prime, a long-term only, smart Beta fund, outperformed the benchmark by +313 bps, while Arabesque Systematic, built on quantitative systems capturing market sentiment, outperformed by +1087 bps. When ranked against their respective Morningstar peer groups – across both ESG and non-ESG funds – the Prime Fund ranked in the top 20 percent while the Systematic Fund ranked in the top 5 percent.
Paris COP21: The Tipping Point
The COP 21 Paris Accords will be viewed as the Tipping Point event in history that has put the world on a trajectory of achieving, if not surpassing, the overarching goal to keep global warming levels under 2°C. This Tipping Point in global climate action has sent the right signal to the global investor community, thus creating new and unique investment opportunities which have immediate and increasing value.
One message from Paris is now clear: private sector strategies, like those executed by State Street’s carbon reduction and sustainability partner, Blue Delta Energy, exemplify how embracing entrepreneurship and the markets to mitigate climate change yields tangible results and a strong bottom line.” The Breakthrough Energy Coalition launched by Bill Gates and 27 other wealthy individuals (and the University of California) is another good example of the push from the investor community to fund technology R&D that innovates new, reliable and affordable clean energy technologies.
So why is Paris any different from past COP events? This time it wasn’t about setting the rules of the game through a single, binding “top down” approach but rather about a “bottom up” approach where the majority of countries abided by a pledge-and-review system. Business and public interests have truly started to merge. The momentum is set to effectuate change going forward. The global investor community is taking action by applying a right balance of pressure, both defense and offense, on the 195 member-state countries to honor their INDC commitments.
For global financial players of all stripes, it’s time to answer the question, are you playing defense, offense or nothing at all?
 The Fossil Free Indexes US index is based on the capitalization-weighted S&P 500 index negatively screened for The Carbon Underground 200, the largest public fossil fuel companies globally, ranked on the carbon content of their reported reserves.
|*As of October 2015|