The current economic and financial models used by the investment industry need to be reconsidered if the targets outlined in the 2015 Paris Climate Change Agreement are to be reached, according to a new report entitled Navigating low-carbon pathways from Hermes Investment Management. Doing so is the only way to address the valuation threats climate change poses to investment strategies, which is part of investors’ fiduciary responsibility to their clients.
The report points to the important role investors have to play in closing the emissions gap between current commitments and the levels required to deliver a world in which global warming is limited to 2°C or less. However, while significant progress has been made, many investors have yet to fully integrate climate change into their investment decision-making processes and stewardship of companies and other assets.
Decarbonisation is a clear social trend today, with the longevity of an asset now inextricably linked to its environmental credentials. Investors need to play their part in financing emerging technologies and services, and in supporting adaptation to climate effects. Cooperation with policymakers will also be imperative to build a supportive public policy environment.
“We need to challenge the current economic and financial models used by the investment industry if we are to ensure the world does not breach the scientifically-guided objectives we have set for ourselves on climate change.”
“We at Hermes believe that to ignore carbon risk is to ignore valuation threats to portfolios. We therefore have a fiduciary responsibility to play our part in steering the direction of companies and supporting their transition towards a 1.5°C world. The challenge, however, is bringing this issue into the way the finance industry operates.”
The report suggests that, within an industry driven by market benchmarks, investment decisions tend to be short term and aligned with the mainstream average. Against that backdrop, it is challenging to incorporate longer-term climate externalities into today’s investment models.
“The question is how to review the benchmarks being used by the industry to account for a wider range of risks and opportunities within longer timeframes.”
The report goes on to emphasise that disclosure of carbon risks are critical, including carbon footprints and mitigation strategies. Hermes actively assesses the carbon footprints of its portfolios to ascertain what drives their carbon intensity. This has given some useful guiding insights over the years: investment style is a strong predictor of carbon footprint and stock-picking has the highest impact on portfolio carbon footprint. However, both the quantity and quality of data on carbon risks need to be improved to enable better assessment of how those risks could affect asset values and to allow for more finely-tuned integration of those risks into mainstream investment processes, according to the report.
It is also important that investors assess and disclose their own exposure to climate risks. Ideally investors should disclose the extent to which, through their investment strategy and other actions, they are achieving alignment with the transition to a low carbon economy.
Finally the report calls on investors to be more forceful in their advocacy to maintain and increase the momentum towards a world where global warming is limited to 2°C or less.
“Engagement is a critical component in seeking to lower the carbon emissions made by a company or asset. Moreover, it is our view that engagement, as opposed to divestment, is the more responsible action to take as it may lead to a higher likelihood of reduced emissions. There is no guarantee the acquirer of the divested asset or security will share our view on climate change risks.”
According to the report, a step-change in energy efficiency is possibly the biggest single opportunity to achieve emissions reductions as it represents almost 50% of investment opportunities globally. Data shows that as of today only 20% of the necessary energy efficiency from buildings, for example, has been achieved.