The evidence on the importance of limiting temperature rises to well below 2°C continues to grow and investors will have a crucial role to play in bringing this about, says Hermes Investment Management in its 2018 Carbon Report.
Climate change is fast becoming a central theme for investors, both in terms of the risks it creates for the companies we invest in and the opportunities it provides for companies that can help the transition to a low-carbon economy.
The report stresses that navigating the low-carbon transition will require some hard decisions, hard data and systematic, forensic engagement.
Saker Nusseibeh, Chief Executive, Hermes Investment Management, said: “The financial case for acting is becoming ever-clearer. Companies that aren’t thinking about how to adapt to the low-carbon economy are at risk of being left with stranded assets, while those that are offering solutions are really well-placed to thrive”.
Many investors are universal owners, and increasingly aware that they are broadly exposed to physical risks such as rising sea levels and drought, as well as transition risks such as stricter emissions regulations. All of these factors can affect profitability and the viability of business models, including the risk of assets being stranded.
The key is to invest for the long term. “If you have a decades-long time horizon, factors that are not seen as important over the short term become really crucial. If your factory is located on a riverbank and water levels rise; if your factory needs inputs that will be subject to a carbon price; if it is reliant on high-carbon technology, your company is going to be affected,” said Nusseibeh.
Fund managers have to do more than invest for short-term profit. Leon Kamhi, Head of Responsibility, said: “We believe that the role of the fund manager is not only to pick stocks to see what the returns might be, but also to be a good owner of these stocks. The stewardship that fund managers do is crucial”.
This is going to take some hard decisions. Some sectors and companies are preparing for the transition to a low-carbon world better than others. While they have both faced significant challenges, the automotive and utility sectors also have significant opportunities for growth – in electric vehicles and renewable energy respectively.
However, Oil and gas companies may have to face the fact that the interests of investors and society may be best served by them shrinking to limit the impacts of climate change. “No company in the world wants to shrink, but in a low-carbon world, there are very few value-creating opportunities for the oil companies,” stated Kamhi.
To help companies decarbonise, investors need to be forensic in their engagement. Rather than just calling on companies to be more environmentally-friendly, they need to have the information at their fingertips to be able to say: “Your emissions per unit are far higher than your peers, please explain. What can you do to bridge the gap”
Engagement must be at the centre of the investment process, the report says. “At Hermes, we have senior people doing our engagement with business experience. Effective engagement requires people who are really connected to what is going on within the business and not box-tickers. Our engagement and fund manager teams talk to each other so we engage as investors, not as campaigners,” Kamhi stated.
One key development in engagement has been the creation of investor coalitions such as Climate Action 100+, a five-year investor initiative “to engage systemically important greenhouse gas emitters and other companies across the global economy that have significant opportunities to drive the clean energy transition and help achieve the goals of the Paris Agreement”, which was launched in December 2017.
Hermes is one of 310 investors with more than $32 trillion in assets under management signed up to the initiative, which is engaging with the top 100 systemically most important emitters, who are responsible for about 80% of total emissions, and asking them how they plan to reduce their climate impacts.
The Task Force on Climate-related Financial Disclosures (TCFD) is also starting to gain traction, as more and more companies sign up. TCFD shifts the focus of climate risk disclosure from the company’s impact on the environment (e.g. emissions) to how climate change will impact the company’s business model and value. While the quality of submissions is still highly variable, they are improving, and they will give investors a better insight in companies’ climate risks over time.
Low carbon technologies and products that are better and cheaper than what they replace are starting to emerge, helped by financial innovations such as the growth of the green bond market., which looks set to accelerate further as a huge amount of corporate debt is rolled over by 2021-22, the report points out.
But many investors remain complacent, taking a short-term view and delaying actions to reduce the carbon risks to their portfolio. The direction of travel towards a low-carbon economy is clear, but “investors must ensure that they, and the companies they invest in, are on the right road,” said Nusseibeh.