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A climate for change: matching awareness with action

“We need 2018 to be the year of investor leadership on climate change.”

So said Mindy Lubber, CEO and President of sustainability non-profit Ceres, reflecting on the 2018 Investor Summit on Climate Risk at the United Nations on 31 January. At Hermes, we agree. Climate change is – both literally and metaphorically – a slow-burn issue, but the grave risk it poses over time is disconcerting.

Research shows that unless serious action is taken, the global temperature will rise by much more than two degrees Celsius by the end of the century. Last year marked the 41st consecutive year with global temperatures at least nominally above the 20th century average, and six of the warmest years on record have occurred since 20101. Atmospheric concentrations of greenhouse gases (GHG) are currently at levels not seen in 800,000 years, and in the 10 years to 2010, worldwide emissions of greenhouse gases increased by 35% to 46bn metric tonnes2.

It is therefore impossible to overestimate the importance of the 2015 Paris Agreement: it unites the world in a single deal on tackling climate change for the first time in history, by committing signatory countries to keeping a global temperature rise this century well below 2ºC , limiting GHG emissions, and transitioning to a low-carbon economy.

According to the PRI, nearly 400 investors representing $22tn in assets under management stood by the Paris Agreement last year, urging governments to implement it by driving investment into the low-carbon economic transition and supporting companies’ climate-reporting frameworks3.

Moreover, it found that 74% of asset owners see climate change as one of the most important long-term investment trends, up 8% from 2016.

We have seen first-hand evidence of this: our clients are increasingly citing climate-related risk as one of the most salient elements in the environmental, social and governance, (ESG) sphere. Cognisant of our role as fiduciaries, managing climate and carbon risks and identifying opportunities have – and continue to be – one of our team’s key priorities as the economy decarbonises.

‘The tragedy of the horizon’

In 2015, Bank of England Governor and Chairman of the Financial Stability Board (FSB) Mark Carney labelled climate change “the tragedy of horizon”4. That is, the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors, imposing a cost on future generations that the current one has no direct incentive to fix. In his capacity as FSB Chairman, he also established the Task Force on Climate-related Financial Disclosures (TCFD) to give investors information to identify companies most at risk and best prepared for climate change.

It is therefore important for investors to understand climate-related financial risk. It can broadly be divided into two major categories – carbon risk, which is related to the transition to a low-carbon economy, and climate impact risk, which is related to the physical impacts of climate change (see Figure 1).

Figure 1: Understanding climate-related financial risk  

Source: Hermes Investment Management as at March 2018

Climate-related financial risk may originate due to a plethora of reasons, including but not limited to: changing demand for carbon-intensive exports, incentivising individuals or institutions to ignore risks, and changing investor appetite for carbon-intensive assets (see Figure 2). And while identifying where climate-related risks may originate from is straightforward, evaluating the impacts of climate change and assessing carbon risk presents a mammoth challenge for investors. The scale of the task ahead is evident: in 2013, Trucost estimated that the cost of GHG emissions from business activities that were linked to reduced crop yields, flooding, disease, acidification of oceans, and biodiversity loss totalled $2.7tn5.  Moreover, despite the majority of asset owners perceiving climate change as a major investment theme, a recent PRI study found that only 17% of asset owners incorporate both carbon risk and climate impact risk within their asset allocations. However, accelerated action on climate change is needed before these risks can be incorporated into investment strategies.

Figure 2: How climate-related risk may originate

Source: Hermes Investment Management as at March 2018

A cooling consensus: accelerating action for a low-carbon world

Capital markets have a key role to play in turning ambition into action on climate change, and a number of investor frameworks and initiatives have been established to accelerate the transition to a low-carbon economy. They include:

  • The Investor Agenda: Promoting the key actions and initiatives that investors around the world are taking to meet the goals of the Paris Agreement, manage the risks of climate change, and build a low-carbon economy. The actions are focused on four key areas: investment, corporate engagement, investor disclosure, and policy advocacy.
  • RE100: A collaborative, global initiative uniting 116 influential businesses committed to 100% renewable electricity, working to massively increase demand for – and delivery of – renewable energy. It was developed by The Climate Group in partnership with CDP.
  • Institutional Investors Group on Climate Change (IIGCC): A forum for investors to collaborate on climate change. The IIGCC’s Corporate Programme, formerly the ‘Aiming for A’ initiative, and its Collaborative Engagement sub-group will incorporate the selective use of institutional quality shareholder resolutions as part of meaningful investor dialogue with high impact companies.
  • TCFD: The TCFD issued a set of recommendations in June 2017, which provides a framework and approach for all companies to report on climate impacts in their mainstream financial filings, such as annual reports.
  • Transition Pathway Initiative: Supported by asset managers and owners with $6.5tn in assets under management, this group assesses how companies are preparing for the transition to a low-carbon economy.
  • Portfolio Decarbonisation Coalition: A multi-stakeholder initiative that seeks to support and catalyse the transition to a low-carbon economy by mobilising and convening institutional investors committed to restructuring their portfolios accordingly.
  • Montreal Pledge: By signing this pledge, investors commit to measure and publicly disclose the carbon footprint of their investment portfolios on an annual basis. It allows them formalise their commitment to the goals of the Portfolio Decarbonisation Coalition.
  • Climate Action 100+: A five-year initiative led by investors to engage with the world’s largest greenhouse gas emitters to cut GHG and improve disclosure and oversight of climate-related risks. About 256 investors with $26tn in assets under management have signed on to the initiative.

We are members of, among other initiatives, the Transition Pathway Initiative, Portfolio Decarbonisation Coalition, the Montreal Pledge, and Climate Action 100+. We have also committed to support the TCFD, as documented in our white paper, ‘The low carbon opportunity – and the risks of missing out’. We believe the TCFD could be a game changer, enabling all investors to make more informed decisions that take into account climate risks and opportunities. The adoption of the TCFD’s recommendations is essential to advance the quality of mainstream financial disclosures related to climate change risks in companies and portfolios.

At Hermes, climate change is – and continues to be – a critical element of our broader strategy to integrate ESG factors into all of our Global Equities funds. We have stepped up our data procurement in this area, liaised with climate change experts, and hosted a number of internal sessions discussing the risks and opportunities of climate-risk-related issues.

Stewardship is also a core element of our investment approach, and we actively advocate for change at particular companies as well as at a broader market level in an effort to ensure robust corporate governance structures and principles are implemented and applied. Moreover, our responsibilities and investment philosophy are underpinned by a number of key guiding documents, namely ‘Hermes Responsible Ownership Principles’, ‘ESG matters’, and ‘Delivering holistic returns’.

Coming clean on carbon: Our investment approach

It is possible to assess climate change-related risks through the use of our proprietary tool, the ESG Portfolio Monitor, which Hermes has used to measure portfolio-level carbon footprint since 2013. It is now part of our portfolio monitoring process.

Meanwhile, the ESG Dashboard, another proprietary tool, helps us assess the environmental-risk exposures at the company level over time (see Figure 3). It is available across our entire investable universe of companies – approximately 4,500 stocks – and it pits companies directly against the KPIs of the industries to which they are exposed.  The Dashboard also presents any KPIs which could represent a weakness for the business, thereby alerting investors to any red flags or issues worthy of corporate engagement, such as climate change or carbon risks.

Figure 3: Carbon capture: the ESG Dashboard

Source: Hermes Investment Management as at March 2018

Managing and assessing climate- and carbon-related risks

We use the ESG Dashboard to conduct a qualitative assessment based on the following climate-related metrics:

  • Environmental footprint: Environmental factors are used to identify companies that operate sustainably, with robust policies and procedures in place.
  • Carbon exposure: The Dashboard’s environmental impact lenses show the percentage of a company’s assets at high, medium or low carbon risk based on its business and geographical grouping. Companies can often have similar GHG emissions but different risk exposures due to their geographical grouping.
  • Controversial business: examples include companies operating in the Arctic, which have contributed to pollution in the region. It is important to gauge the action taken by companies to remedy any adverse impacts.
  • Company positioning: This includes assessing company statements, membership of climate risk-related organisations, communication with shareholders, and stress-testing and scenario reporting.
  • Alignment with the UN Sustainable Development Goals (SDGs): The Dashboard uses the SDGs as a framework to identify a company’s specific focus, highlighting its reliance on green revenue sources, such as renewable energy or transformative technologies. This helps us identify forward-thinking companies that are delivering positive environmental and social impacts.
  • Company disclosures: Disclosures related to environmental targets and climate change are essential as they assess the ambition and mind set of companies. For investors, transparency is significant as it helps them understand how companies assess climate-related risks and opportunities.

These considerations are captured in an environmental score which identifies companies that are exposed to less environmental risk relative to industry peers. It also takes the company’s historical – and current – performance into consideration, favouring companies with an adequate level of disclosure about environmental risk, which is demonstrative of a proactive, risk-focused approach.

Across our suite of Global Equities Strategies, we assess companies based on relevant environmental metrics, ensuring robust management of climate-related risks. These risks are then analysed in the context of our long-term time horizon and incorporated into our valuation of companies. Our Low Carbon Strategy goes even further, as we avoid companies that have material exposure to fossil fuels and a high carbon intensity. Instead, we favour companies that support the transition to a low-carbon economy and focus on minimising further climate change (see Figure 4).

Figure 4: Our low-carbon investment strategy

Source: Hermes Investment Management as at March 2018

Searching for the next decade of winners

The transition to a low-carbon economy also presents investment opportunities. Today, we seek to identify companies which do the following:

  • Align their revenues to green opportunities, by generating revenues from solar power, green financing or energy efficiency;
  • Fulfil broad sustainable trends, such as pollution or waste reduction;
  • Find solutions to adverse climate change-related impacts, through the creation of eco products or automation;
  • Sign up to climate change-related initiatives, such as RE100 and We Mean Business;
  • Make climate change-related commitments, such as using alternative fuels;
  • Enter green indices, for example Green200; and
  • Adopt the TCFD’s recommendations.

For successful companies, governance is key, as evidenced from our previous research paper, ESG investing: Does it just make you feel good, or is it actually good for your portfolio? We look for accountability at the board level to demonstrate best practise when assessing climate-related risks.

Some companies, such as current holdings Stora Enso and BHP Billiton, are already leading the way on mitigating climate change and carbon-related risk in their respective industries. Stora Enso, a pulp and paper manufacturer, has set meaningful energy consumption targets and assessed its product footprint in detail, while miner BHP Billiton has completed a scenario analysis of its business. Additionally, at board level, some companies are encouraging their executives to tackle climate change faster by applying targets within remuneration schemes which have long-term payoffs.

Engaging on climate change risks 

It is also important for companies to discuss and disclose their approach to climate change. As aforementioned, stewardship is a fundamental part of our investment approach. This is driven by Hermes EOS, which advises on proxy votes and engages company directors and executives about ESG and strategic risks that concern shareholders.

By engaging frequently with companies on climate change risks and environmental reporting, as well as wider issues around policy and sustainable business practices, the insights from Hermes EOS create a powerful force for positive change. Examples of constructive engagement include: encouraging the adoption of the TCFD recommendations for disclosing clear, comparable and consistent information about threats and opportunities related to climate risk, speaking with companies ahead of their AGMs to flag climate risk-related issues that could be remedied, acting as active owners on behalf of shareholders, tracking companies’ progress on climate change issues and sharing company best practice where possible. Moreover, our voting policies and membership of industry initiatives, as previously discussed, encourage companies to align their business models with the 2015 Paris Agreement.

Engagement case study: Duke Energy

A serious coal ash spill in the Dan River, North Carolina, in 2014 caused by a burst pipe at Duke Energy’s Eden power plant prompted our engagement with the company. In our view, the incident highlighted that board refreshment was needed, as some long-tenured directors did not have the obvious skills to steward the company during this difficult period. Moreover, as one of the largest greenhouse gas emitters in the world, climate change has become an increasing focus of our engagement with Duke Energy.

Our engagement

Shortly after the coal ash spill, we met the company’s sustainability and governance management teams and Chief Financial Officer Steve Young. Since then, we have had regular meetings with the company, to discuss governance and sustainability. Written follow-ups to the board and other company representatives followed, in which we outlined our concerns, clarified our discussions at meetings and made suggestions for improvements.

Over time, we have developed a good relationship with the company, despite significant differences of opinion at times. In late 2017, we were asked to comment on the draft of the company’s proposed climate change report.

Changes at the company

We welcome the company’s move to improve its transparency by publishing such a report, strengthen the specification for its Lead Independent Director role, refresh its board with Directors with a range of skills and experience and implement the right of shareholders to have access to nominate candidates to the board on the management proxy statement.

The board’s oversight looks substantially more capable to us than it did four years ago, with some of the long-serving directors departing from the board, and some with good quality CEO and other relevant expertise, including deep knowledge of nuclear power, joining it. Having supported a campaign to provide shareholders with access to nominate candidates to the board on the management proxy statement, we welcomed the company’s implementation.

We will continue to foster our relationship with Duke Energy as it demonstrates its commitment to being part of the transition to a low-carbon economy and provides evidence that it is managing water and extreme weather risks.

In March 2018, Duke Energy published its 2017 climate change report. At the time of going to print, we were analysing the report and will provide feedback and suggestions for improvement.

Clearing clouds of uncertainty

To move forward on climate change, transparency is key. Company disclosures on climate change have improved significantly overtime, but there are still plenty of gaps. Our clients increasingly request more information about carbon risk in our portfolios and our action on climate change.

Internal discussions have also accelerated in the last year, with the establishment of an internal working group to strengthen our understanding and further our analysis of carbon-risk monitoring and reporting implications. As a result, Hermes built a strategic approach, whereby we set specific and measurable climate and carbon risk targets against which we monitor and measure progress and report on our performance annually6.

Green light: Moving forward on climate change

The transition to a low-carbon economy is driving innovation through research, development and the adoption of new tools for change. However, we also recognise that further research, analysis and evaluation of climate- and carbon-related risks is needed.

One such area is the financial risk associated with carbon pricing models. This hinges on a company’s carbon efficiency, geographic location of operations, business model, and market conditions sector-wide. Moreover, a company’s business model and broader market conditions will also dictate whether companies are able to absorb the increased costs related to carbon pricing models or pass them on to their customers. At present, we are currently expanding the work we already carry out, evaluating the usefulness of analysing financial risk in carbon pricing models. And as we seek to drive long-term progress towards a low-carbon future, we will continue to step up our response to climate change to better understand the scale of carbon-related risks and opportunities.

The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

It should be noted that any investments overseas may be affected by currency exchange rates.

Past performance is not a reliable indicator of future results and targets are not guaranteed.

1 “Global Climate Report,” published by the National Centers for Environmental Information in December 2017

2 “Climate change indicators: global greenhouse gas emissions,” published by EPA in May 2014

3 “Investor action on climate change: A PRI-Novethic assessment of global investor practices,” published by the PRI in September 2017

4 “Breaking the tragedy of the horizon – climate change and financial stability,” published by the Bank of England on 29 September 2015

5 “Natural Capital at Risk: The top 100 externalities of business,” published by Trucost in April 2013

6 “The low carbon opportunity – and the risks of missing out” published by Hermes Investment Management in November 2017

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