Climate change as caused by human activities is an established scientific fact. At last, political leaders have agreed on an ambitious objective to limit global warming. There remains, however, uncertainty around how climate change will pan out and what policy initiatives that will follow. Investors can not and do not, just sit on their hands, but how to adjust long-term institutional portfolios in order to mitigate risks and capitalize on new investment opportunities is nevertheless not as straightforward.
Financial and non-financial objectives
Basically, investors can have non-financial or financial objectives when approaching carbon-related aspects to their investment portfolios. Surely, a non-financial slant is easier to handle. According to a non-financial narrative, stakeholders just don't want to have investments that is directly associated with carbon emission and climate change. Reducing portfolio carbon footprints to the largest extent possible should then be an uncontroversial investment objective. The direct impact on carbon emissions would, conversely, also be quite limited as the changing of hands of carbon-intensive assets in the secondary market will have no effects on carbon emissions, per se. Indirectly, however, should substantial divestments lead to new equilibrium prices reflecting significantly higher risk premiums, and higher expected returns, for carbon-intensive assets, that would make it more costly to make physical investments in related projects. If that is decisively important for fighting climate change is, of course, debatable.
For investors with financial objectives, investment decisions related to carbon and climate change are arguably more complex. Most institutional investors do have financial objectives. Where the Swedish AP-funds are concerned, for instance, return objectives have top priority. The funds are subject to taking environmental (as well as social and governance) aspects of their investment into account, but not trade them off against expected returns. With such “dual objectives”, financial aspects related to carbon divestments must be assessed more rigorously. Theoretically, it is in situations where markets have not appropriately priced factors related to effects stemming from coming policy initiatives that divestments are warranted. In practice, of course, such assessments are utterly hard to make. It’s not just the sequence of policy events that is hard to predict but also the policy formula. Will the vitally important internalization of carbon pollution be addressed with carbon taxes or cap-and-trade systems, for instance? If taxes are preferred, which rates should investors realistically expect?
Take AP2, one of the four Swedish Buffer Funds, as an example. In order to reconcile the dual objectives, AP2 a couple of years ago choose to divest not just on a metric of carbon footprints. The preferred method was more granular, seeking to assess which companies that are most at risk, from a financial standpoint, when carbon pollution costs will eventually be internalised. Different companies are at different risk of having their stock price being adversely affected, depending on e.g. their energy mix and project portfolio but also valuation level and adaptability. This analysis was conducted in the Energy and Utilities sectors in Developed as well as Emerging markets portfolios. Overall, AP2 at the time divested from close to 100 companies in the two sectors. In the energy sector, all pure coal companies were divested. In the utilities sector, divested companies at the time represented a quarter of total electricity generation.
As an indirect effect, these divestments also reduced the carbon footprint significantly.
Even though it is debatable if a reduction of carbon footprint should be an explicit stand-alone objective in portfolio construction it is nevertheless a good policy to disclose carbon footprints. As an Institutional investor, AP2 was one of the original signatories of the PRI in 2006 and has backed efforts to increase carbon disclosure among the companies the fund own, expecting that to give firms incentive to redesign their operations in ways that reduce carbon emissions. AP2 first measured and reported portfolio carbon footprints in 2009, in the run-up to the climate summit in Copenhagen, when it was generally hoped that global initiatives on carbon pricing were to be brought forward. AP2 measures and report on carbon footprints once a year and has also taken initiatives to harmonize standards for the measurement of carbon footprints (neither that as straightforward as one might think).
From risk space to opportunity space
Turning from a risk-mitigating perspective to new investment opportunities, the mega-change in energy-producing and distribution systems and technological solutions to bring down carbon emissions at large, surely call for huge investments in new infrastructure and energy efficiency techniques and processes. To a large extent this is already underway. Institutional investors can potentially play different roles in this transition. It could be argued that the optimal amount of carbon-impact investments, from a “social welfare” point of view is higher than what the private market will accomplish. By lowering return requirements (and expected future return expectations) investments could be boosted, but investors would then essentially subsidise new infrastructure and technology which is not a conceivable goal for an institution with financial objectives. This also brings back the memory of the “Tech-bubble” 15-20 years ago, when investors mixed up promising technologies and companies with their respective stock and investment prospects. Furthermore, it is not reasonable to expect that institutional investors, on average, would be better positioned to “separate the wheat from the chaff” in growth sectors associated, in one way or another, with decarbonisation. Long-term investors could though play a role in extending the investment horizon and bring patience to investments that potentially have a long time to come to fruition. A long investment horizon, however, is not a substitute for superior due diligence capabilities and investment projects with long look-up periods need to be priced to compensate for illiquidity.