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Institutional Investing and Climate Change: Don’t Worry About Ethics, Worry About Fiduciary Responsibility

São Paulo Stock Exchange (Bovespa)
Photo credit: Rafael Matsunaga.

Leaders from around the world have been congregating in Paris for COP 21 with hopes of reaching a global agreement to combat climate change. At the top of the agenda lies the question: What will it take to unlock the trillions in additional private sector investment dollars necessary to avoid the catastrophic effects of inaction?

A key piece of the puzzle is to engage the few, large institutional investors composed of a select group of pension funds, insurers, and sovereign wealth funds that dominate the global capital markets. As the world’s largest shareholders, these investors hold unique power to change the behavior of the world’s biggest companies. If they signal that a company’s carbon footprint or climate change preparedness is critical to their investment decisions, corporate boards and CEOs will respond.

But there’s a challenge. The received wisdom is that it is not the role of institutional investors to align their investment decisions with achieving positive environmental or social outcomes. As the argument goes, institutional investors act as fiduciaries to their beneficiaries—such as, for example, state pensioners—and their legal obligation is to deliver the best financial performance possible. Effectively, this means making investment decisions solely on the basis of financial return. Concerns around combatting climate change or saving the environment should not, therefore, be factored into the investment decisions—these are ethical issues and for institutional investors to take them into consideration would be imprudent and unlawful. Reflecting this logic to a tragicomic extreme, the Wisconsin Board of Commissioners of Public Lands, a state agency that manages over $1 billion in public funds, voted in April of this year to prohibit staff from discussing climate change at work.

“The rationale for mobilizing capital towards climate-friendly investments doesn’t hinge on ethics. It hinges on managing risk and capturing opportunity.”

This line of argument is both dangerous and wrong. The rationale for mobilizing capital towards climate friendly investments does not hinge on ethics. It hinges on managing risk and capturing opportunity, which is something everyone agrees institutional investors should care about.

Even setting aside the overwhelming scientific consensus around the intensity of the economic risks posed by climate change, the increasing competitiveness of renewable energy and threat of stricter greenhouse gas regulations alone pose a significant and palpable financial risk to carbon-heavy investment portfolios. Most large institutional investors have long-term investment horizons, many with obligations that extend into the 22nd Century. They are therefore exposed to, and must manage, the complex layers of climate change risk—physical, technological, and regulatory—that they’re certain to face.

Given these facts, why have so few institutional investors taken seriously the responsibility of managing the long-term risks of climate change? One reason is that assessing the climate risk exposure of individual firms is said to be too complex. Another more prosaic reason is that individual investment managers are not rewarded for reducing exposure to long-term risks, but rather are compensated on the basis of their performance to current benchmarks. The focus on the shorter-term is thus justified for reasons of both rationality and expediency.

“Now it has really been made obvious that carbon is a risk, and it’s a risk for business. It’s now very difficult for anyone to say ‘Oh, I didn’t know it was a risk’.”

Fortunately, a growing number of institutional investors are seeking to surmount this reasoning. As Philippe Desfossés, CEO of France’s largest funded pension fund, ERAFP, notes: “Now it has really been made obvious that carbon is a risk, and it’s a risk for business. It’s now very difficult for anyone to say ‘Oh, I didn’t know it was a risk’.”

Aligned with this view, a number of pioneering investment managers are developing innovative investment strategies to address the risk of climate change without compromising financial returns. One example is the Fourth Swedish National Pension Fund, AP4. In 2012, AP4’s CEO, Mats Andersson, raised the question of what he could do to reduce the risk exposure of billions of dollars invested in passively managed portfolios designed to track stock market indexes. With the support of several partners including Amundi, Europe’s largest asset manager, AP4 developed a “decarbonized index,” a share index-tracking fund that excludes the most carbon-heavy polluting companies across all sectors offering effectively a hedge against climate risk. To date, the strategy has outperformed the benchmark, and AP4 has announced that it will move its entire $20 billion equities portfolio into similar strategies, with the goal of later doing the same for their fixed-income portfolio.

Divestment from carbon-intensive companies is not the only strategy that institutional investors are pursuing. They are also making direct investments into companies and projects that contribute to a low-carbon economy such as recently announced by The California State Teachers’ Retirement System, a $176 billion U.S. pension fund. A commitment to investing in green bonds such as made by Zurich Insurance Group is another means through which institutional investors are reducing their risk exposure to climate change while supporting climate-friendly investments.

Fortunately, there is an increasing number of institutional investors who recognize that reducing the risks of climate change and building sustainability, all while achieving market returns, is now feasible at significant scale. Indeed, last week, the Portfolio Decarbonization Coalition (PDC), a group of institutional investors committed to reducing greenhouse emissions announced that it is now overseeing the decarbonization of $600 billion in Assets Under Management (AUM). This is very encouraging news particularly given that PDC’s original target was of achieving a threshold of $100 billion AUM by COP 21.

However, there is more to be done.  $600 billion still only represents less than 1 percent of the estimated $71 trillion held by institutional investors, and a fraction of the estimated $53 trillion which, according to the International Energy Agency, must be invested between now and 2035 to prevent catastrophic climate change from taking hold.

There is no excuse for inaction. The fiduciary mandate is clear, we have a set of proven tools, and real-world examples of successful investment strategies for institutional investors to follow. And the time to take action is now—not only for the sake of the world’s long-term wellbeing but also to maximize portfolio returns.

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