Philip Pearson looks at the issues impacting LGPS funds as they attempt to decarbonise their portfolios to both reduce climate risks and capture associated investment opportunities.
Addressing climate change is one of the greatest challenges facing humanity today. To mitigate the risks and adapt to the impact will require a concerted effort by governments, companies and individuals over many years. Enormous amounts of capital will be needed to deliver the necessary changes, so it’s clear that institutional investors including Local Government Pension Scheme funds have a key role to play.
Most LGPS funds invest widely across different asset types, sectors and countries worldwide. So decarbonising their portfolios in a way that reduces climate risks and captures the associated investment opportunities will be very challenging. So, what are the specific challenges and how might investors address them?
Dealing with uncertainty. Many governments have made significant progress in recent years introducing policies to combat climate change, but further measures (such as carbon taxes) seem inevitable. The scope and timing of these are uncertain, as is society’s response to the measures that have already been taken. As a result, it’s difficult for investors to predict how quickly portfolios will decarbonise “naturally” and what additional actions they will need to take. In such circumstances, it seems appropriate for investors to respond to climate change progressively over time, taking actions only when it is clear they are appropriate and continually reviewing their climate strategy.
A “foggy” picture. Sound investment decisions are based on good data, but the climate data available today, regarding greenhouse gas (GHG) emissions for example, is far from perfect. There are issues of data availability, coverage and accuracy. Data are generally available on GHG emissions in companies’ own operations and as a result of the energy they consume (so-called Scope 1 and 2 emissions), but Scope 3 emissions (those generated by companies’ supply chains and through the use of their products and services) are less well understood. Coverage varies too, being generally good for listed companies but weak for private businesses. Common standards governing the calculation and validation of climate data remain embryonic. In these circumstances, investors must base investment decisions on the best data available, but push portfolio companies and data service providers to make rapid improvements.
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Engagement vs divestment. Institutional investors are generally encouraged to engage with companies in their portfolios to ensure that management deliver the necessary decarbonisation initiatives. Engagement can be more effective if backed by the threat of divestment. Indeed, divestment by long-term investors has been shown in some cases to be the step that ultimately forces management to take the necessary action.
Divestment is not possible in portfolios designed to track market indices, though indices can be redefined to exclude problematic types of business. Active managers are free to divest, but it can be challenging to determine when to do so. We believe investors should agree with their managers the criteria that will be used to determine when divestment is appropriate.
Engagement can be more effective if backed by the threat of divestment. Indeed, divestment by long-term investors has been shown in some cases to be the step that ultimately forces management to take the necessary action.
Balance is essential. Decarbonisation will be a highly complex programme delivered over many years. Adopting a balanced approach is key. Investors need to strike a balance between divesting high-emission assets today, and thereby achieving an immediate reduction in portfolio emissions, and continuing to finance high-emission businesses that deliver a progressive reduction in emissions over time. Similarly, investors will need to decide whether to finance businesses involved in the provision of products/services critical to decarbonisation, which represent attractive investment opportunities even though they currently have high GHG emissions and therefore higher climate risk.
Offsetting residual emissions. It is generally accepted that neither society nor individual investors will be able to completely decarbonise. Residual emissions in an investment portfolio will need to be “offset” by assets that absorb and lock away GHGs (a process referred to as “sequestration”). Such assets are considered to have negative GHG emissions. Investors can invest in them directly or by entering into contracts that give them the rights to the GHG storage capacity of the underlying assets (“financial offsetting”).
Offsetting is not the quick fix to climate change that some have advocated. Potential investors need to consider carefully various issues including limited capacity, project integrity and the adverse impact on financial returns.
The only asset class with negative GHG emissions currently available at commercial scale is forestry, and, even then, only when subject to rigorous constraints on forestry management, the use of the timber products and carbon accounting. New technologies, such as carbon capture and sequestration (CCS), are being developed but none is yet proven at scale. Huge areas of forestry would be needed to offset a material proportion of current global emissions and it is unlikely these could be made available given other pressures on land use, such as agriculture. Furthermore, investors will face competition for access to offsetting capacity from industrial users in hard-to-decarbonise sectors.
Offsetting is not the quick fix to climate change that some have advocated. Potential investors need to consider carefully various issues including limited capacity, project integrity and the adverse impact on financial returns.
Effective governance
Measuring and reporting the sequestration capacity of an asset is a technically complex process that is open to abuse. Effective governance is key. Not all sequestration projects developed to date are considered robust in this respect. It is vital that investors undertake careful due diligence before committing capital.
Purchasing emission rights under financial offsetting programmes has a cost that is expected to rise over time in line as carbon is removed from the global economy. Forestry that is managed to maximise sequestration capacity delivers lower financial returns than it would if managed solely for commercial purposes. Investors in either need to consider the impact on overall investment returns.
In addressing climate change, institutional investors face many challenges. Given their critical role in financing the decarbonisation process, let us hope they succeed in dealing with them.
Philip Pearson is head of LGPS investment at Hymans Robertson.
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