INSIDE VIEW: Climate investing is still about performance

With concerns over climate change growing, DWS sought advice from a range of experts. The asset manager’s senior ESG strategist, Murray Birt, explains.

Until recently, it would have seemed far-fetched that a climate scientist would be the opening keynote speaker at a conference of central banks and financial sector regulators. But earlier this year, Dr Emily Shuckburgh of the British Antarctic Survey found herself doing exactly that at a landmark event in Holland.

Equally, eyebrows would have risen at the idea of a major law firm publishing a report on climate change, or that the UK association of actuaries might issue a professional ‘risk alert’ on climate change to its members.

With 2018 another year for record-breaking extreme weather, the risks and impacts of climate change are becoming starker. At the same time, more financial institutions, companies, governments, central banks and regulators are stepping up their action in response. But more is required as the IPCC warned recently that carbon emissions still pose an existential risk to society.

Over the next two years, the UN and many heads of state and prominent individuals will lead an international effort to encourage all institutions to take stronger action to address climate change. The aim of this collective effort is to put humanity on to a path to meet the Paris Agreement goals to limit climate change by dramatically cutting carbon emissions and making financial flows constistent with a sustainable and resilient future.

Dr Shuckburgh explains how at no point in human history has atmospheric carbon dioxide been as high as it is today, which dramatically increases the number and severity of extreme weather events. Limiting risks requires an unprecedented transformation of our economy, reversing over the next ten years the emissions increases that have occured over the past four decades.

These, as well as other developments, inspired DWS to bring together experts from the UK’s scientific, legal, actuarial, accounting and investment consultant communities to produce a new report: ‘Experts on climate change’.

In the report, Pinsent Masons concludes that whatever their private views, climate change is now a governance issue for every pension fund trustee. Failure to engage risks trustees being in breach of a board’s fiduciary duties.

The actuarial and accounting view of Grant Thornton is that all actuaries should acquire an appropriate level of professional knowledge of climate risk and how climate should be included in their actuarial advice. Climate change is also pertinent for auditors of corporates with pension schemes.

The investment consultant Redington suggests that pension funds ask their managers and consultants about their investment process, engagement, infrastructure and reporting and accountability.

The investor case for action can be seen economically and financially. In 2006, the economist and academic Lord Stern concluded that climate change is the greatest market failure ever seen and that the costs of action are far less than the costs of inaction.

More than 10 years after this report, Lord Stern reflected that the risks and costs of inaction were underestimated, while the cost of reducing emissions are being transformed by rapid technological advances.

Over the next 15 years, an estimated $90 trillion is projected to be invested in cities, energy and land-use systems. A prominent group of business, international leaders and top economists have persuasively made the case that it is the nature of these investments (low or high-carbon energy systems, compact cities or urban sprawl) that will determine our future growth, prosperity and whether we avoid dangerous climate change.

Our report suggests that what matters is whether these risks and opportunities are reflected in valuations.

Leaving it too late
So-called valuation mirages occur often in finance and there is plenty of evidence that capital markets do not recognise ‘predictable’ risks until it is too late. For example, analysts covering a US coal company believed that profitability would recover, just before it went bankrupt.

Forthcoming DWS analysis examines whether physical climate risks are reflected in stock valuations and capital costs, building on our pioneering effort to examine physical climate risks in equity portfolios with a top data provider.

Such findings can justify an active or passive strategy to improve risk-adjusted returns by overweighting leading companies and underweighting or excluding laggards. Environmental, social and governance (ESG)/climate funds should also seek to avoid unexpected factor exposure, which our quant equity team has studied .

Climate change should be analysed and valued like other risks. Divesting, or over/underweighting stocks only shifts financial risk and does not truly change real CAPEX decisions unless investor influence is also used to encourage companies to integrate ESG factors into their strategy and policy-makers to improve policies. A growing number of asset owners are setting engagement expectations.

Climate change is important, but it is only one issue. What about diversity, water/air pollution or how companies treat workers?

DWS and the University of Hamburg’s analysis of more than 2,000 academic reports found strong positive links between corporate financial performance and ESG issues.

Combining multiple data sources is the approach we have used at DWS using our ESG Engine, a proprietary software that integrates seven data sources into our investment systems and processes, for which all of our active investment professionals have been trained.

Increasingly asset managers are required to develop bespoke solutions for investors to consider, and we expect that climate strategies will expand to encompass the social aspects of climate change. Pension funds, insurance companies and family offices need to draw on the best available expertise to take action on the opportunities and risks of climate change.

©2018 funds global mena

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