By Ian Simm
Talking about climate change is fashionable again. In the year when the concentration of carbon dioxide in the atmosphere touched 400 parts per million for the first time in human history, President Obama has elevated the topic in his in-tray, the Chinese are experimenting with “cap and trade” and the Liberal Party in Australia is threatening to roll back policy if elected in September.
Institutional investors who are minded to be cynical about the issue are probably picking the wrong answers to five key questions.
First, isn’t the science too uncertain to act? Over the past five years, the scientific consensus has concluded resolutely that human emissions of greenhouse gases are heating the planet and will continue to do so. There is uncertainty over the rate of warming and the effect of feedback mechanisms, especially clouds, so future climate and weather conditions can only be thought of in terms of scenarios. Yet investors are trained to make decisions in uncertain circumstances.
Second, do pension funds need to act now? Although the most plausible climate scenarios suggest that dangerous climate change may be many decades away, governments are likely to act with increasing determination to reduce emissions, often with scant regard for the value of investors’ assets. Although in the initial phase of their carbon legislation European and Australian policymakers strove to neutralise the impact of legislation on the private sector, Germany’s expanding base of subsidy-supported renewable power generation has eroded the margins of the fossil fuel burning utilities.
Third, won’t climate change affect just a small part of a typical pension fund portfolio? Policy that depresses returns for power generators will of course impact utility assets, and higher energy prices are likely to harm companies producing basic materials such as steel, cement and chemicals. But what about the effect of changing patterns of disease on the portfolios of pharmaceutical companies, the increasing incidence of extreme weather events on infrastructure or the impact of shifting climatic belts on timber assets?
Fourth, isn’t climate change just a risk issue? Investors certainly face direct risk of more frequent, severe weather, indirect risk that climate change policy will reduce asset values and reputational risk that their stakeholders are unhappy with a “do nothing” response. Impax and FTSE have identified over 1000 listed companies for which a majority of their business is derived from markets linked to climate change and related resource efficiency themes; by tilting their portfolios towards this growing set of opportunities, investors can create a natural hedge against climate change related risks.
Finally, isn’t it sufficient just to nudge today’s portfolio? A typical pension fund investor may be tempted to ask the appointed external managers to keep a look-out for climate change related opportunities. However, these managers are generally given a three to five year performance objective and are therefore unlikely to have much incentive to create a hedge at a scale that will protect the investor’s portfolio. Only by consciously allocating to a new bucket at the portfolio level can the investor have a reasonable chance of establishing meaningful protection.
The recent financial crisis demonstrated that most investors are woefully prepared for the unexpected. Unlike a classic bubble that bursts catastrophically, climate change is a more complex issue that will impact portfolios through incremental and quantum change. Investors who plan accordingly are likely to out-perform.
Ian Simm is chief executive of Impax Asset Management