Sustainability

Dear board, a date for your diary…

In case you missed it, the forthcoming COP26 climate conference recently joined the Olympics, the World Cup and other big events with various commentators marking its ‘100 days to go’. Such a catchy media tag line is popular with everyone it seems. For investors, you wouldn’t expect them to go scrambling into their diaries to blank a week off to focus on proceedings. Or even schedule to record on TV to make sure not a minute of the riveting policy discussions is missed, should inconvenient day job workloads force them to miss the live action.

However, if you sit on the board of a pension fund or an insurance company you might ask how we suddenly arrived a point where all stakeholders are talking the language of net-zero, and some are staking their reputation on it?

Only a short time ago, ex-President Trump and his cohorts were so proud of their achievements in trying to halt the low carbon transition that it seemed the language, and prospect, of ‘hot house earth’ and runaway climate of 4 or 5 degrees was perfectly reasonable.

Whilst the new IPCC report is certainly alarming at the apparent sensitivity of the climate to emissions, and cements urgency as the way forward, from a pure emissions quantity perspective, the worst cases can now be ruled out.

As the Inevitable Policy Response (IPR) programme showed us in 2019, even the assumption of a second Trump term would not be enough to stop the momentum behind a policy acceleration in the 2020s, driven by a combination of EU policy leadership, the rapid change in the economics of renewable energy and institutional pressure from large investment funds. This latter pressure culminated in May in the unforeseen signal of investor preparedness to sack oil company board members to force a transition strategy, rather than divest their shares.

In 2019 some investors thought IPR was way too ambitious in its transition forecast but much of it eventuated. After the Trump veil was cast aside the realities of the underlying transition momentum were much clearer. Indeed, once the Biden bridal party was installed it was Black Friday sale for everything net zero as countries, funds and companies queued up to announce their own commitments. Now we have climate policy shifting into the end game of the WTO, G7 and G20, there is little turning back.

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Following this burst of pent-up momentum, it would be natural for some asset owner boards that treat climate primarily as a watchlist issue, to tick the box and think job done?

Au contraire, sadly, as we are still in the initial stages of transition impacts on portfolios. How can we expect asset owner boards to really understand the complexity of the transition given the nature of interacting drivers of the acceleration between geopolitics, institutional pressure and technology?

This is a complex enough issue for the giants of public markets so what can an asset owner board really do? Certainly, a house view on the future is critical, as opting for a standard asset allocation with a reliance on passive indices and the wider market to sort the mess out is unlikely to yield optimal results.

In a world increasingly dominated by temperature constrained scenarios, the greater realism of the IPR forecast has been welcomed by leading asset owners and managers alike. But the matching of reality to shorter term targets for with net zero commitments is creating sleepless nights for some, particularly insurance companies.

The spotlight now for boards is clearly towards the CIO and investment committee and the core processes of strategic asset allocation and manager selection. Overlaying forward looking return assumptions with the outputs of historically facing SAA models requires judgement and a pivotal decision to be active over this theme.

Stick with the status quo approach in both public and private markets and you risk following the herd so late that leaders have swallowed all the early investable and valuation opportunities.

And how do you discuss this with your asset managers? How do you encourage asset managers not to game the market timing by staying in assets which are clearly exposed in the long term?

If your active managers have built understanding on the theme and create some resilience by moving early to tilt your portfolio but the policies do not arrive to ensure profitable returns or market peers are slow to help boost associated low carbon valuations, then how do you discuss underperformance?

Ditto the decision on picking transition themed benchmarks and the unhealthy addiction to tracking error in some funds.

How does the board stay patient enough to back those managers in public and private markets reflecting their belief in the most likely future outlined in IPR while the managers promise that the rest of the market has not quite understood the issue?

Likewise for new thematic managers clearly with the right ideas but lacking the 3-year track record.

Add to this the huge complexity of picking which company transitions look credible and the discussions with managers become exceedingly difficult indeed. Trust in a long-term strategy is easier said than done when short term realities tempt asset owners back to the index to recover.

And what of the unlisted opportunities where much of the upside likely sits? Forestry in real assets seems as certain a long-term bet as any, with IPR forecasting an emissions overshoot that will require huge reforestation. Consider also other negative emissions opportunities and others in private equity, infrastructure and real assets.

With some asset owners revisiting asset allocation only every few years, a mad dash to re-allocate from equities holding the traditional incumbents, to backing the new era upside, is a behavioural cultural and process shift that may simply be beyond many boards.

For those that started this change early, a well navigated transition will yield superior returns, but for those setting their calendar reminders for COP26 for the first time, some degree of hope and luck will be required, a fact that is already instilling fear in many boards, making this the greatest investment governance challenge of their lives.

Julian Poulter is head of investor relations at the Inevitable Policy Response (IPR) and co-founder of Energy Transition Advisers and previously was CEO of the Asset Owners Disclosure Project (AODP).

 

 

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