Investors position for climate alpha

At CalPERS, the largest pension fund in the US, the rationale for investing in the energy transition is as compelling as it was for technology investors in the early 1990s. The $500 billion pension fund for California’s public sector workers has pledged to invest $100 billion (up from $50 billion) in climate solutions by 2030, convinced the sector can generate alpha and help reduce emissions in the portfolio.

“If you go back 30 years and asked an asset allocator if they should have overweighted technology, the answer today would be that would be a good idea. We are at a similar point now as we were in the early 1990s, and we want to position the portfolio,” says Peter Cashion, managing investment director, sustainable investments at CalPERS on a Top1000funds.com webinar in partnership with Pictet Asset Management.

Pension funds like CalPERS’ growing commitment to the transition is reflected in a recent paper by Pictet Asset Management and the Institute of International Finance.

Although more investor capital is flowing into the transition, the authors also flag the yawning shortfall. Moreover, financing the energy transition is gobbling up most institutional capital, leaving sectors like agriculture and transport struggling to finance change.

“In order to meet 2050 net zero goals an additional $8 trillion needs to mobilize annually,” says Emre Tiftik, director of sustainable research at the IIF. “For each one dollar invested in fossil fuels we currently invest one dollar in clean energy and this needs to grow from 1:1 to 1:7.”

It’s not only the lack of capital that signposts the risks ahead, it’s also the source. Tiftik adds that if governments continue to finance the transition at current levels it will add an additional $200 trillion to global sovereign debt by 2050.

“This is not reflected in governments long term projections.”

Active investment

Tiftik argues that active investment is a helpful tool for investors seeking to pick winners in the early years of the transition. A strategy endorsed by Pictet Asset Management (Pictet AM) where stock picking begins by using the SDGs to measure the extent to which a company is aligned to the transition.

“We have an internally developed tool that assesses SDG alignment for all companies in the benchmark index MSCI ACWI” says Yuko Takano, senior investment manager of Pictet AM’s Positive Change strategy also speaking on the webinar. “It’s possible to see that higher-aligned companies have higher returns,” she said, explaining that alignment refers to corporate “leaders” – businesses that are already aligned with net zero and benefit from a green discount in their capital costs.

Pictet AM’s Positive Change team also buckets companies into “improvers” and “opportunities” categories. Opportunity stocks have the lowest level of alignment to the SDGs and lower valuations, and the team engages and nudges management in the direction of change. Investors should seek to hold a mix of opportunity and improver stocks because these companies represent a valuation opportunity.

Takano describes a bottom-up stock picking process based on fundamental research. The team particularly hunts for proof of sustainable business models that can profit in the new economy. Another element of research includes robust analysis of company financials.

“Transitioning takes a lot of capital,” she said. If the company has a weak balance sheet or high levels of leverage, it will be screened out.

“Being an active manager allows us to probe and question, and try to get more insights,” she says.

CalPERS is also developing a more active approach to climate investment, weaving in climate risk and scenario analysis into portfolio construction. For example, the team believes it is possible to generate outperformance by investing in companies that are climate aware and have efficient energy and water usage.

“Companies that are resource efficient [have a] lower cost structure and are more profitable. Companies focused on this have significantly outperformed in the last five years,” says Cashion, adding that strategy at the pension fund is shaped around partnering with managers that lead in the space. “It comes down to material knowledge asymmetry. Us as investors having knowledge that the market hasn’t factored into decision making.”

In another approach, in July CalPERS invested $5 billion in a climate transition benchmark put together with FTSE. The platform underweights high emitters without a transition plan and overweights high emitters with a transition plan and is sector neutral.

In public equity the team are looking at active managers with a view to working with a handful in a concentrated portfolio where the manager takes active bets on which companies will outperform because of the transition.

CalPERS augments its approach with a bespoke taxonomy that defines the three key areas it will invest. One is around mitigation and investing in renewables for example, where the pension fund has seen most deal flow. Another is shaped around adaptation, focused on investments at the forefront of innovation like heat resistance crops or reinforced infrastructure. The third classification is investing in companies prepared to transition like high emitters with credible decarbonization plans.

“We are investing in high emitters today with a clear path on how to reduce emissions over time. This supports decarbonisation of the whole economy, not just in our portfolio and this is where the largest capital investments are needed,” explains Cashion.

In private markets, CalPERS has already or will invest $5 billion, mostly focused on infrastructure and private equity. In private equity the deal sizes are smaller, but the number of investment opportunities is significant and offers diversification benefits. CalPERS is also opening up to new managers in this space.

“We are now looking at more mid-market asset managers; more niche or those that have a dedicated climate strategy.”

Other points in the report

The Pictet AM-IIF report also details the impact of carbon pricing, an essential element in the transition. The IIF’s Tiftik says carbon prices will cause energy prices to increase by as much as three times over the next 30 years with implications for economic activity and labour markets, and potentially reducing political will around the transition.

Although carbon prices will drive up energy prices, the impact on inflation will be limited because the transition will lead to output losses with significant implications, particularly socially.

He also flags that the inefficient use of capital in the green revolution could lead to bubbles. All revolutions have a habit of creating bubbles because of asset misallocation.

“We are worried about this and need to monitor it closely,” he concludes.

Published in partnership with Pictet Asset Management