“The more you read about climate change, the more worried you become”, says Carola van Lamoen, Head of Sustainable Investing. However, “mankind is hugely creative, and we can live up to the challenge”, says Climate Strategist Lucian Peppelenbos. The two experts discuss the risks and opportunities of climate change for asset managers in this podcast episode. Tune in.
The Phoenix Group (Phoenix) and Aberdeen Standard Investments (ASI) have a deep and enduring relationship which is the result of many years working together. ASI manages £171.5bn* of assets under management on behalf of Phoenix. Over recent years both companies have worked together extensively on developing a roadmap to integrate ESG principles into the investment management strategies which underpin the management of these assets.
This paper sets out our approach to achieving Net Zero within these investment strategies. We recognise this is just the start of an important journey together and we hope that our experience to date is of value to the reader.
Through all the turbulence of the past year, a source of enormous hope for the health of the planet has emerged: the automotive industry is shifting toward electric vehicles (EVs) even faster than we envisioned only a year ago. With steady support from governments and leading automakers in the face of the COVID-19 crisis, the global market share of electrified cars, SUVs, and other light vehicles grew from 8% in 2019 to 12% in 2020, and has shown continued strength in early 2021.
This shift will accelerate dramatically in the years to come. In fact, our updated forecast predicts that by 2026 electrified vehicles will account for more than half of light vehicles sold globally—four years sooner than we anticipated in our previous report. What’s more, we see zero-emission vehicles replacing internal combustion engines (ICEs) as the dominant powertrain for new light-vehicle sales globally just after 2035.
The transition from the ICE age to the EV age over the coming decade will represent rapid change in most countries. But from an environmental perspective, the EV age isn’t coming fast enough.
Climate change is one of the defining issues of our age. Its physical manifestations are negatively affecting ecosystems, human health, and economic infrastructure. And even if the world is able to keep global temperature increases to 1.5° above pre-industrial levels, much more disruptive outcomes are coming.
Meanwhile, energy systems and patterns of economic activity are being profoundly changed by the growing array of policy initiatives, private-sector commitments and technology advances that aim to constrain greenhouse-gas emissions and limit climate change.
It is vital that investors understand how physical climate change and the energy transition affect the investment returns of the companies and markets in which they invest. We believe that doing so will enable us to build more resilient portfolios and generate better long-term returns for clients. Asset owners and regulators are also increasingly demanding this.
Research that looks at the relationship between economic transparency and defining investment qualities such as yield spreads, credit ratings and stock price volatility shows sovereign transparency helps improve the value of assets, enables countries to lower their borrowing costs and achieve a better credit rating.
Sovereign transparency helps improve the value of assets, enables countries to lower their borrowing costs and achieve a better credit rating. Speaking at FIS Digital 2021, Marshall Stocker, director of country research, emerging markets at Eaton Vance Management in Boston, explained how the firm’s proprietary index which tracks sovereign transparency in 130 countries has become a valuable investment lens. The discount rate on assets shrinks as transparency improves resulting in assets going up in value, he said.
The index is compiled by rating the availability of a sovereign’s economic data on an annual basis. Key points include if economic data is published in English and how regularly it is updated.
“We find that countries prepare documents in their local language but not in English,” Stocker said, adding that the Eaton Vance index also differs from others in the market given it looks at all available monetary, fiscal and economic data.
Stocker added that economic development and transparency are linked, making transparency crucial for emerging markets. Moreover, the index illustrates that wealthy countries are also the most transparent and he added that contrary to common perceptions, transparency does not create more volatility for investors.
China sits in the the bottom half of countries when it comes to economic transparency. Stocker also told delegates that higher levels of sovereign transparency don’t necessarily increase levels of trust in a government. Elsewhere, he noted that some countries (like Ukraine) have relatively high levels of transparency, but struggle to subsequently enforce rules and laws to deal with the challenges transparency reveals.
Stocker said that asset owners have an important role in engaging sovereign governments on transparency, describing a process whereby Eaton Vance holds sovereign level discussions comparable to investors at a corporate level. The firm shows up at the table with evidence to prove that changes in governance are good for countries.
Majdi Chammas, head of external asset management at AP1, explained how Sweden’s $45 billion buffer fund is integrating transparency into its emerging market passive exposure. The fund uses a corporate scoring process whereby greater transparency increases a company’s weighting in the index. Launched with one of the fund’s emerging market managers, transparency is one of the key pillars in the strategy.
Engagement around transparency is particularly important, says Chammas. Strategy involves engaging with corporates that have a low level of disclosure.
“If the level of disclosure is low, the first thing we do is engage,” he says. In many cases, companies have the data but are often not aware of it. Moreover, although information might not be disclosed by companies or is hard to access, huge amounts of data exists and information can be gleaned from unstructured data and social media. For example, employee discussions can feed into valuable ESG insights.
It led to Chammas reflecting on the challenge of integrating ESG into passive portfolios that own all companies in an index. Through this strategy, AP1 has created a portfolio that has all the hallmarks of passive given its liquidity, systematic characteristics and ability to capture equity premia. He also touched on API’s obligation to be a role model globally, hence the fund opening up and sharing its solutions with other investors.
Fossil fuel exclusion
Elsewhere, AP1 has begun excluding fossil fuels from its entire exposure.
“We thought it would be tough to exclude such a big part of the portfolio, but we’ve had real success,” Chammas told delegates. Although excluding fossil fuel groups in segregated mandates wasn’t too challenging, the process was more problematic in AP1’s fund exposure and has resulted in the investor launching some new funds and strategies with managers.Recalling the drive behind the strategy change, he said it was based on AP1’s climate and scenario analysis and the financial risk posed from fossil fuel groups.
Chammas concluded that exclusion is only one part of the AP1’s strategy. Engagement and dialogue and an active approach, particularly in China, is just as crucial.
Stocker concluded that emerging markets do face challenges around access to data and poor policy. But by engaging and trying to improve the situation will lead to change. It involves fundamental understanding of the challenges in each country, he concluded.
Inflation holds investor opportunities as well as perils. Emerging markets, commodities and linkers do well in a climate of rising prices while central banks are likely to act quickly and aggressively in response rather than early or gradually.
Inflation is set to rise further but the consequences are not all bad, said Patrick Zweifel, chief economist at Pictet Asset Management based in Geneva, Switzerland in the opening session of FIS Digital 2021. Zweifel, who has been at Pictet for two decades and has a particular expertise in emerging markets, said some asset classes perform well in inflationary regimes.
He explained that it is important to distinguish between the two sources of inflation (supply side and demand side) which each feed into different cycles. Lockdowns to contain the virus led to the lower supply of goods and lengthened delivery times leading to a rise in prices. Another phase will depend on how economic policy impacts demand, and the extent to which wages rise leading to higher inflation expectations.
He said that the combination of rising wages and higher inflation leads to sustained inflation overtime which can also make it uncontrollable – a risk he said central banks always seek to avoid. Elsewhere he noted the distinction between inflation caused by spikes in prices in goods and spikes in prices in services. Goods have a much lower share in most inflationary baskets compared to services.
“It is rare to have inflation driven by goods,” he said, noting that services will be the source of most inflation into the future.
Zweifel noted how inflation has risen in the US driven by supply side bottlenecks and pent up demand. This has led to expectations of US inflation hitting 2.5-3 per cent by 2022.
However, he cautioned that a lot of uncertainty about consumption spending could cool inflation as could uncertainty about how much of this spending will be tilted to services. The most extreme scenario pushes core inflation up to 4 per cent by end of next year, he forecast.
Millan Mulraine, chief economist at Canada’s Ontario Teachers Pension Plan flagged the challenge of allocating to inflation protecting assets but also meeting return targets. To which Zweifel counselled on the importance of avoiding risk assets when growth is low and highlighted good inflation hedges like gold and inflation linked-bonds.
Moreover, inflation can occur in a period of strong or low growth. When economic activity is high and inflation is low, risk assets thrive; when economic activity is high and inflation is high – the regime he said “we are currently moving into” – risk assets and commodities perform well. Another scenario comes when economic activity is low but inflation is high. He said that moving through the different cycles can take time, but also warned that markets can move quickly.
Emerging market equities and fixed income, hard and local currency, also offer investor opportunities, performing well in a climate of strong growth and rising inflation. He said it was important to look at emerging markets in the context of their own growth, rather than compare growth to developed markets.
“What matters most is emerging market growth,” he said, explaining that as long as it is solid the fact that it is lower that developed market peers is not important.
Emerging markets are also set to benefit from global trade and rising commodity prices. As for the impact of rising treasury yields, this isn’t damaging to emerging market asset classes either, he said.
As long as emerging markets are seeing their own strong growth it is possible to see traditional asset classes in the emerging market space do well despite rising long-term US yields.
He also noted that the dollar tends to underperform when growth is strong and inflation is high.
“The best performing environment for the US dollar is when everything is bad,” he said, adding that as long as inflation is demand driven, risk assets will continue to perform well.
Next the conversation turned to the role of central banks in controlling inflationary pressure. A concern front of mind for Kylie Willment, chief investment officer, Mercer Asia Pacific who asked for insight into central bank messaging around tapering and interest rate rises in the months ahead.
Zweifel responded that central banks will be unlikely to act early.
“My understanding,” he concluded “is that central banks are most likely to be late and aggressive rathe rather than too early and too gradual.”