Trustees need practical guidance on how to implement a comprehensive investment approach to climate change. Helga Birgden, head of responsible investment for Asia Pacific at Mercer and Nathan Fabian chief executive of the Investor Group on Climate Change Australia/New Zealand,  show them how.

In the 2013 Global Investor Survey on Climate Change, more than 80 per cent of asset owners such as pension funds identified climate change as a material investment risk. Despite this only 25 per cent said they had changed their investment strategy or decisions as a result of their risk assessment. While leading pension funds are making changes, many trustee boards are yet to implement a comprehensive investment approach to climate change.

To address this implementation gap, IGCC and Mercer recently filmed real life trustees in a role-play of a board meeting of the fictitious Perfect Storm Pension Fund.

The aim was to discuss and agree concrete steps a trustee board could take to address climate investment risk. Seven areas were discussed in the form of board resolutions on: investment policy; strategic review; investment tradeoffs and timing; increasing climate sensitive allocations; measuring investment exposures; and disclosing performance to the market.

Each area is discussed below and the meeting videos and resolutions can be viewed here.

Investment Policy: Explicitly addressing trustee investment beliefs on climate risk in the Investment Policy Statement or in a separate ESG Policy is a necessary first step to activate the fund stakeholders and its service providers around the challenge of climate change.

A widening of the investment lens to focus on protecting a portfolio and enhancing opportunities by opening access to growth is what is required. Investment beliefs need to be driven by evidence, conviction and reasonable consensus. Addressing the relationship between climate change and fiduciary duty, corporate governance and the materiality of environmental and social issues to company performance depends on it. The evidence of climate related economic risk, government policy and technology change is more comprehensive than ever. Many leading funds have taken this step already.

Strategic Review: In the strategic review, both near and long term impacts from climate change on existing investments across asset classes, regions and sectors should be reviewed.

Information for the review can be gained from research and analysis via fund collaborative research studies, from research conducted by the fund’s portfolio management teams, asset managers and specialist advisors. Strategic asset allocation and portfolio reviews tabled at board meetings allow trustees to participate in the consideration of systemic risk factors which may be material to the overall fund’s performance and its investment strategy.

Tradeoffs and timing: Next, tradeoffs between climate impacts and mitigation pathways should be assessed and assumptions built in to mandates.

Less mitigation action by governments, businesses and investors will mean worse climate impacts. Strong mitigation steps may avoid the worst climate impacts, but will change investment returns from emissions intensive activities.

The important questions are whether physically vulnerable assets are at risk, whether emission intensive assets and related supply chains are at risk, or both? While investors are not scientists there is sufficient information available for investors to make a judgment about how climate and regulatory impacts will play out and position their fund accordingly. Some public company boards are embracing this conversation on tradeoffs in their strategy and capital deployment activities.

Investment allocations: To implement policy means allocating capital.

There are a number of ways that leading funds consider allocation, including risk mitigation at the portfolio level and identifying growth opportunities in sustainability related sectors and markets. The former includes how managers address climate risk and opportunity within their investment framework, the latter how managers are gaining exposure to various themes and new ideas to capture revenue and alpha opportunities in responding to climate change.

Pension funds can also allocate to environmental themes by focusing on solutions to environmental problems and resource scarcity, for example in renewable energy, energy efficiency and clean technology, water and waste management and agriculture.

Environmental themes can be accessed through either pure play investment strategies, which focus on one particular theme such as energy, or through a broader approach, combining various environmental themes. There are now many options for pension funds to allocate capital to climate sensitive activities in public and private equity, in fixed income, infrastructure and real estate.

Measuring exposure: Forming good investment strategy relies on good information. Analysing exposure to greenhouse gas emissions and to low carbon assets is the first step in a necessary internal review by pension funds.

The questions that such analysis should provoke include how to best assess the risk and return implications of reducing emissions exposure and whether hedging against climate impacts can occur while maintaining returns. Without asking these investment questions or being prepared to change allocations, portfolio footprinting is a solitary step that has provided limited benefit to the funds that have performed it.

Disclosure: Finally, investors rely on well functioning markets. Low transaction costs and high deal flow rely on high quality and available information.

It is in the self-interest of pension funds to create a market for emissions reduction investment opportunities and encourage more low carbon deal flow and business activities. Disclosing carbon exposures of funds will help to develop a market for responses to these problems. Disclosing exposure by using emerging metrics on financed emissions will provide more information for markets and options for funds to respond to climate risk. Disclosing information about low carbon investments will also help the market to develop more of the opportunities that funds favor and less of those that they don’t.

Conclusion

A trustee board that implements each of these steps will be making climate sensitive investment decisions in practice.

Difficult tradeoffs will still need to be assessed, but the necessary information and tools are now available to guide trustee boards.

The science of climate change is relatively clear, the economic impacts are well understood and the quality and quantity of investment analysis is reaching investment grade. While some uncertainties remain on government policies, changes in markets and future technology trends, these issues should be addressed at the tactical investment level, rather than at the strategic level by trustee boards.

Given that so many pension funds already identify climate change as a material risk, following through with a comprehensive investment approach is the necessary and prudent response. The seven example resolutions discussed by the Perfect Storm Pension Fund Board can provide the basis for a comprehensive response to climate change by pension fund trustees.

The Perfect Storm Pension Fund board meeting role-play can be viewed here.

 

Investors should take care in selecting corporate engagement firms to ensure the engagement reflects their portfolio holdings, warn academics at Oxford and Maastricht Universities following a new study which reveals a home bias in such activity.

As the investment portfolios of large institutional investors become increasingly global, it is particularly important that they carefully select engagement provider so it mirrors their investment portfolio, says Michael Viehs, research fellow at the Oxford University Smith School of Enterprise and the Environment and co-author of the paper.

“If investors are actively exercising proxy votes, shareholder resolutions and engagement the implications of this paper are they should move carefully to select providers to ensure engagement activity reflects their portfolio,” he says. “If they are delegating engagement and hire intermediaries then it is most important that asset owners are aware of the home bias.”

The paper, co-authored with Professors Rob Bauer from Maastricht and Gordon Clark from Oxford, entitled  “The geography of shareholder engagement: Evidence from a large British institutional investors”, shows that geography is an important determinant in the occurrence of engagement.

The study looks at the global corporate engagement activities of a UK-based engagement agent, which acts on behalf of 25 institutional investors.

It analyses the engagement activities of that firm with 397 firms identified as “priority firms” in 37 different countries from 2006 to 2011.

Through an empirical investigation the paper examines the extent to which geography drives those engagements, and the extent to which geography is a determinant of successful engagement.

The paper finds the engagement agent to be very active during the period, raising 6,837 objectives at the 397 firms. Further, there were 592 instances in which the investee firms changed according to the requests of the investors, which the authors determine to represent successful engagement.

The existence of a home bias is evident in that firms from the UK, the agent’s home country, get significantly more objectives than their foreign counterparts.

“We argue that the proximity to target firms and better knowledge of the regulatory environment in the home market, and hence reduced information asymmetries, drive our results,” the authors say in the paper.

Further, one of the more interesting results is that while there is a home bias in that more UK firms are engaged, the success of engagement is higher with corporations outside the local jurisdiction.

The academics proffer that this is because the institutional investor more carefully targets and selects firms abroad for which the expected success likelihood is highest in the first place.

Understanding how to best use corporate engagement is important Viehs says, because it can be a boost to shareholder returns.

The paper “Active Ownership” examines corporate social responsibility engagements with 613 US public companies from 1999–2009.

It shows that there is an abnormal stock price reaction of 4.4 per cent to firms where the institutional investors successfully achieved change, providing the first evidence that the corporate engagement activities of the institutional investor are value-enhancing for shareholders.

 

This paper, which examines the impact of the trend in the US of corporate funds freezing their defined benefit funds and offering defined contribution plans, shows that net of the increase in total DC contributions, firms save 2.7-3.6 per cent of payroll per year, and over a 10-year horizon they save 3.1 per cent of total firm assets.

However the authors conclude that the workers would have to value the structure, choice, flexibility, or portability of DC plans by at least this much more to experience welfare gains from freezes.

 

To access this article, authored by Joshua Rauh from Stanford University, Irina Stefanescu from the Board of Governors of the Federal Reserve System,  and Stephen Zeldes from Columbia University, click below.

Cost shifting and the freezing of corporate pension plans

 

In the January/February issue of the Financial Analysts Journal, Jack Bogle, founder and former chief executive of the Vanguard Group, looks at the “all-in” investment expenses including not only expense ratios byt transaction costs, sales loads and cash drag.

He highlights, in particular, how damaging these costs can be over the long run, and reaffirms the warning he has consistently given to fund investors over the years:

“Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns”.

 

Bogle is now president of the Bogle Financial Markets Research Center. His article from the FAJ can be accessed here

 

Now in its fifth year GRESB, the benchmark that measures the sustainability performance of real estate portfolios, has been influential in changing the sector’s performance and environmental impact. Now Nils Kok, executive director of GRESB and associate professor in finance at Maastricht University, says that infrastructure and private equity assets are ripe for a benchmark as well.

The real estate sector is responsible for about 40 per cent of global greenhouse gas emissions and for 75 per cent of electricity consumption in the US alone so accountability with regard to sustainability can have a huge impact in this sector.

Just how much energy is consumed in the sector is demonstrated by last year’s GRESB survey which reported on 30,690, 998 MWh of total energy consumption, and 17,188,742 metric tonnes of GHG emissions.

Since the Global Real Estate Sustainability Benchmark (GRESB) began in 2009 carbon emissions from the real estate sector have significantly reduced, demonstrating the power of benchmarking funds on sustainability.

Executive director of GRESB Nils Kok says that five years in, he can now confidently say the industry is moving forward, which can be measured in disclosure and results.

“It is most encouraging, emissions are coming down quite quickly,” he says.

By example in the 2012 GRESB report, 171 property companies and funds surveyed reduced GHG emissions by 6 per cent – this is a reduction of 432,000 metric tons of CO2, the equivalent of removing 85,000 cars from the road.

 

Changing behaviour

The GRESB survey has been powerful in changing behaviour in the property sector for a number of reasons.

Firstly it was the result of collaborative work by a group of 11 of the world’s largest pension asset managers and Maastricht University including APG, PGGM, USS, ATP and OTPP.

Their aim was to create shareholder value and reduce the sector’s substantial carbon footprint.

Kok, who is a visiting Scholar at UC Berkeley and associate professor in finance at Maastricht University, says one of the reasons GRESB has been effective is because it is a single tool used by a large number of investors.

“One of the lessons from GRESB is you really need a number of larger investor to bundle ambitions into a single tool. It needs to be standardised and you have to give in and get consensus to what you measure,” he says. “Harmonisation is important.”

GRESB is now used by more than 100 institutional investors with combined $6.1 trillion to engage with their investments to improve the sustainability performance of their investment portfolio, and the global property sector, and it now covers 49,000 assets in 46 countries.

“Investors value disclosure above performance, transparency above ranking, that’s the message investors are sending,” Kok says. “Look at the numbers we have reached, it’s a tipping point, if you don’t disclose then you’re a minority.”

There are now 543 real estate companies and fund managers participating, and while that has been partly due to the influence of investors it is also evident that being green is beneficial to the portfolio holdings and returns of managers.

Kok says that small improvements in buildings can have large effects, and the impact of energy costs directly affects tenants and investors.

The economic significance of green buildings can be seen in energy savings, but also lower insurance premiums, and it has also reputation effects which impact rent and corporate preferences.

Research conducted by Kok which looked at 28,000 office buildings, 3,000 of which are certified by EPAs Energy Star or the US green Building Council, found that green buildings have higher rents and higher selling prices.

It shows the average non-green building in the rental sample would be worth $5.6 million more if it were converted to green. Further his study has found that a $1 saving in energy costs is associated with an increase of effective rent of 95 cents, and a 4.9 per cent premium in market capitalisation, which is equivalent to $13 per square foot.

But Kok argues there are still a number of measures that can be taken to improve efficiency further. For instance, having a sustainably built building is only useful if the tenants take advantage of what is available.

“There is room to influence the behaviour of occupants,” he says pointing to Number One Bligh Street in Sydney, Australia as an example. “The building is impressive, but per square feet it is not that impressive because it is intensively used by traders and banks which have intense energy use.”

There is s still a lot of innovation that can happen, Kok says, pointing to technology improvements but also sharing concepts seen in the consumer space like Airbnb.

“Things like Airbnb work well in the consumer space, and it would be good to get some more flexible concepts in the commercial space like short leases or flexibility in the use of space.”

 

Infrastructure and private equity benchmarks

The survey, which was designed in 2009, captures more than 50 data points of environmental and social performance integrated into the business practices of each real-estate company or fund. It looks at the management of the company and also the underlying assets.

Kok believes the same could be applied to the infrastructure and private equity asset classes and that investors are showing greater interest in these areas.

“Within infrastructure you could look at the ESG that the manager applies, but then also the underlying assets and social characteristics. It is ripe for a standardised measure as well,” he says.

There are still a lot of relative differences among managers and funds within real estate, but also infrastructure and private equity, and Kok says a benchmark helps.

“The question about a benchmark is does it measure the right thing, we think it does,” he says. “There are always reasons why a fund underperforms its peers and the benchmark can be a starting point for a conversation.”

While acknowledging that there is danger in a benchmark being reduced to a single number, Kok says transparency and performance of a benchmark focuses the mind especially of top management. This works for financial benchmarking and other forms of benchmarking as well.

 

Sustainability and performance

Since GRESB started collecting data in 2009 there has been a substantial improvement in the sustainability performance of real estate across the globe.  Importantly sustainability improvements also correlate with returns.

This is demonstrated in a paper by Kok and fellow Maastricht professors Piet Eichholtz and Erkan Yonder – Portfolio greenness and the financial performance of REITs – that finds investment performance of REITs is positively related to the adoption of Energy Star and LEED certification in REIT portfolios.

In a prior interview Eichholtz, who is chairman of the Global Real Estate Sustainability benchmark, says the paper shows there is a relationship between greenness and performance.

“The greener the company/portfolios the better the performance, also free cashflow was higher and risk was lower, and beta was substantially lower,” he says. “This paper shows that the relationship between financial performance and sustainability is really there.”

Eichholtz says the philosophy of GRESB is that “you can make good money by improving the world”, he says.

“Members of GRESB, the pension funds, see that sustainability and investment performance go hand in hand and they talk to companies and say get your act together.”

 

 

 

For information on the 2014 GRESB survey click here

 

Given the importance of equity risk premium, it is surprising how haphazard the estimation of equity risk premiums remains in practice.

This paper by Aswath Damodaran at the New York University Stern School of Business examines a number of different approaches to determining the equity risk premium and why different approaches yield different values. It closes by looking at how to choose the “right” number to use in analysis.

 

The paper can be downloaded here