ESG: Climate Change, Powering Ahead

Institutional investors are finding increased opportunities to allocate capital to support environmentally-conscious targets as businesses in almost every industry make the transition to sustainable and green operations. Under the umbrella of environmental, social and governance investing, the imperative of climate change — and the need to achieve the global commitment to net-zero greenhouse gas emissions by 2050 — is presenting more nuanced and more numerous investment opportunities for asset managers and their clients.

ESG: Climate Change, Powering Ahead Webinar

Our panel of experts discusses the risks and opportunities in the transition to a net-zero economy, emerging sectors and advances in risk assessment and metrics at a more granular scale, considerations across asset classes and developments with indexed and impact strategy.

Featuring

Ella Hoxha

Global Bonds Senior Investment Manager

Pictet Asset Management

Stephanie Rowton

Director, ESG Indices

S&P Dow Jones Indices

Marina Severinovsky

North America Head of Sustainability

Schroders

Chris Whitehouse

T. Rowe Price Investment Management Head of ESG

T. Rowe Price

Wednesday, March 30, 2022

2:00 p.m. ET

Climate-related investments will continue to grow in the face of increasing investor commitments. “Given both the government and corporate decarbonization pledges that we’re seeing, and public awareness of the issue, our expectation is that huge quantities of capital are going to be withdrawn from sectors that emit carbon and reinvested in those that aid the transition,” said Marina Severinovsky, head of sustainability, North America for Schroders. Another major underpinning for this shift is from next-gen investors — millennials and Generation Z — who are increasingly part of the investor community and more likely to demand that their portfolios reflect their values while meeting return objectives. “They see sustainable investments as a way to contribute to the change they’re looking to see in the world,” she said.

T. Rowe Price Investment Management’s head of ESG, Christopher Whitehouse, stated that institutional investors are continuing to look for ways to decarbonize their portfolios. In some of the “obvious” opportunities like solar or wind energy, investors have already priced in a lot of the potential in their performance, he pointed out. The firm is also looking down the value chain for opportunities in renewable diesel and battery-storage technology. T. Rowe Price has a proprietary impact investing structure that aligns with United Nations Sustainable Development Goals. (See chart).

Pictet Asset Management focuses a lot on finding leaders in the new momentum created by net-zero. “Tomorrow’s picture will be different from today’s picture because the world is changing. Economic agents are changing their business models and countries are changing their composition. [gross domestic product] over time. So it’s absolutely essential to not only look at how things are today, but also what they might look like in five, 10 or 15 years,” said Eric Borremans, head of ESG at Pictet Asset Management.

Schroders’ climate-focused investing comprises several different approaches, ranging from sustainable strategies which actively aim to do better than the index in terms of carbon intensity to thematic strategies, Severinovsky said. Examples of the firm’s thematic approach include the Global Energy Transition fund, which considers long-term investments in companies involved in the transition to clean energy, and the Global Climate Leaders fund, which focuses on companies that gain a competitive advantage by leading on climate change commitments.

Passive ESG strategies are also becoming more popular. S&P Dow Jones Indices offers several strategies, from core ESG indexes and low-carbon and net-zero approaches to more thematic and fixed-income strategies, said Margaret Dorn, senior director and head of ESG indexes, North America, at the firm. These indexes use data sets that account for industry-specific, financially significant ESG and climate risks.

The green economy — companies and initiatives committed to meeting environmental goals and resource conservation — comprises just 5% to 10% of the global economy, and it has a lot of room to grow, Borremans said. “It’s not insignificant, but it’s not a lot.” However, he said, “it’s growing fast: probably at least twice the rate of the global economy. It’s a growth story and a very profitable one. But because it’s still relatively small, you’re bound to have supply-and-demand shocks and valuation bubbles.”

Investors should carefully consider how they will identify green opportunities. Borremans explained that investors could continue to penalize certain energy companies that are currently carbon-intensive, even though these companies have already committed to reducing their emissions and are still early on the transition. These companies could see a rise in their rating as they move further down the road to net-zero emission.

Borremans said that these types of transitioning businesses are similar to investing in distressed debt companies, with the expectation that they will improve in credit quality and become high-yielding or investment-grade assets. “We’re looking to be a catalyst for change and benefit from that rerating,” he said.

This approach emphasizes the importance for forward-looking analysis when investing in climate-related investments. “We have never had an economy that has been faced with a situation like this, so you can’t really do back tests because it hasn’t happened before,” Borremans said.

With the heightened focus on climate-related investments in institutional portfolios, asset managers are more engaged in helping asset owners understand the unique risks involved in companies and issuers undergoing the transition to a net-zero economy — and the need for consistent monitoring to keep up with changing conditions.

Read: Legislation to Support Clean Energy Would Impact Key Sectors

The Task Force on Climate-Related Financial Disclosures, or TCFD, has defined climate-related risk in terms of two main categories: transition risks and physical risks, said Margaret Dorn, senior director and head of ESG indexes, North America, at S&P Dow Jones Indices. She said that these risks are like a symbiotic relationship. If one side is too focused on the other, it could lead to unacceptable levels. “You may want to look at climate change more holistically and address all key elements, including transition risks and physical risks, as well as opportunities available for investors to finance industries and activities that lead to a lower-carbon economy.”

“We are now seeing increased interest and awareness from investors about the risks that climate change poses to their portfolios, because the productive assets and business models of underlying companies are at stake,” said Eric Borremans, head of ESG at Pictet Asset Management.

Physical risks directly impact a company’s operations and are caused by climate events, such as natural disasters, or climate shifts, such as rising sea levels or drought. Dorn said that investors continue to gain insight into the nature of these risk factors and how they could impact a company in the future.

“We want to map out the physical risks of, say, a company’s property, plant and equipment in various climate scenarios, and the associated risks to those assets,” said Christopher Whitehouse, head of ESG at T. Rowe Price Investment Management.

Investors have also been requesting more data and transparency from their companies as a way to better understand physical risks. Whitehouse said that T. Rowe Price is encouraging portfolio companies to report TCFD-related emissions as part of this process.

Although transition risks are less tangible, they could impact reputational or financial losses due to technological, policy, and legal changes or shifts in culture or the market perception of companies.

Dorn used the example of carbon pricing to illustrate how S&P DJI thinks about transition risk. While there seems to be market agreement that the global price of carbon will rise in the future, there’s uncertainty around how much it will increase. “So, there’s a financial risk implication that companies will either have to absorb the additional costs of carbon emissions or, ultimately, pass it on to their customers,” she said. “Either way, you know that carbon could have direct financial implications for companies.”

Dorn noted that institutional investors are becoming more aware of the significance of physical and transition risk, and are therefore building portfolios that can withstand both.

While it’s often easier for investors to understand physical risk, since they can visibly see climate changes in their own environment, transition risks cannot be overlooked, particularly with increased regulatory focus on carbon-emissions disclosure and other areas.

At the same time, the availability of more and better data has deepened investors’ understanding of climate risks. “As the data gets more granular, so do the investment strategies that can apply the data,” Dorn said.

S&P DJI’s climate indexes offer investors tools to address different values, objectives and opinions on how to respond to the risks and opportunities of climate change. For example, the S&P Paris-Aligned and Climate Transition indexes, or PACT, provide a science-based approach to climate investing aligned with 1.5 degrees Celsius, while they stay as close as possible to the benchmark index, offering broad, diversified exposure. Back-tested data for both the S&P 500 Net Zero 2050 Paris-Aligned index and the S&P 500 Net Zero Climate Transition index have exhibited outperformance over their S&P 500 counterpart, Dorn said (see chart).

Investors recognize the wider social consequences of climate change and are willing to take on financial risks.

“My viewpoint on climate change is that it’s an existential threat,” said Hari Balkrishna, portfolio manager of the Global Impact Equity Strategy at T. Rowe Price. “If we don’t actually solve for it, a few trillion dollars lost from the global economy is going to be the least of our problems. We’re going to be wrought with devastation and social issues.”

Balkrishna can use this perspective to help him evaluate companies. “There are many companies that are delivering positive environmental and social impact,” he said. “And they have better bottom-line and top-line growth prospects than the index. I correlate impact investing with smart finance.”

Asset managers have committed more resources to developing proprietary models and seeking more precise approaches to address climate risk because there is not a standardization in climate-related metrics that can be used to evaluate companies.

“Data and materiality give us a common language to discuss climate issues, make comparisons across companies and [evaluate opportunities] with internal managers,” said Christopher Whitehouse, head of ESG at T. Rowe Price Investment Management. Data underpins the firm’s active-management approach and informs its due diligence with companies, he said. It also indicates the climate-related metrics it believes each portfolio company should disclose, and monitors how companies are doing on those disclosures.

Schroders uses its own metrics to build climate-related investment strategies. “It’s quite challenging to compare companies using external data and draw conclusions that you can really have faith in,” said Catherine Macaulay, sustainable investing analyst at Schroders. “So we place a high value on developing our own methodologies that we trust and invest heavily in a number of proprietary tools that look at climate risk as well as the broader environmental and social impact of companies.”

For example, Schroders’ SustainEx tool measures companies’ Scope 1, Scope 2 and Scope 3 emissions, as well as potential benefits from avoided emissions, and quantifies these in dollars, Macaulay said. It uses a similar approach for other environmental or social indicators. “We find that measuring the impact in dollar terms is more tangible when compared to external scores that have little meaning in isolation, and it allows you to compare a diverse range of impacts on a like-for-like basis.”

The in-house models form a key part of Schroders’ climate escalation framework — which sets out how it will help drive the transition to a low-carbon economy — and enable the firm to monitor company performance and progress against expectations. “Through working with portfolio companies and encouraging them both to commit to and deliver change, we can drive real-world emissions reductions that actually move the needle,” Macaulay said.

Despite the difficulties in comparing climate-related investments across companies or issuers, the metrics used to measure specific climate risks are becoming more precise.

“We’re looking at implied temperature rise and decarbonizing a portfolio,” said Holly Turner, sustainable investment analyst at Schroders. “What does the portfolio look like in 2030 or further into the future, based on implied temperature rise?” It is particularly important to look at these types of implied metrics when investing with a decarbonization theme and thinking about a portfolio’s impact in the future, she noted.

Asset managers also use metrics to identify greenwashing — a form of deceptive marketing in which a company’s actions on sustainability don’t align with its public stance. “There are a lot of oil and gas companies that have renewable investments and green websites that will try to convince [investors] that they are turning green,” said Balkrishna at T. Rowe Price. “But if you run the math, you can see that few of them have even 15% of revenues from renewables in 10 or 15 years. Materiality using accounting data is really a simple smell test.”

Read: Schroders Climate Transition Action Plan

On the other hand, some power utilities — among the biggest carbon emitters — are driving a truly meaningful transition toward renewable energy, Balkrishna said. “These are some very interesting investment opportunities, where the market hasn’t given [these companies]Full credit for their renewable energy generation [and their efforts]He stated that they are actually moving in that direction. “There is a huge decarbonization journey happening” in this sector.

“We go through a very rigorous process to measure material alignment to one of our impact pillars, effectively building an impact model on every company we invest in” Balkrishna added. “That requires a lot of measurement where we, as an active manager, get involved in measuring the ex-ante and ex-post impact of our clients’ investments, from a bottom-up perspective.”

Investors who are evaluating equities need to be careful. This is true for all asset classes. S&P Dow Jones Indices is increasingly working on climate-related investments in fixed income and alternatives, such as infrastructure and commodities. “We’re coming into a maturation stage of ESG, in which investors are looking to diversify their ESG application into many different asset classes,” said Margaret Dorn, senior director and head of ESG indexes, North America, at the firm. “We approach that mandate with the same due diligence and research process that we would any index strategy.”

When evaluating sovereign issuers, Schroders uses climate-related metrics. “Sovereign ESG can get less airtime than corporate ESG, but we don’t think it’s any less important” in terms of materiality, Macaulay said. Schroders’ proprietary tool measures sustainability at a country level for more than 150 governments and considers indicators such as carbon emissions, biodiversity losses, forestry and investments in clean energy.

Hoxha said that investors will be more interested in a climate lens on sovereigns if they are looking to make a lasting difference. “The idea is that the more investors come on board, the more the pressure increases on sovereigns. But it hasn’t really been tackled yet in the markets.”

Green bonds are still an important part the ESG universe. Asset managers warn investors to be wary of greenwashing as they grow in number.

“The volume and flows of green bond issuance are rising very quickly. It makes perfect sense when they are bonds issued by specialized companies that will use the proceeds to finance green assets,” said Eric Borremans, head of ESG at Pictet Asset Management. “But it’s a mixed bag out there. There’s dark and very light green, and even some brown,” he said, referencing the different levels of environmental quality of green bonds.

Asset managers expect greater regulation and transparency as the green bond market matures. Hoxha said that standardization of data will also be a key factor in investors being able to evaluate these bonds.

Dorn advised that investors should do their research to discover the many indexed strategies available to them to help them achieve their goals. An index’s rules-based approach can provide greater transparency for sustainable investing. Investors have full access to the composition of the index, including information on the data being used, the criteria for security selection, weighting, as well as the criteria for security selection.

S&P DJI’s data approach has evolved to include forward-looking analyses, as opposed to just using more traditional models, which tend to be more backward looking, like carbon-footprint analysis, Dorn said. For example, S&P Global’s Trucost Transition Pathway approach seeks to identify companies that are on track to being aligned with a 1.5 degrees Celsius scenario over the coming years.

Climate-related investments have become mainstream in Europe thanks to aggressive regulation, which was adopted earlier than the U.S. regulatory efforts. The U.S. is pursuing more aggressive climate-related initiatives at its regulatory agencies, including the Securities and Exchange Commission. It is creating rules for public corporations to disclose their greenhouse gas emissions.

The 26th Conference of Parties summit in Glasgow, Scotland, last November, focused global attention upon climate change. It emphasized the importance of investors continuing to address climate risk in their portfolios, as well as better sustainability disclosures from companies. Some asset owners have joined United Nations-convened Net-Zero Asset Owner Alliance in the United States, while others have announced portfolio targets to net-zero emissions.

Read: A Indexed Approach to Net Zero

European investors have committed themselves to meeting Paris Agreement-aligned benchmark goals with portfolios that meet annual targets for decarbonization and limiting global temperature rise to 1.5 degrees Celsius. Europe’s recent activity reflects new regulations that require European investors to report the climate-related impact of their portfolios, starting in January 2023, under the Sustainable Finance Disclosure Regulation, or SFDR taxonomy, including carbon emissions of their overall portfolio, said Eric Borremans, head of environmental, social and governance at Pictet Asset Management.

“In Europe, we’re looking at overlapping components of climate action to achieve a fund goal,” said Holly Turner, sustainable investment analyst at Schroders. “We have funds that have developed a decarbonization commitment over time; as well as those that define universal climate parameters — such as an assessment of low-carbon transition — by using proprietary tools — such as avoided emissions — to identify climate solutions; and a net-zero dashboard to track corporate climate commitments.”

“Our avoided-emissions framework provides an additional lens by capturing a corporate’s contribution to emissions savings through offering low-carbon products and services that allow for the substitution of high-carbon activities. These savings are generally not reflected within conventional scope 1, 2, and 3 emissions,” she noted.

“Europe is where we’re getting the most interest” on climate-related investments, said Ella Hoxha, senior investment manager, global bonds, at Pictet Asset Management. “Most, if not all, of our clients are sending us questionnaires and asking what we’re doing on climate, what we’re doing on the emissions side and how we are managing performance.” That’s likely a good sign for the ESG industry as whole, she added. “It’s still early days, but there’s a lot of attention — and where attention goes, solutions come,” Hoxha said.

Read: Sovereign bond investing: A climate-focused approach

Investors are more interested in specific metrics and outcomes that will help them to focus on their climate focus. The index products at S&P Dow Jones Indices that are aligned with the Paris Agreement provide for those very specific objectives. “We’re looking at areas like greenhouse gas-intensity reduction, brown-to-green share revenue improvement, high-impact sector exposure, physical risk improvement and fossil fuel reserves reduction,” said Margaret Dorn, senior director and head of ESG indexes, North America, at the firm.

Schroders has seen investors and governments increasingly recognize that forests, and other aspects, are essential in achieving the ambition to limit global temperature rise to 1.5 degrees Celsius. Catherine Macaulay is sustainable investing analyst at Schroders. “COP26 really brought this to light. We saw a pledge from more than 120 countries to end deforestation by 2030, and a second commitment from more than 30 financial institutions — including Schroders — to eliminate agricultural, commodity-driven deforestation within our portfolios.”

She noted that Schroders’ partnership with Natural Capital Research allows the firm to “explore possibilities to allocate directly to projects that establish, protect and enhance nature and maximize natural carbon sinks.” Natural carbon sinks include, for instance, plants and oceans that take in and store carbon dioxide from the atmosphere. One example of Schroders’ focus on nature is a sector view of direct and supply-chain gross value-add for varying levels of nature dependency (see chart).

Global investors are paying more attention to ESG metrics, regardless of whether they invest in an active or passive strategy. “With increased focus on reporting, more and more clients want to understand their current emissions from their portfolio,” said Christopher Whitehouse, head of ESG at T. Rowe Price Investment Management. “That’s something that the whole asset management industry is grappling with, both in terms of the products needed and how to service the shifting needs around carbon-neutral portfolios.”

All aspects of ESG are expected to continue to grow across geographies, asset classes, and all aspects appear poised for growth. “A focus on ESG began in Europe but is now transitioning to investors in the United States,” Whitehouse said. “That pace has accelerated and is informing investment decisions across asset classes, both in equity and fixed income.”