Climate risk and financial services - the road from Paris

Finance experts meet at the London Stock Exchange today to discuss how they can support green infrastructure investment. The climate agreement adopted by all 195 governments in Paris has pushed the issue higher up the agenda of many in the financial services sector. The WEF Global Risks report this year notes that climate risk is a growing concern in many companies. With a stretch goal to limit warming to 1.5 degrees, the Paris Agreement is more ambitious than many expected. But the deal itself recognises the big gap between the overall global goal and current national climate policies and emissions targets.

Companies now have to manage the risks of both climate policy that aims for 1.5-2 degrees - affecting their operations and markets - and potential climate impacts of 3-4 degrees of warming. Lenders, investors and asset managers will want to assess how these risks affect their portfolios. In particular, pension fund trustees and fund managers may consider:

• How do you assess climate change risks? What are the most material risks?
• What is the carbon intensity of an investment portfolio? Is this a good measure of climate risks (physical, transition, litigation)?
• Are climate change risks factored into investment selection and portfolio management, and if so, how?
• Should you be setting a climate risk appetite as you might for other material risks? How would you manage a portfolio to achieve a specific appetite? How do you manage this when most companies are themselves portfolios of assets with differing carbon intensity?

Our Low Carbon Economy Index estimates that to limit warming just to 2 degrees, the world economy needs to decarbonise at a rate of 6.3 per cent every year. The current Nationally Determined Contributions (or emissions targets), only achieve an average decarbonisation rate of 3 per cent per year, leading to roughly 3 degrees of warming.

This suggests that business faces both the risks arising from increasingly ambitious policies and regulations designed to reduce emissions and accelerate the low carbon transition and the physical risks implied by 3 degrees of warming. 

The Prudential Regulatory Authority (PRA) report in September 2015 also identified the physical risks (first-order risks which arise from weather-related events), and the policy or transition risks (arising from the potential re-pricing of carbon-intensive financial assets). The report also highlighted the potential litigation risks arising from those who have suffered loss and damage from climate change. Finally there is the reputational risk of failing to meet expectations of the regulator, asset owners and others in addressing these issues and decarbonising investment portfolios.

Thermal coal is especially vulnerable. National climate plans specifically target coal-fired power generation, outlining efficiency standards, taxes and cap and trade systems. Carbon pricing deliberately changes the economics of fossil fuel consumption for the worse. Unlike oil in transport fuel, thermal coal is more easily substituted for less carbon intense natural gas or renewables. Technology development and environmental regulations are expected to undermine coal demand. These could lead to early retirement of coal assets and significant write-downs in their value.

It is already clear that opportunities and risks will abound for lenders and investors alike. Over time, the national climate plans should raise the relative value of lower carbon investment. For example, these plans outline the significant investment in renewables required: according to some calculations, $1tr in clean energy investment is needed each year globally. But the profitability of these investments will be affected by fluctuations in policy incentives, the carbon price and other market factors.

Fossil fuel divestment campaign gains momentum

One reaction to these climate policy risks has been to simply divest from fossil fuels. The divestment campaign has gained momentum, with some banks and pension funds committing to freeze new coal investments and divest from fossil fuel public equities and corporate bonds (normally within 5 years). Since September 2014 divestment commitments have become mainstream - growing from 181 institutions representing just $50bn to 500 institutions representing $3.4tr under management by December 2015.

Pension funds have been urged to divest their holdings in fossil fuel companies, with some of the most recent notable divestments including the following:

• The UK Environment Agency Pension Fund stated in October 2015 that it will reduce its exposure to coal reserves by 90 per cent and oil and gas reserves by 50 per cent over the next five years, and invest 15 per cent of its fund in low carbon, energy efficient and other climate mitigation opportunities.
• The public pension fund of the city of Oslo, Norway, announced that it will divest its $9bn pension fund (€8bn) from coal, oil and gas companies, becoming the first capital city in the world to ban investments in fossil fuels. 
• The Dutch pension fund PFZW announced that it will divest from coal companies and reduce its investments in other fossil fuel companies. The fund has €161bn of assets under management. 

Fiduciary duty

But many pension fund managers are uncertain about how fossil fuel divestment aligns with their fiduciary duty. This relates to the financial case for managing climate risks and whether fossil fuel divestment raises or reduces long term value. Supporters and opponents of divestment can both argue that they are managing assets in accordance with the best interests of their beneficiaries.

A recent study called Unhedgeable Risk by The University of Cambridge Institute for Sustainability Leadership, indicated that short-term shifts in market sentiment induced by awareness of future climate risks could lead to economic shocks and losses of up to 45 per cent in an equity investment portfolio value (23 per cent loss for fixed income portfolio). Around half of this decline is "hedgeable" if investments are reallocated effectively, but the other half being "unhedgeable," meaning investors and asset owners are exposed, unless some system-wide action is taken to address the risks. The conclusion from this report being that a divestment strategy is an essential part of a manager's fiduciary duty.

In contrast, Professor Daniel Fischel of the University of Chicago found that a hypothetical divested portfolio would lose 70 basis points per year compared with the optimal portfolio over a 50 year period. In response, some pension funds such as the London Pensions Fund Authority (LPFA) have taken the position that fossil fuel divestment would constitute a breach of the fiduciary duty due to the expected negative impact on financial performance.

Whilst opinion is divided on divestment, what is clear is that climate risks are becoming more material, with some estimating that $2tr of energy assets alone potentially becoming valueless if the 2 degrees target is to be met. On this basis, it would be prudent for pension funds and their managers to assess the implication for their investments and have an appropriate approach to manage these risks.

The low carbon transition

In our view, a rapid low carbon transition poses a potentially material risk to financial institutions that manage carbon intensive assets or liabilities. Asset owners and asset managers, as well as banks, will find that value is affected as the world adjusts to a low carbon future. Carbon intensive companies, particularly those producing or consuming thermal coal, are most likely to be negatively impacted by the transition, relative to lower carbon industries. This presents a strong business case for quantifying and actively managing climate risks in investment portfolios, including stock selection and the focus of company engagement. Indeed, a number of initiatives have already drawn support in this area, including:

• The Portfolio Decarbonisation Coalition, co-founded over a year ago by UNEP and UNEPFI, which now has 23 members, committed to decarbonising at least US$100bn of assets, and by the end of 2015 had reached US$600bn.
• The Montreal Pledge (launched at the Principles for Responsible Investment "In Person" conference in 2014), which requires all 117 signatories to commit to measure and publicly disclose the carbon footprint of their investment portfolios on an annual basis.

A fund-specific evaluation of risk could be undertaken to highlight key areas for action. By assessing the level of risk, and being able to compare climate risk against other risks, a pension fund will be in a better position to manage its climate risk exposure. This should ensure it is well-positioned for the transition to a low carbon economy that the Paris Agreement heralds.

Jon Williams is a partner in the sustainability and climate change team at PwC

This article is part of BusinessGreen's Road to Paris hub, hosted in association with PwC.