Climate risk: An investment imperative fraught with challenges
Climate change is altering the dynamics of investing by posing meaningful risk while also offering substantial new opportunities for growth and investment. Institutional investors of all types increasingly recognize climate change as the primary driver of the greatest shift in asset allocation over the past 50 years, and investors are thinking critically about how to address this megatrend in their portfolios.
Put simply, inaction on climate change is increasingly an untenable position for institutional investors.
Unfortunately, many barriers remain that may prevent investors from taking meaningful action to decarbonize their portfolios. The nonlinear, asymmetric, and non-mean-reverting nature of climate risk makes incorporating climate considerations particularly challenging for investors.
The most commonly used portfolio-construction techniques for addressing climate risk aren’t suitable given the constraints facing many investors. Short-term approaches such as divestment and exclusion as well as cumbersome bottom-up decarbonization strategies can leave meaningful risks unaccounted for and cause investors to miss out on powerful return opportunities. In particular, the data-intensive nature of bottom-up decarbonization approaches may cause many investors—particularly smaller ones with less internal resources—to become paralyzed by the complexities of attempting to account for climate risk at the individual investment level.
The dynamic and non-mean-reverting nature of climate change calls for a multi-faceted top-down approach to decarbonizing long-term portfolios.
Effective decarbonization starts at the top
How can institutional investors facilitate the innovation and solutions needed to meet the global climate challenge while building more resilient and durable portfolios? A top-down approach allows long-term investors to efficiently and systematically achieve their decarbonization goals while positioning their funds to capitalize on the opportunities related to the shift to a low-carbon economy.
An efficient top-down process comprises the following six primary elements:
- Align investment beliefs with a decarbonization commitment. Investors can start by documenting how their investment beliefs will change to accommodate a decarbonization commitment. Then, investors can adjust their strategy and objectives from the top down to accommodate those changed beliefs. This process involves establishing exactly why a decarbonization strategy is necessary for fulfilling a fund’s purpose.
- Determine the optimal decarbonization approach for each segment of the portfolio. A top-down approach doesn’t require investors to make one-size-fits-all decisions that apply across the entire portfolio. Rather, investors have an array of top-down approaches at their disposal—and different approaches can be used for various segments of the overall portfolio. Top-down decarbonization approaches include principles-based investing, analytic and catalytic investing, and even employing carbon-silent strategies for very short-term investments. Investors can determine which approach is best aligned with a specific segment of the portfolio and use multiple levers to make progress along the path toward decarbonizing.
- Assess the role of externally managed assets. Considering how externally managed assets will contribute to the investor’s decarbonization commitments and adjusting investment mandates accordingly plays a key role in achieving climate-related goals. In some cases, this may involve attaching a side letter to document responsibilities and expectations that have changed. These efforts help to ensure that a consistent approach is used across the portfolio, whether those assets are managed internally or externally.
- Focus on companies’ trajectories. Simply excluding companies because of their current carbon footprint—with no view toward those companies’ plans to decarbonize—could prevent companies from accessing the capital they need to transform their businesses and reduce their emissions. Furthermore, this exclusionary approach could cause a portfolio to be drastically under-allocated to meaningful portions of the global economy, such as energy, industrials, and materials. It is more appropriate for long-term investors to remain invested in so-called “transitioning assets,” which are companies or assets that cannot yet be considered climate-friendly but are on the path to decarbonization.
- Prepare for non-linear progress. The reduction in a portfolio’s net carbon emissions won’t occur at a constant rate. At times, the decarbonization path may appear to stagnate or even move in the wrong direction. Investors can acknowledge and account for the non-linear nature of decarbonization progress in their risk-appetite statements.
- Analyze progress and reassess. Implementing a top-down decarbonization strategy isn’t a set-it-and-forget-it proposition. The dynamic nature of the technological and regulatory landscape, along with constantly shifting market fundamentals, necessitate a flexible approach to addressing climate risk. Investors need to constantly evaluate emerging climate-related threats and opportunities while assessing whether the decarbonization approach used for each portfolio segment remains aligned with the fund’s overall mission.
In this report, we explore the realities and opportunities facing long-term investors as they develop top-down strategies for addressing climate risk. We also provide resources to guide investors in applying the appropriate combination of top-down decarbonization strategies across their portfolios while integrating decarbonization objectives into investment beliefs, risk appetite statements, and investment mandates. Above all, these tools can be utilized by those with explicit decarbonization goals as well as investors for whom a formal commitment to decarbonization may be inappropriate.
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