Key Themes of Discussion

INVESTOR BIASES

Cultural change doesn’t happen overnight. For an issue that seems as insurmountable and colossal as climate change, the challenge of risk detection and time horizon prediction is exacerbated by a slow adoption cycle. To accelerate this belief adoption, believers need to find common ground with major capital holders and their traditional managers. In his keynote address, Public Policy & Investment—View from the State Level, Treasurer for the State of Rhode Island Seth Magaziner proposed breaking down climate change into personal terms. Climate change is not a vague existential threat. Consumers are already paying for climate change through homeowner insurance and their utility bills. But investment professionals are as responsible for the moratorium as the public. Managers now know they are going to have to be able to discuss climate change in investment meetings, but they have little framework, data, experience, or expertise to undertake these conversations. Instead, too often they avoid having them. Treasurer Magaziner noted that the financial and sustainability systems should not be bifurcated; there has to be an intention to translate skill sets from both ends of the interest spectrum. Investment professionals need scientific and social justice expertise, and social and environmental activists and policy experts need investment professional buy-in. Competition will eventually force managers to engage on climate change, but the consequences of slow conversion are precarious for both the investment industry and global economic stability.

Pensions

How do you use the entire firepower of an institution to advance a mission? Considering climate change in making investment decisions is a logical step, said Brunsting. As fiduciaries, investment professionals are familiar with developing processes to evaluate risk and other relevant decisions. These professionals are responsible for taking a broad look at the science and proposing a set of actions that pension funds can pursue to address climate change within their portfolios. Fiduciary responsibility, Treasurer Magaziner noted, concerns everyone in a pension plan—if the focus is on maximizing returns for an 80-year-old participant while ignoring the interests of a 23-year-old participant, managers are not performing their fiduciary duties to the younger individual. Money management necessitates a perpetual focus. It cannot be about only maximizing returns; extending returns must also be considered. In their session, Brunsting and Wolfensohn explored the power of major asset holders to influence their wealth managers. Trustees that represent beneficiaries are eager to bring climate change issues into the boardroom, but face resistance from peers solely focused on growing an investment corpus. Smaller pensions funds don’t have the staff or capacity to attend to ESG issues. Thus, larger players requesting managers’ policies consider climate change can have a wonderful multiplier effect with benefits downstream. The industry, Brunsting and Wolfensohn noted, is already seeing the conjunction of these efforts. The California Public Employees’ Retirement System (CalPERS), the largest public pension fund in the United States, with investments worth $330 billion,[i] announced in August 2017 the Global Climate 100 initiative, whose goal is “to meet the Paris climate accord target of reducing carbon emissions by 80 percent by 2050” by targeting the “100 companies in 20 countries [that] account for half of the public equity portfolio’s carbon emissions, or 16% of global emissions.”[ii]

Public Sector

The Public Sector Panel and Sustainable Cities session led by Adam Krop, Sustainable Infrastructure Advisor at CDP (formerly the Carbon Disclosure Project), began with the question: What are the information gaps in the development and financing of sustainable infrastructure projects? Zach Solomon, Vice President at Morgan Stanley, believes green bonds are an effective start to bridging gaps on the topic of sustainability. Rob Thomas, Chief of Energy and Environment, Deputy Energy Coordinator for the City of Newark, agreed on the usefulness of the instrument in aligning disparate interests, adding that the problem is getting different silos of the public sector together, let alone uniting the public sector with the private sector. He continued that a lot of education needs to be done to change how investors think about business and risk. The science is there around climate change, and—especially in the financial world—risk is seriously considered. But there’s no capacity at the community level to understand how to structure ideas differently. In Thomas’ view, the lack of consistency and consolidation is also driving complacency. No standard body has arbitration as to what E, S, and G actually are. This lack of information and awareness is so entrenched, he added pointedly, that many cities and municipalities are issuing and building products that are technically “green,” and they don’t even know it. Leonard Jones, Managing Director–Public Finance, Public Projects & Infrastructure Finance at Moody’s Investors Service, noted that there are successful examples of public/private symbiosis. ESG risk has long been incorporated into credit ratings by firms like Moody’s. This is particularly true in the insurance markets: many localities have Federal Emergency Management Agency (FEMA) backing, and, therefore, resiliency quality.[III]Without FEMA, cities and regions devastated by factors that may or may not be correlated with climate change[IV] (some recent examples include Houston, TX, Puerto Rico, and Santa Rosa, CA) would be debilitated by massive infrastructure costs. It is the interest in closing the information gaps that is pressuring these ratings agencies to be more transparent about climate-specific evaluations. Elliot Trexler, President and CIO of Global Return Asset Management, led the group during his panel, Using Climate Data in Investment Decisions: A Case Study, through a thought exercise: Given a five-year time horizon, which company would you invest in, General Motors or Tesla? While most of the audience refrained from raising their hands either way, Trexler used the case study to emphasize how the ESG factors that actually affect returns may or may not immediately appear rational. Ian van der Vlugt, Senior Technical Manager at CDP, and Vikram Puppala, Associate Director, Carbon Solutions, Indexes, Green & Social Bonds at Sustainalytics, highlighted that the factor that makes the difference always seems obvious in hindsight. But prediction is different; improved disclosure may not have any impact on making forecasts more accurate. What ESG factors are even relevant for investment success? Companies outperforming in one facet—for example, Tesla as a leader among environmental companies—may find their Achilles heel in social and governance practices.

CLIMATE CHANGE RISK MITIGATION

On his panel, Climate Change Products and Integration Techniques, moderator Michael Lear, CAIA, CFA, CIMA, Vice President and Financial Advisor at Bernstein Private Wealth Management, asked Karen Wong, CFA, Managing Director and Head of Equity Portfolio Management at Mellon Capital, how she has considered integrating climate change risk. Globally, our reliance on fossil fuels is undeniable, Wong began. So, she has taken what she describes as a gradual approach. Gone first from Mellon’s portfolio was coal, the most carbon-intensive fuel. This was a relatively easy change, as there are many substitutes. However, this just shifted Mellon’s investments to other energy companies. At that point, massive infrastructure problems made moving up the sustainability scale difficult. As an incremental step, Wong made the decision to use carbon emissions rather than fossil fuel reserves as the indicator of risk. But data is weak: not enough companies disclose carbon data; those that do report often have stale numbers; data can be effectively irrelevant; and regardless of quality, data can lead to faulty conclusions. Furthermore, as Trexler later emphasized, ultimately, it is very hard to tell when each ESG factor is going to impact the stock values within a portfolio. Wong identified several approaches to circumventing data issues. Estimated data can be of high quality if provided by an assiduous vendor. Shareholder engagement can be seen as a tool for key risk mitigation. Wong also recommended moving beyond current company results to consider impact trends: carbon footprint relative to peers, explicit policies instated, and increasing disclosure from a company around climate change issues. In recent studies by both MSCI Inc. and Aperio Group, neither an ESG alpha nor risk factor was identifiable. However, in the first afternoon session, Should ESG Be Embedded as a Risk Factor in Multi-Factor Models?, George Bonne, PhD, PRM, Executive Director of Equity Factor Research at MSCI, stated that MSCI is proceeding with adding an ESG factor to its European risk model. The research suggests that sustainability-minded companies experience correlation with other factors, among them higher profitability, lower volatility, value, and size, but they have no unique commonality. Despite what the data is able to show at this time, MSCI does not consider this move to be premature. As co-panelist Lisa Goldberg, PhD, Director of Research at Aperio Group and Co-Director of the Consortium for Data Analytics in Risk (CDAR) at the University of California, Berkeley, noted, evaluating climate change risk is both an art and a science. Before a security can be priced, investors need to understand if an aspect of risk is undiversifiable. What risk models do so well, she noted, is to distill thousands of variables to a small number of manageable factors. In the search for an ESG factor, firms addressing ESG issues must experience significant co-movement that is unexplained by pre-determined risk model factors. While no evidence of an ESG factor has been identified yet, Goldberg sees no problem in risk researchers being proactive. So, the audience asked, can we choose our factors? Goldberg responded that, at this time, investors don’t have access to customizable risk models. What they do have control over is selecting which ESG levers to press, even if those move an investor completely outside of a standard risk model. In the final session of the day, What Markets Can Learn from Modeling Value at Risk from Climate Change, Laline Carvalho, Director of the Financial Services Ratings Group at S&P, and Robert Kopp, Director of the Institute of Earth, Ocean, and Atmospheric Sciences and Professor of Earth and Planetary Science at Rutgers University, discussed the economic costs of climate change. Humans don’t seem to have the capacity to think beyond short time frames, and the climate problem is intrinsically long term, said Carvalho. Furthermore, weather risk, which too many seem to believe encompasses climate change, is only one component. Horizon risk is a huge variable, and emerging risks from natural forces must be considered in how the climate, public policy, and the sociopolitical environment shift in response. The Paris Agreement’s primary goal is to keep “global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius.”[v] Business as usual, Kopp said, means we’re looking at a 6 degree Celsius increase. We are not at all close to the necessary adaptability, he said, and the economic costs of our unpreparedness will be severe. According to Kopp et al.’s study Estimating economic damage from climate change in the United States, “The combined value of market and nonmarket damage across analyzed sectors—agriculture, crime, coastal storms, energy, human mortality, and labor—increases quadratically in global mean temperature, costing roughly 1.2% of gross domestic product per +1°C on average.”[vi] Opportunities within specific sectors and broad ESG alpha “Sears is a stranded asset. That is not ‘ESG’; that is just reality. But climate change is a reality too.” —Timothy Dunn   Terra Alpha Investments (“TAI”) takes what Timothy Dunn, CFA, Founder, Managing Member, and CIO, referred to as a “quantamental” approach to investing. TAI only considers companies that disclose on ESG performance (energy use, water use, and waste), on the premise that these companies have better operational efficiencies and understand that returns are enhanced by addressing climate change challenges. For TAI, there is no distinction between an ESG and a fundamental factor. The long-standing efficiency of a company can be determined only with these two perspectives operating in synchrony. Kate Starr, CFA, Chief Investment Officer of Flat World Partners, turned the conversation to private equity and alpha in her panel, Impact Investing: Climate Change Solutions. Sasha Brown, Principal at the Ecosystem Integrity Fund, and Bill Hallisey, Founding Partner of NewWorld Capital Group, see sustainable investing not as a moral issue but as an economic one. The double or triple bottom line is a fallacy. There is one bottom line and sustainability is a critical component. They noted how the market has already seen environmental products become commodities—e.g., LED lighting—so investors are aware that the opportunities exist, even if they don’t have the expertise to identify them. Even so, an emerging ecosystem of investors is providing value and capital through the entire capital chain. Brown and Hallisey advised others that this is not a speculative practice. The companies seeing success are operating in existing markets and addressing problems that exist today.

Summary

Asset managers not considering climate change risk and/or other ESG factors are simply not part of the conversation and risk marginalization in the burgeoning shift of our financial system. To determine which companies are actually doing better than people think, Brown, Hallisey, and Dunn are among those using information that others, as Dunn noted, are ignoring. Among other risk-concerned investors, Wong is looking at the past three years of performance and appearing optimistic. But Wong is cautious to draw conclusions, considering Mellon Capital’s approach as a case study of striving for benchmark performance while incorporating ESG at best. At the very least, asset owners are becoming picky about whom they will work with and who holds their assets. So, it may be prudent for managers to understand ESG is a factor after all. ____ Overall, the event was a rousing success. Organizers Andrea Dalton, CFA, of Revelio and Kenneth Lassner, CFA, of Aperio Group have much to be proud of: they found the room packed, the audience highly engaged, and the speakers enthusiastic about the subject matter.

Summarized by Shauny Ullman, SRI/ESG Investment Associate at Aperio Group

 

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[1] www.calpers.ca.gov [ii] calpensions.com/2017/08/21/trumps-out-but-calpers-steps-up-on-climate [iii] www.swissre.com/global_partnerships/Swiss_Re_and_partners_to_develop_resilience_bonds.html [iv] earthobservatory.nasa.gov/Features/RisingCost/rising_cost5.php [v] unfccc.int/paris_agreement/items/9485.php [vi] science.sciencemag.org/content/sci/356/6345/1362.full.pdf