Portfolio managers are facing an entirely new type of variable to consider when choosing securities. Stock and bond investors cannot afford to ignore climate change, which will affect economies, industries and companies in different ways. We asked two AB portfolio managers and two experts, from Columbia University and Willis Towers Watson, to provide their perspectives on what it will take for asset managers to effectively address climate change in their investment processes.
1. How should investors apply climate change findings to assess specific physical or transition risks to companies?
Satyajit Bose, Associate Professor of Practice; Associate Director, Program in Sustainability Management, Columbia University: There are a variety of climate change findings for different geographical locations, at different time horizons and with different confidence intervals, that affect a range of industries. The active investor’s critical work is to parse through diverse and distributed information, sift continuously to determine materiality and make the best possible capital allocation choices for people, planet and profit. This requires understanding which issuers are likely to be hurt by floods or by drought. It requires understanding the policy response: which issuers are most at risk from carbon pricing and which will benefit from designing and scaling the solutions.
The best way for investors to fulfill their responsibility to allocate capital efficiently is to study, model, analyze and integrate all the new, mostly publicly funded and publicly available information on climate risks and opportunities that they have not previously incorporated in security selection and portfolio construction. Active investors are experts at combining financial information, estimates of uncertainty and good judgment to make optimal decisions. There is no reason why they cannot do the same with climate information.
Tim Hodgson, Co-Head of the Thinking Ahead Group, an independent research team at Willis Towers Watson: We typically invoke the notion of beliefs as the foundation to any investment decision. Do you believe that climate change is a hoax, but you are competing in an ecosystem where a growing proportion of other players believe it is real? If yes, you will apply climate change findings in a very different way to someone who believes climate change is real. If you believe climate change is real, do you believe that the requirements of fiduciary duty constrain your ability to take it into account? Asset owners that are self-confident have no problem with the way that fiduciary duty (or its local equivalent) is written—they see climate change, and other ESG matters, as directly affecting financial returns and risks and so must be directly managed. Non-self-confident asset owners would like safe-harbor protection.
In my view, every sector of the economy will be affected and needs to transition. This suggests the next 10 years could be very favorable for those undertaking long-horizon fundamental research. Could the world’s largest company in 2050 be in the carbon capture and storage business?
Shawn Keegan, Portfolio Manager—Sustainable Credit, AllianceBernstein (AB): For fixed-income investors, assessing the physical and transition risks to companies is manifested in the company’s current and forward credit rating. Investors must assess whether addressing climate risks now can improve future credit ratings or whether the company has the financial strength to make the necessary transition without negatively affecting its credit rating. The credit rating directly drives the cost of debt within a company’s capital structure.
2. Beyond the first-level impacts of climate change, what types of lesser-known second- or third-level impacts should be incorporated into investment research?
Michelle Dunstan, Global Head—Responsible Investing, AllianceBernstein (AB): Investors must think broadly and with a longer-term view about the cascade of potential impacts. For instance, take carbon taxes. The first-level impact on an industrial company with significant carbon emissions is some form of taxation, which our analysts would incorporate in that company’s cash flows, lowering its returns and value. But what if carbon isn’t taxed in that company’s jurisdiction? Might it be taxed in the future? If not, will new regulations force the company to commit capital expenditures to install scrubbers or other remediation solutions? Might that company’s customers or employees make different decisions—choosing a lower-carbon-intensive competitor’s products or eschewing that company as a potential employer, depriving it of top talent? Our analysts and portfolio managers have already seen these outcomes for some companies they cover. Extending this analysis to other companies highlights winners and losers; for example, manufacturers of scrubbers and emissions technology could benefit, as could direct substitutes or competitors with a lower-carbon footprint.
Shawn Keegan: Company transitions get most of the attention when it comes to climate change. Investors tend to focus less on the potential for climate change to affect future GDP growth if it’s not confronted by governments. For fixed-income investors, who incorporate broader macroeconomic indicators in research, this is important. If climate change isn’t addressed, we need to know what it might do to a country’s growth rate and understand the secondary effects to companies that either produce or sell into countries that may be negatively affected. We also need to understand how climate change might affect a company or country’s credit rating. If climate change isn’t being addressed, it could lead to slower growth, putting pressure on credit ratings and raising future debt costs.
Satyajit Bose: Humans tend to respond and adapt to persistent shocks. Climate change and the potential breaching of planetary boundaries have already sensitized a new generation of consumers, employees and investors to the adverse impacts of many kinds of corporate activity, including carbon emissions, planned obsolescence, plastic pollution, ocean acidification, global freshwater overuse, endocrine disrupters and phosphorus runoff. Methods of value extraction will be scrutinized, and a premium will be placed on clean alternatives. Extreme weather events will induce greater decentralization in supply chains. These second- and third-level impacts create opportunity for companies working on solutions. Examples include the rapid uptake of mobile banking and payment solutions after natural disasters for the billions without access to standard financial services, or Internet of Things sensor systems designed to certify that high-value pharmaceuticals stay within temperature and humidity tolerances throughout their journey from manufacturer to end-consumer.
Tim Hodgson: The recent decision by the UK’s high court that the Airports National Policy Statement, which allowed Heathrow’s third runway, was unlawful, highlights a first-order impact— that air travel is a growth business that is incompatible with limiting global warming. However, the decision also flags the risk of second-order impacts. Since we know putting greenhouse gases into the atmosphere raises global temperatures—and the directors of fossil fuel companies know this too—companies that still sell fossil fuels for burning face the possibility of litigation for damages.
On the positive side, the transition to a zero-carbon economy will yield a zillion opportunities across every sector. And our current thinking ahead would suggest dematerialization as a major unifying theme (e.g. renting rather than owning; growth of circular economy).
3. How should climate data from companies and expectations and challenges for data in the future be assessed in research, particularly given the uncertainty of climate change forecasts and the wide range of potential outcomes?
Tim Hodgson: I would like to challenge this question. The predictions of climate scientists over the last 30 or 40 years have been astonishingly accurate. The only inaccuracy was the time frame—everything they predicted has happened, only more quickly than predicted. We know the current rate at which we are putting greenhouse gases into the atmosphere, and we know we have to get this down to zero as soon as possible. That looks pretty certain. And it gives a very clear direction for action. So, we could choose to simplify the data problem down to the emission of greenhouse gases.
If we collectively choose to maintain positive emissions, then I agree that a wide range of potential outcomes becomes possible. But once we get beyond +1.5C of warming, the risks of triggering climate tipping points—and therefore setting off runaway temperature rises—start to grow in a nonlinear fashion. In that situation, investment research will not be one of humanity’s most called upon skills.
Satyajit Bose: No asset manager worth her salt ever complains about the uncertainty of long-term earnings forecasts and the wide range of potential future valuation multiples. It’s part of the daily practice of an active asset manager to embrace uncertainty and look for mispricing before initiating a position, and also to monitor the evolution of uncertainty and the dispersion of information in the marketplace to anticipate paradigm shifts in pricing. Climate data from companies is just one source of information—necessary, but not sufficient—similar to earnings forecasts. The best way for analysts and portfolio managers to integrate climate risks and opportunities is to strive continuously to understand the science of the physical processes of climate change, to use their understanding of political risk and social systems to anticipate policy responses, to ask how underlying cash flows will be affected, how the natural and human capital which forms the foundation of those cash flows will be affected, and how the market’s perception of value will change.
Michelle Dunstan: While the range of climate change outcomes is wide, it is not infinite. Research is based on both modern science (e.g., how much water is contained in the Greenland and Antarctic ice sheets and how would a two-degree temperature rise impact sea levels) and analyzing historical periods—paleoclimatology (e.g., where was the sea level the last time the Earth’s temperature was two degrees warmer). These scenarios and boundaries help us analyze a company’s resilience to a range of impacts. For instance, if a company’s cash flows were basically unaffected by a severe climate change scenario, our analysts can have a high degree of confidence in that investment under any potential climate change outcome. However, if a company suffers severe cash flow degradation in all but the most minimal of climate change impact scenarios, we’d be very cautious about adding that stock to a portfolio. This can allow a portfolio manager to diversify climate change benefits and risks across a portfolio, just as they would for any other factor with an uncertain outcome.
Shawn Keegan: Even as companies provide more climate-related data out to investors, there are still many challenges to using this data within an investment process. The depth and consistency of the data varies. Not all companies are putting out climate-specific data, so it’s often hard to draw comparisons across an industry or companies. Specific data points and formats are provided by companies without any set of standards for investors to use within their investment process.
As a result, we think investors must first have their own climate change forecasts. Then, assumptions used by companies can be assessed in the same way as typical financial data released by companies is evaluated.
4. What characteristics of companies or organizations signal a forward-thinking approach to climate change versus companies that are not adequately addressing the issues?
Michelle Dunstan: Many companies are quite forward thinking, while others are in denial. Forward-thinking companies typically have a clear and substantive disclosure on both the potential impacts and their plans of action. They address it fully in annual reports, company presentations and sustainability reports. Executives and board members are willing and able to answer detailed questions on climate change. The most advanced typically have detailed climate change scenario analyses and a long-term plan for dealing with a two-degree scenario and other potential outcomes.
Satyajit Bose: Three attributes of a corporate culture signal an ability as well as a willingness to thrive on the dramatic change that will be driven by climate impacts. Firstly, a diverse mindset that eschews analytical monocultures indicates the company has the internal ability to adapt. Having observed the culture of companies like Enron and Tyco in my past as an investment manager, I am always wary of a company that places the single-minded pursuit of profit upon a pedestal. Secondly, a commitment to rigor and the patience to investigate and articulate complexity and nuance. As an investor with limited information, if I am not acquiring new insights when I listen to management’s articulation of their climate strategy, then they probably haven’t thought too carefully about it. Thirdly, I look for a willingness to invest in people and skills. Human capital today is far more scarce than financial capital—low interest rates and the high cost of education are an indication of that. A corporate culture that places its faith on automated processes, passive choices, human cogs and centralized authority, where the combined chairman & CEO is constantly making grand pronouncements that aren’t reflected in reality, is an indicator of desperate greenwashing.
Tim Hodgson: In the Thinking Ahead Institute, we are passionate believers in the importance of organizational culture. Culture will determine whether the organization delivers anything meaningful relative to the well-meaning words of leaders. Incentives are one component of our culture model and are essential to get right if trying to reposition an organization to be truly forward-thinking.
Shawn Keegan: Actions are more important than words. We look for things like compensation tied to specific climate targets or financial incentives within a company’s capital structure. A few companies around the world have started to add a sustainability or climate target to a portion of their executive’s overall compensation. This will align the company and executives with directly addressing climate change within their organization.
Within fixed-income markets, we recently saw the first issuance of a key performance indicator (KPI) bond from Italian energy group Enel, which carries a cost penalty if it fails to meet renewable targets. Under the bond’s terms, if Enel’s renewable generation doesn’t reach 55% of overall generation by 2021, the coupon will increase by 25 basis points. This type of KPI structure aligns companies and investors.
5. Can you provide tangible examples of investing decisions that were affected by including climate change implications in your analysis and decision-making process?
Shawn Keegan: In the utilities industry, we’ve reviewed the generation capabilities and the fuels used to produce electricity. We’re investing in companies that have tangibly reduced generation from coal but also have transferred generation to renewables. Our analysis aims to assess the future direction of a company’s generation with tangible goals to further reduce brown energy.
DTE Energy, a US utility, issued a five-year bond in 2019 that was priced cheaply versus BBB credit, but at the time, more than 50% of its generation was concentrated in coal. The market wasn’t pricing in the overall climate risk and potential stranded assets, in our view, and we decided not to invest.
In the auto industry, the internal combustion engine is a leading producer of greenhouse gases. The mass production and affordability of electric vehicles (EVs) is a key for consumer transition. All major global auto companies have laid out plans to shift more production to EVs over the coming years. We’re focusing on companies that are actively shifting capex toward achievable targets in this market shift. Engagement with auto companies on progress towards targets will guide the long-term success of these investments.
Michelle Dunstan: We’ve invested in refiners that stand to benefit from the 2020 IMO (International Marine Organization) rules imposing tougher sulfur oxide emission restrictions on shipping companies. Our analysis focused on how the new rules would be implemented and the impact on fuel prices. Our conclusion was that there wouldn’t be enough low-sulfur fuel to meet higher demand. Our energy team then conducted a complex analysis on the global refining network to determine the cost structure of flexing refineries and using higher-cost refineries to generate sufficient quantities of diesel, along with the impact on relative demand for low-sulfur versus high-sulfur crude feedstocks. As a result, we concluded that the few refiners that were able to use high-sulfur crude oil and transform it into low-sulfur products, such as diesel or jet fuel, would be highly advantaged and represent attractive investment opportunities. Of course, we will revisit the thesis as the impact of the coronavirus and oil-price volatility on economic growth and demand unfolds.
The long-term consumer shift toward EVs is also creating opportunities. But rather than looking only at EV manufacturers such as Tesla that are well known and quite expensive, we have scoured the suppliers that enable its technology, which are underappreciated and represent better investment opportunities, in our view. We have found attractive investments in battery manufacturers and battery materials companies that produce copper, lithium and graphite.