Risk Management

The fact that climate change risks are mostly long term, and carbon regulation seemingly far off in the distance, has the effect that these risks generally aren’t being adequately considered and planned for now. Ask any Chief Investment Officer what his considerations are in evaluating investments and they will most probably say “risk and return”. It is a simple relationship that most people understand – in fact anyone who has been to the horse races or had a bet understands the essence of this relationship – that a higher reward often comes at the cost of a higher level of risk.

The slow, and sometimes stumbling, nature of the regulatory environment surrounding climate change means that carbon-related liabilities and risks are entering investment portfolios at a gentle, some would say funereal, pace.

The fact that climate change risks are mostly long term, and carbon regulation seemingly far off in the distance, has the effect that these risks generally aren’t being adequately considered and planned for now.

Despite there currently being no global greenhouse gas emissions agreement in place, there is a promise of one to emerge in 2015, which is likely to at least try to meet a 2 degree limit in forecast temperature increases. Surely this should have asset owners and there fund managers on high alert.

The issue with emissions is that they are nearly all produced by very long term, capital intensive assets such as power stations, mines, smelters, etc. These assets typically have a useful life of over 25 years or even 40. If anything goes wrong late in the life of an asset, such as a rapidly increasing carbon price, then the value of that asset, and the returns for investors, are significantly impacted or may disappear altogether.

According to the International Energy Agency, carbon emissions will be priced above $110/tonne by 2030. Many of the heavy-emitting, capital intensive assets are likely to be stranded well before that level is reached. The trouble is that they will all be stranded at the same time.

This reveals the true risk of the problem when it comes to climate change – at an asset level the risks require regulatory intervention (such as carbon prices) to be revealed and so focus often goes to the short term impact on share prices, but their nature is so widespread and so laden with sudden impact risk that they are systemic. Therefore, there will be very few safe havens. As such, three of the four traditional risk management tools – avoidance, insurance and diversity are unavailable at a portfolio level, leaving hedging as the only viable option. The risk posed to the value of emissions intensive investments by carbon regulation will only be managed effectively through hedging investments in low-carbon and other climate change-related mitigation and adaptation investments such as renewable energy, energy efficiency, water and waste management.

To react to this problem there is, amongst some leading asset owners, a change in the way that systemic risk is perceived and managed. At an asset allocation level, as the Mercer SAA report alludes to, hedging via increased low carbon investment can occur leaving the job of seeking high carbon returns with perceived low risk in other parts of the portfolio unfettered.

Of course the regulation that creates the risks is tied to the politics and in one or two key countries the politics is somehow tied to the science. The fact that a contrarian scientists or a political figure can manage to throw doubt on the weight of conclusions by every credible scientific institution or journal is a clue to the complexity. To be contrarian, go against the massive majority is good for debates but it has no place in the serious business of retirement savings risk management

The only issue of course is risk. As an asset owner, once you decide that the likes of NASA, MIT, Cambridge University at al qualify as prudent organisations, then climate risk is largely a question of how to assess the pace and intention of the world’s governments as they either ignore their prudent advice or slow down commitments already made at Copenhagen and other subsequent agreements.

But how do we price this political intransigence? The issue is one of base case versus sensitivity analysis. The funds management market are attracted to the historically stable returns of the fossil fuel economy and so any doubt as to its future is often parked in the sensitivity analysis. The analysts would argue that there is some doubt as to whether US Congress will ever combine forces with Europeans and the Chinese to create the necessary rapid action that would land many assets in trouble but they would consider this a “what if”. The asset owners of course don’t have that luxury. They need a base case – they need an expected value that they can apply to their entire portfolio. Therein lies the challenge of climate risk management.

The fact that pension funds face a great challenge in climate change is not news. If the physical ramifications of dangerous climate change ever materialises, it is difficult to see any pension fund, or economy for that matter, with a growth story. Change, such as wars or economic reorganisation, can stimulate but not for long. Fundamentally, increases in productivity and new opportunities fuel growth and in a world of natural resource depletion, extreme weather events and population explosion it is difficult to see the emerging markets propping up the growth story of first world pension funds once their march from poverty to middle class is brought to a halt by climate change.

Pension funds and other asset owners whose portfolios were dented in the sub-prime crisis might consider whether or not the trend of one in 100 year events, both physical and financial, is not a trend worth hedging against in order to even partially protect one’s portfolios. To do so though would mean leadership, breaking away from the herd to some degree and challenging the status quo. To not hedge is to trust, nay gamble, on the market correction of climate change being smooth enough and gradual enough to allow them to trade out profitably.

When you consider that the markets of fossil fuel extraction, stationary energy, transportation, mining, manufacturing, agriculture and the servicing and financing of those industries make up a good chunk (perhaps 50-60%) of a portfolio, added to the fact that the 2 degree carbon budget runs out in 2024, then you need to be a unfettered optimist to see a circumstance where this won’t at some stage cause major issues for portfolio managers. Add this to the Chinese strategy to leapfrog the US economy via a clean energy war and leaving your portfolio unprotected in some way is starting to look like a serious breach of fiduciary duty.

Consider how fragile the decision to ignore climate hedging options really is. The decision not to hedge is based on a perception that the low carbon economy is stalling, physical impacts or changing political landscapes won’t drive a global agreement in the lifetime of their investments or that other asset owners don’t follow the advice of the leading asset consultant Mercer and adopt such a strategy. This sounds like a risky proposition.

When considering the carbon regulation and its likelihood, fund managers facing uncertainty seemingly focus on return because in the short term getting some early return helps to bank the returns before the problems arise. Thus their investment banking arms invest into more and more fossil fuel investments (such as Glencore) because as far as we can see they are profitable in the short term. The only problem with this approach is that it seems so unlikely that people and their leaders will calmly watch the planet warm to dangerous levels – in fact the acid rain and CFC agreements of the 1970’s and 1980’s indicate a good track record in attacking major issues – and this seems to be absent in much risk management thinking.

Many successful entrepreneurs don’t have these problems and indeed are not incentivised to act in this way. Entrepreneurs are so certain of their long term returns that they perceive risk and return very differently from fund managers who are more constrained. Entrepreneurs ask “what is the risk that NASA, Cambridge University, The American Academy of Sciences et al are all wrong?”. They then invest their time and money and sit and wait for the change and the higher returns.

Indeed, some asset owners are already starting to see the risks in remaining heavily invested in high carbon assets and are chasing the opportunities that the entrepreneurs and innovators have seen for some time.

We are not talking about an overnight reallocation of huge proportions in a short space of time – but set against the very low, exposure most portfolios have to low carbon assets and the imbalance is alarming. Suddenly it is the entrepreneur, sitting on the long side, who looks like the risk manager. The leading asset owners have embraced this thinking and are now finding that an entrepreneurial streak is actually a core part of their risk management approach.

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