Waking up to reality: the race to put numbers on climate risk
Sustainability is a term used liberally and vaguely in the financial world. But it has a precise meaning: living so that we do not make it harder for future generations to live. That principle is violated by today’s economy, including its financial markets. But little by little, the heart of markets — the decisions investors make — is facing up to what it has long repressed. Jon Hay reports.
Climate change is no longer a fringe issue in financial markets. It’s orthodox. If you deny it, or think the Paris Agreement is unnecessary, you’re likely to be considered a dinosaur. We all agree: the future’s green, right?
Yet the S&P Global Oil Index of 116 companies is worth $2.7tr. There’s an awful lot of savers’ money locked up in those shares, and they still trade at 19 times forward earnings.
Next year, Saudi Aramco is expected to float, for perhaps $100bn. It is one of the lowest cost oil producers, so perhaps it is a good bet — it may end up being the last oil company left standing. But is there much noise in the financial world about whether investors ought to be ploughing more money into getting carbon into the atmosphere?
An analysis by Carbon Tracker and Energy Transition Advisors, using the fairly cautious assumptions of the International Energy Agency about how much carbon can be emitted to give a 50% chance of avoiding warming more than 2C, found that the energy sector can afford to emit about another 450 gigatonnes of CO2 by 2035.
To hit that, about 41% of capital expenditure expected by 2025 needs to be avoided in gas, and 24% in oil. No new coal mines ought to be dug. That’s a total of $2.3tr of dangerous capex in the next eight years.
But neither governments nor the market are currently signalling that to the fossil fuel industry. Financial institutions are enduring an episode of schizophrenia — believing in climate change, but behaving as if it was not real.
Occasionally, they have a flash of sanity, as in May, when 62% of ExxonMobil’s shareholders backed an AGM motion, opposed by the board, that it should report on how its business model will be affected by efforts to keep warming to 2C.
“The ExxonMobil case really showed mainstream investors are much more interested in climate change than even a year ago,” says Hans Biemans, head of sustainable markets at ING in Amsterdam.
But overall, while few in finance dispute the direction of travel, hardly anyone has a grasp of the numbers involved: how fast the climate is changing, and what practical steps they will have to take. Treating the climate and environment as externalities — free resources whose cost is borne by no one — is deeply engrained in human culture.
Making it normal
The moral calls have been clear for decades, but have not changed behaviour much. What may finally be bringing climate change on to financial firms’ radars is risk.
For the last three years, Lauren Compere, director of shareholder engagement at Boston Common Asset Management, has been knocking on the doors of big banks around the world, asking them what they are doing. Are they alert to the risk that companies they lend to might be damaged, by either physical climate change, stricter policies or shifts in demand away from high carbon products?
Banks are budging, Compere says. “There are two extremes: action on coal, and commitments to green financing and renewables. What we don’t see is all that stuff in the middle. That’s where banks need to really operationalise and standardise the way they are not only assessing risk, but also promoting their positive role.”
A bunch of press-released initiatives are fine, in other words, but what banks — and investors — need to do is embed an assessment of climate risk into their everyday investment decision-making.
“How are banks supposed to be managing this issue if they are not setting goals to reduce and transition their portfolios?” asks Compere. “We also feel that’s very important on the positive side. Investors want to invest in banks that are actually well positioned for the transition.”
Measure to manage
Banks are starting to do this. “When we are deciding if we can work with a certain client, climate risk is part of our assessment,” says Joop Hessels, head of green bonds at ABN Amro in Amsterdam. “We look at credit risk, project risk and counterparty risk — which includes sustainability risk.”
Usually, however, such checks go on deep inside an organisation. Its shareholders and bondholders have little way of knowing how carefully it is managing its climate risk. That means they cannot tell companies to improve, nor move their capital to better performers.
To address this gap, the G20 Financial Stability Board’s Task Force on Climate Related Financial Disclosures (TCFD) called in July for all issuers, lenders and investors to start reporting on their management of climate risk as part of their main financial statements.
A hundred CEOs, running companies worth a combined $3.5tr, have committed to complying, as have investors managing about $25tr of assets.
“The TCFD is going to be very meaningful,” says Stephanie Sfakianos, head of sustainable capital markets at BNP Paribas in London. “Although there is some disappointment that it isn’t mandatory, as a board member of a company you are supposed to be managing the known risks to your business. If the risks are now so well publicised, it’s going to be a lot harder to say you didn’t know about them, whether or not that reporting is mandatory.”
Sticks being waved
History suggests that a regulatory push can do wonders, and such nudges are starting to happen.
Article 173 of France’s Energy Transition Law of 2015 requires asset owners — and hence, asset managers that work for them and the underlying companies — to disclose their carbon footprints and how they are aligning portfolios with the 2C global warming goal.
“It creates competition between asset managers to have a clean portfolio,” says Marcus Pratsch, head of sustainability research at DZ Bank in Frankfurt. So far, he admits, “Investors are not coming to us asking ‘how do I protect myself?’ No one is really thinking about worst case scenarios. There is a positive thinking in the market.”
Even green bond investors, Pratsch says, are becoming more careful about the overall sustainability performance of the issuers they invest in.
Allianz Global Investors has been producing about 260 fund-specific reports for its French institutional clients to help them prepare their annual Article 173 reports. “There was no hard, defined format from the regulator in France, though there is guidance from the French asset management association,” says Steffen Hoerter, global head of ESG at AllianzGI in Frankfurt. “You have a lot of discretion about how you show the level of ESG integration, the carbon footprint, the share of companies that provide products in the green economy — and then assess the transition risk of companies in the portfolio. We have worked out a way to do it, using MSCI information for the most part.”
AllianzGI's experts have worked out ESG portfolio metrics and statistics that make sense for the new requirements, and they also explain how to read the reports.
The TCFD, similarly, is more a set of principles than a detailed handbook for climate reporting. The banks involved have formed a working group on how to do their reports, which should include scenario plans, such as what happens if the climate warms by 2C.
“The big accountants need to finally come up with some more pronounced environmental accounting models,” says Biemans. “They have been developing this for the past 40 years but somehow it has never come to the surface. There are various accounting models that include externalities, but how can it become mainstream?”
The Sustainability Accounting Standards Board, based in San Francisco, is one impressive attempt to do that. Its Standards Board was formed this year and early in 2018 sector advisory groups will be formed to help with implementation.
“They have done a really good job,” says Rob Fernandez, director of ESG research at Breckinridge Capital Advisors in Boston. “The fact that you’re starting to see certain companies report using SASB standards is interesting, given that they’re still provisional. We do believe standardised reporting will help ESG analysis overall.”
Plenty of upside
Two other official constituencies are starting — very gently — to prod the financial sector to face climate change squarely.
One is the European Commission. Its High Level Expert Group on Sustainable Finance, formed in December 2016, is its first full recognition of the need to green finance — a central promise of the Paris Agreement.
So far, the signs are promising. “It seems from the HLEG’s preliminary report that they are going to be taking on board the TCFD’s report and recommendations,” says Mark Lewis, a member of the TCFD and head of European utilities equity research at Barclays in Paris. “It would be up to the Commission to consider whether to propose changes that would entail mandatory reporting.”
Politicians and market participants are cautious, lest European companies be disadvantaged by higher reporting costs. But Lewis says: “Given the sheer momentum in institutional investor engagement, there’s an argument that you are going to be at a disadvantage if you are not being transparent.”
The need to be seen to be doing good goes beyond investor relations, and beyond the climate. “It’s also the broad global support for the Sustainable Development Goals,” says Olaf Brugman, head of sustainable markets at Rabobank. “If you are a professional, multinational company, if you want to be a leader, and want your operations to be legitimate, you will have to position yourself relative to those movements and show what you are doing that has a positive contribution.”
Central banks wake up
The second official power centre has few qualms about adding to the compliance burden it imposes — and that is central banks.
Simon Zadek has been centrally involved in the effort to draw their attention to climate change over the past three and a half years, as co-director of the UN Environment Programme’s Inquiry into the Design of a Sustainable Financial System.
“In February 2014 there wasn’t a major central bank that would have tolerated a conversation about environment and climate, as if it was something to do with them,” says Zadek. “Now, there’s not a major central bank governor that would dare to stand up in public and say ‘this is nothing to do with us’. This is a community that has never been part of the sustainable development conversation, and now they are. That’s got to be worth something.”
Action that changes banks’ risk exposure is happening very gradually, but central banks, such as those in China, the Netherlands and the UK, have established the principle that climate change is a legitimate area of their concern, because it could impair financial stability.
Once companies, banks and institutions can no longer avoid thinking seriously about climate change, they may do it rather well.
“Billion dollar companies absolutely understand how to build capabilities around risk,” argues Zadek. “Yes, climate risk is complicated, but the reality is they will work out the metrics.”
A deeper problem will remain to be solved, however. Even if all actors are clear-sighted about the risks facing them, and take the right steps to protect themselves by internalising value and externalising costs, that may not be enough to save the climate.
“Most often the solution to a collective action problem is to bring in the state,” says Zadek. “Large scale externalities are where the real innovations in risk assessment and management will happen.”