‘Let 100 flowers bloom’: an investor’s guide to climate risk
While the COP21 climate negotiations took place in Paris, we explored climate action from the investor’s point of view with Mats Andersson, CEO of AP4, the Fourth Swedish National Pension Fund.
There is a 1.6% chance* that temperatures will rise to 6°C above pre-industrial temperatures, with catastrophic consequences.
That may not sound like much – just 1.6%. But to an investor, that much exposure to disaster should make you think very hard. Think of it this way – if there was a 1.6% chance that a plane would crash on any given flight, you’d expect 1,300 crashes every day. Would you get on a plane with those odds?
We’ve taken risks with the climate that we’d never take with other things – and risk matters to investors. Climate risk has been underpriced generally, and carbon intensity in particular is not priced into valuations. Decarbonisation has the potential to safeguard portfolios against significant downside risk. Crucially, a decarbonised portfolio can also perform – there is no conflict between sustainability and returns.
I believe that this fact is being increasingly recognised. In fact, I have never seen so much momentum for action.
“No way back from here”
When we began the Portfolio Decarbonization Coalition (PDC), we aimed to reduce the carbon intensity of $100 billion of institutional investors’ investments before Paris.
Many people said we would never do it.
But by the end of November we had passed $230 billion of assets under management.
To me, what is even more exciting is that this represents underlying assets of $2.2 trillion. There is real momentum there – and as the awareness grows among investors that carbon emissions are a real risk, the trend will continue. In fact I think there’s no way back from here – we are on the right route and I am optimistic that we will stay on it. No one who is investing in sustainable businesses is going to regret what they're doing.
Underlying returns at reduced risk
A lot of this momentum has come from the private sector, and there are some really good examples of companies building climate action into their business models – in fact I would say many companies are still ahead of investors. IKEA and Unilever for example, are demonstrating that sustainability can be achieved at the same time as performance.
I think investment strategies should reflect this. For example, at AP4 we have created an index in which we list companies by sector according to their exposure to carbon risk. We eliminate the worst performing third in each sector, and make our investments among the rest. We get the same underlying returns, but we have reduced risk by, we believe, 50-70%.
In the long run, the companies who are missing out on investment because of their exposure to climate risk will start to hurt.
This is not the only possible strategy – in fact I think that there should be multiple approaches, so we can ‘let 100 flowers bloom’. But the important thing is that we are acting, and it is delivering returns. The biggest risk is to take no action at all.
The tragedy of the horizon
A few years ago I sat down with a man I deeply respect – a mentor of mine – who had been extremely successful as an investor and had spent ten years figuring out risk. He asked me: “how do you mitigate the risk of climate change?” And at that time, I didn't have an answer – in fact, amazing as it seems now, no one had it on their agenda.
Well, they do now. When Mark Carney, the Governor of the Bank of England, addressed Lloyd’s of London in September, he made it clear that investors must take the risk of climate change into account. He called the failure of the financial sector to see the scale of the risk the Tragedy of the Horizon and called for greater transparency. In France, there has been a move to making funds declare their exposure to climate risk.
Is it enough? No – there is more to be done. We need to end subsidies for fossil fuels. I would like to see carbon payments, so that people start to pay for what they pollute today, rather than leaving it to future generations, which I believe is immoral. Nonetheless, even more important than what happens in Paris itself is what happens afterwards. And from an investment point of view I believe we have momentum to build on.
* According to the Intergovernmental Panel on Climate Change (IPCC).