Investors can’t kick the can down the road any more when it comes to addressing the impact of climate change in their portfolios.
After years of deliberation by regulators, researchers and corporate executives about how climate change should be addressed by the financial industry, 2018 saw major steps on multiple fronts in converting that talk into action.
Led by Europe, countries around the world began developing legislative frameworks based on those countries’ commitments to the 2015 Paris Agreement on climate change. Meanwhile, regulators and companies alike have started to act on the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosure (TCFD).
But it’s not just regulation that’s moving the needle. Extreme weather events worldwide are showing why action is needed now. In Australia, for example, a prolonged drought caused by changing climate patterns could cut the country’s gross domestic product by a full percentage point over two years, according to an article in the October 2018 edition of Company Director Magazine, published by the Australian Institute of Company Directors.
As a result, the question no longer facing investors is when will they need to take steps to limit the impact of climate change on their portfolio—but how to do it now. At State Street, we’ve been studying this question for years to gain a deep understanding of the science of climate change as well as the rapidly evolving regulatory landscape. Based on this knowledge, we’re partnering with our clients to help them actively address climate risk in their portfolios by being an active steward of their assets, providing a vast array of climate-related data and creating climate-focused investment strategies.
Europe’s Evolving Regulatory Landscape
Regulators around the world took significant steps in 2018 toward converting goals for reducing carbon emissions into concrete regulations that have real teeth, and it’s not surprising that the European Commission (EC) led the charge.
The EC has committed to three climate and energy targets by 2030 as part of the Paris Agreement—40% reduction in greenhouse emissions from 1990 levels, 27% share of energy coming from renewable sources and 30% improvement in overall energy efficiency. European policymakers, at the European Union level as well as in individual countries, are now actively embedding these ambitious goals into regulatory frameworks.
Those current requirements will be supplemented by the European Commission Action Plan on Sustainable Finance, which includes a host of proposed legislation that will codify how asset owners, asset managers and other market participants should incorporate climate risks and other ESG considerations into investment decision-making. Final rules on those requirements are expected in April 2019. These regulatory and legislative initiatives are being supplemented by efforts by governments and investors to comply with the TCFD’s voluntary guidelines for assessing, responding to and disclosing climate risks in investment portfolios.
Aligning Portfolios and Climate Objectives
Current and future regulations on climate-risk incorporation are putting a growing amount of responsibility on the plates of investors. So how can investors align their portfolios with their objectives—both in terms of overall investment returns and climate change?
As climate science and data availability improve, the range of options that investors have to express their climate commitment is expanding. Still, there are essentially three main approaches to incorporating climate risk, all of which incorporate elements of the broader concept of asset stewardship.
The three approaches that investors are using to target carbon reduction are:
- Screening: not investing in companies that are heavily dependent on carbon emissions or fossil fuel use, or avoiding industries with significant climate-related risk exposure
- Mitigation: reducing the portfolio’s exposure to carbon intensity, fossil fuel assets and “brown" revenue derived from extraction or power generation from fossil fuels, as well as increasing exposure to companies that generate “green” revenue from low-carbon opportunities
- Mitigation and adaptation: in addition to reducing exposure to worse-than-average carbon emitters and “brown” revenue and increasing exposure to “green” revenue, tilting the portfolio toward more environmentally resilient companies and ones that are adapting their long-term strategies to account for their exposure to climate risk
Of these three approaches, combining mitigation with adaptation is the newest frontier in climate investing. In the past, many investors focused on mitigation alone. But as extreme weather events become more frequent and the economic ramifications of climate change are more widely understood and accepted, investors are looking for more information from companies about how they are adapting their business strategies to accommodate the impact of climate change.
State Street’s Approach to Climate Investing
Any action taken to address and disclose climate risk involves the broader concept of asset stewardship—actively engaging with portfolio companies on climate risks and opportunities. As the world’s third-largest asset manager, State Street is committed to partnering with our clients to help them align their portfolios with all of their investment objectives and regulatory requirements. That’s why we have made stewardship related to ESG issues a cornerstone of our approach to asset management.
Specifically, we use our influence—our voice and voting power—to encourage corporate boards and management teams to proactively address climate-based issues that could harm or improve long-term performance. We also study how climate change affects specific investment sectors, such as an upcoming paper examining the impact of climate disclosure on agriculture and forestry.
In addition to influencing how our portfolio companies think about climate risk, we also are working to make sure that our clients have the data they need to make good decisions and prove that they are complying with the new regulatory requirements. We have built an extensive ESG and climate data platform that brings together carbon and environmental metrics from multiple data providers as well as information about company-reported greenhouse gas emissions, “green” and “brown” revenues, and company adaptation to climate change.
This data supports State Street’s extensive research in equity and fixed income portfolio construction—whether actively or passively managed—that can be applied to screening, mitigation and adaptation. Our approaches are backed by science-based targets established by the Intergovernmental Panel on Climate Change to limit increases in global temperatures to fewer than 2 degrees Celsius above pre-industrial levels.
Climate-specific reporting is another important element of our investment capabilities. State Street provides climate reporting to measure performance against investment and climate-focused benchmarks. Such reporting allows clients to more easily meet obligations to regulators as well as beneficiaries, trustees and other stakeholders. We are developing portfolio-level analytics to help clients better understand how the transition to a low-carbon economy affects their portfolio.
At a higher level, investors need to understand that the financial industry is transitioning from a period when there was a lot of talk about how to address climate change to a time when investors and regulators are converting that talk into action. As investors around the world continue on this journey of understanding and responding to climate change, State Street is committed to helping them align their portfolios with the evolving science, regulatory landscape and investment risks and opportunities related to climate change.