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COP26 heralds a new investment rulebook

By Craig Baker , Monique Mathys-Graaff and James Wintle | December 17, 2021

Regardless of whether pension funds and other investors have previously embraced sustainable strategies, COP26 has raised the bar for how such strategies will be judged
Investments|Retirement|Climate
Climate Risk and Resilience

In many ways, COP26 in Glasgow was the business and finance equivalent of the 2015 COP in Paris. If it wasn’t clear before Glasgow, it should be obvious now that pension funds and investors are, together with multiple stakeholders, expected to be key contributors to climate solutions. The announcement by the Glasgow Financial Alliance for Net Zero that $130tn of assets under management are now committed to Net Zero amply demonstrated the movement of capital that is under way.

COP26 points of reference

So, what are the key COP26 outcomes for pension funds and investors?

  • For the first time at a COP, the unilaterally agreed text (the Glasgow Climate Pact) specifically mentioned Net Zero as a target and included interim milestones to meet that target – a 45% reduction in carbon emissions by 2030 relative to a 2010 baseline.
  • There was growing recognition that the 1.5˚C temperature target can be achieved only with investment in net zero emissions technologies, plus natural carbon sequestration.
  • Future regulation will emphasise transparency. For instance, the G7 nations made a commitment prior to COP26 to make TCFD (Taskforce for Climate-related Financial Disclosures) mandatory, joining countries, including the UK, that had already committed to that.
  • Climate finance rose up the agenda as the $100bn target for supporting developing countries had continued to be missed since it was set at Paris in 2015. However, the narrative also changed from transfers of finance to helping countries manage their economies more efficiently, with market and non-market mechanisms and capacity building.
  • The Pact wording, that referred to phasing down coal, rather than phasing out, attracted many headlines. But climate transition will change investment economics nonetheless and provide an upside for investment in renewables. More than 30 countries and financial institutions signed a statement committing to halting all financing for fossil fuel development overseas and diverting the spending to green energy.
  • COP negotiators finally resolved sticking points on carbon markets, setting the stage for the international trading of emissions that will potentially reduce the costs of mitigation. Scrutiny will be essential to ensure that the carbon markets do not jeopardise net global emission reductions.

What should investors read into these?

Fundamentally, the COP26 outcomes strengthened the focus on investment objectives that support a pathway to Net Zero, not just carbon reduction. That said, the discussions that took place around issues such as inequalities and biodiversity also reinforced the broader significance of the 17 United Nations Sustainable Development Goals (SDGs) and sustainability-related factors for the future of pensions funds and other investors’ strategies, portfolios and reporting.

Essentially, ‘greenwashing’ will be harder to disguise and increasingly less tolerated - or not tolerated at all.

COP26 strengthened the focus on investment objectives that support a pathway to Net Zero, not just carbon reduction

That aside, the COP outcomes have strengthened the changing dynamics of the nature of risk in several risk categories linked to climate and sustainability – reputational risk, portfolio risk and the risk of lagging the reallocation of capital that comes from shifting ESG (Environmental, Social and Governance) best practice.

Action areas

Asset owners will need to take these factors on board and convert them to shorter-term areas of focus. Three priorities that we would highlight are:

  1. 01

    Set or reset the sustainable investment integration plan

    Besides building understanding of the challenges associated with net-zero and the SDGs, pension funds and other investors need to give serious thought to the vision and beliefs that underpin climate and sustainability strategies – and from those develop or update an integration plan with specific targets.

    There are the short-, medium- and long-term segments, in which the different aspects of physical climate factors and transition add up to the required trajectory. The chosen climate strategies should be categorised and described – both capital allocation and engagement. And as much as possible, the collaborations and delegations in the plan should be outlined with the necessary resourcing.

    One point of emphasis is that the increased public disclosures of investment plans and policies make much wider scrutiny inevitable. This reinforces the need for particularly clear beliefs and principles given that the justification of investment policies by reference to past performance in climate risk scenarios is not possible.

  2. 02

    Continue to prepare for TCFD

    Talking of disclosure, the arguments for submitting a TCFD report are mounting all the time.

    Aside from the fact that TCFD may well be mandatory in many countries and/or sectors already or in the near future, a real, perhaps under-appreciated, benefit of working through the four pillars of the TCFD reporting framework (Governance; Strategy; Risk management; Metrics and targets) is that it forces organisations to address many of their climate challenges in a structured manner with a defined deadline.

  3. 03

    Build a holistic view of climate risks

    Carbon on its own is not a good explanation of the financial risks pension funds and investors may be running. For example, service companies in a portfolio may be heavily reliant on companies or sectors that are particularly exposed to transition risks. Moreover, indiscriminate decarbonisation is not even good for the economy at large until such time as new technologies or sources of power are available and viable on a large scale.

    Don’t fall into the trap of trying to oversimplify and just decarbonise a portfolio in the short term. In other words, don’t confuse the end goal, e.g. net zero, with the tools that may be needed to construct portfolios in the shorter term. For that reason, there’s a need to look at multiple metrics.

Things to consider

There are two sides to all of these action areas. First, there is the impact of climate on the investment portfolio. How will the portfolio perform under climate and other ESG pressures based on potential adaptation measures and the pace of economic transition? Analytical methods in this area are evolving.

For example, Climate Transition Value at Risk (CTVaR) is a methodology that Willis Towers Watson has developed to focus on the effect of climate transition on individual companies by integrating a forward-looking assessment of climate transition risk into traditional risk/return frameworks, aligning climate transition risk with investors’ fiduciary duty. The approach looks beyond top-down issues, such as carbon prices, to consider a wide range of underlying climate-related issues that are expected to influence the drivers of cashflows and returns.

The analysis can then in turn be fed into stock and other asset allocations. In the case of equities, Willis Towers Watson has partnered with STOXX to create the Climate Transition Index as a systematic, transparent way for investors to incorporate climate transition risk into investment decisions.

The flip side is what the portfolio is doing to the climate, a key factor in the potential reputational risk associated with the push for net zero. This involves recognising that engagement with asset managers and investee companies, including taking up voting rights, can be a significant driver of progress towards climate transition goals. It also involves taking well-reasoned and researched decisions about backing the emerging services and technologies that will be needed to really make in-roads into the planet’s climate challenge and that will deliver investment performance.

The ‘business and finance COP’

Even if COP26 didn’t hit all its high notes with regards to government commitments, the broad consensus is that it has significantly upped the tempo of the climate and sustainability mood music that surrounds organisations that control large amounts of private capital.

Pension funds and other investors should be taking steps to ensure they are in tune with the implications for reputation, stakeholder relationships, regulation, reporting and, of course, portfolio performance.

Authors

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Head of Sustainability Solutions
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Managing Director, Retirement

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