Navigating Net Zero: a thought leadership series on climate risk, resilience and sustainability
The series follows on from Willis Towers Watson’s inaugural Climate Risk & Stewardship Summit in May this year, over 3,000 attendees across 3 days explored what the evolving stewardship role of financial institutions as the whole economy transitions to a net-zero and climate resilient future.
You don’t have to believe in climate change to feel its physical and financial impacts. Just as rising global temperatures are resulting in more frequent and intense wildfires, droughts and storms, we are already seeing the effects of the nation state commitments to transition to a low-carbon economy cascading through the financial system. Fossil fuel companies are rapidly losing favour with investors who are queuing up to put their money into renewable energy.
At Willis Towers Watson, not only do we believe the transition is already happening, but we have been preparing for it for some time. We have joined the Net Zero Asset Managers Initiative, committed to a Net Zero target for all our global delegated assets of $165bn and made a commitment to bring our own operational emissions to Net Zero.
Around 131 countries have now committed to or are considering a net zero target
Commitments to Net Zero targets by countries, companies and investors are increasing almost daily. Around 131 countries have now committed to or are considering a net zero target, including the US which rejoined the Paris agreement the day that Joe Biden took up his seat in the Oval office, and China, which has set itself the great challenge of carbon neutrality by 2060.
Such announcements are not merely policy signals: it is now clear that the world is moving in one direction, and fiduciary duty and investment decisions must be aligned with that new world.
There are three things we need to appreciate about the transition:
Being the ultimate stewards and allocators of long-term capital, asset owners must be in the driving seat of this transition. Through careful mandate design, asset managers can help asset owners align with the carbon transition in a way that meets the Paris agreement targets. This will have an impact on the real-world economy as more capital gets allocated towards a low carbon and climate resilient future. When we evaluate asset managers, not only do we ensure that they have ESG fully embedded in their investment processes, we also prefer those who have genuinely made climate part of their DNA and actively engage on this topic. This is relevant in active and passive, across equities, bonds and alternatives.
The risks and rewards associated with this transition are not currently fully reflected in valuations. Understanding how the repricing of climate risks can increase returns (alpha) and reduce risk (beta) provides an unprecedented opportunity for investors. But the market will adjust over time, so we think that the alpha opportunity is likely to be greatest in the next few years. If the current interpretation of fiduciary duty prioritising near-term financial results continues, it may not always make sense to forge ahead of the pathway to net zero regardless of market pricing. The net-zero destination and the overall trajectory of this journey are the more important aspects for investors rather than the position at every single point along the path to net zero.
To do alpha and beta better, the most powerful tool in our investment toolkit is by far stewardship. Standing still in a transition is a contradiction, so we will need to continually improve the status quo to make a real-world difference. Taking a position in the transition is not necessarily just about identifying mispriced assets or how you price the asset against expected earnings for the future. This traditional winners vs losers approach to investing is changing through the power of stewardship of underlying businesses and system-level engagement. By tackling the systemic risks of climate change, societal value converges with financial value for investors. We genuinely believe that there is so much value that can be unlocked by being an active owner of businesses on their journey towards a carbon neutral economy that we amplify the stewardship efforts of our preferred asset managers with the help of a specialist stewardship provider who has been hired specifically to focus on ESG and climate.
Net Zero targets are all very well, but implementation is where the real work starts. In order to achieve these ambitious targets, there are some essential items that we need:
ESG data is far from perfect but we cannot wait until conditions are perfect. We must encourage investors to be comfortable with a level of uncertainty and data paucity. Today, investors spend a lot of time agonising over the level of uncertainty and guesswork embedded in carbon and ESG data while there is a similar level of uncertainty and guesswork embedded in the financial risk return assumptions; the latter is just more established and familiar to investors. We must continue with our endeavour to deepen our understanding of climate-related financial risks and develop the tools to measure and manage them. The metrics we use today may look very different in 5 years’ time – and that is positive, as our understanding of the challenges and the solutions evolve. Scenario analysis can help, but we must be agile in our use of information, while being robust with our findings.
In order to be agile in the way we use imperfect information, navigate insights when we monitor actions and report outcomes (which are often counter-intuitive), meaningfully collaborate across the investment value chain, and innovate for climate solutions – we need transparency at the forefront. This drives engagement and creates a platform for real change as we work towards climate resilience.
No action is sustainable without proper monitoring, so we have completely revamped the way we do reporting for our clients to help them keep on top of what’s important in their carbon journey plans. But we urge caution when we interpret various carbon metrics - most of them are complex, far from precise and also backward looking. That’s why we have been investing heavily in advanced forward-looking climate analytics and solutions. These assessments provide much more useful but sometimes counterintuitive insights, eg as a long-term investor, you may be much better off today with an overweight position on companies that are very carbon intensive but have a robust plan for a successful transition to a carbon neutral future compared with investing into lower carbon emitters with no transition plans.
Climate risks are uniquely difficult in that they are systemic, undiversifiable, uncertain and challenging to hedge. They require collective action to cascade the public commitments down to all institutions to implement a just transition to a net zero economy. Getting the countries that are currently not committed to net zero to do so and increasing the ambition embedded in current pledges is going to be very important as well as shifting what is happening in the private sector. The most impactful action for private finance is to help companies realign their business models to net zero and provide funding for climate solutions. All this requires collaboration across the investment value chain. To facilitate system level collaboration, we have joined the Net Zero Asset Managers Initiative and are working on creating the Net Zero Investment Consultants Initiative.
We are strong advocates of engagement and working together to facilitate a successful transition to a low carbon future. That said, exclusions and divestments still have their place where a company is just not able to transition, or the management of that company has not been able to adapt to the trajectory of the climate transition. We would view offsets as a potentially useful tool that should be used with caution in net zero portfolios. Recognising the finite availability of offsets from land use in particular, and the need to rapidly decarbonise, it is generally accepted that investors should not allow the use of external carbon offsets as a significant long-term strategy for decarbonisation goals by assets in their portfolios. We will advise our clients that carbon offsets should be reserved for situations where there are no technologically and/or financially viable ways to eliminate emissions.
Their weight should increase dramatically in investment portfolios. Many of them, such as renewable energy, transport electrification, and reforestation, are the perfect match for pension funds’ liabilities with inflation linkages and long-term stable cashflows, often supported or partially funded through public funds. We have been successfully investing in a wide range of climate solutions for over 10 years, but more are required in the market. Every sector of the economy will require innovation – across construction, agriculture, mining, water management, transport, etc.
The direction of travel on climate is clear but there will be a lot of uncertainty and complexity on that journey. The first step is understanding whether your actions move you towards your destination as all businesses will be required to transition to a carbon neutral position. This is particularly difficult but also particularly important for carbon intensive industries and businesses which in aggregate will pave the way to a low carbon economy… or not… but we can expect governments around the world to apply various levers to make it happen.
As a result, investors can select those businesses that engage with transition plans in a serious and comprehensive manner and hence have a better chance to be a winning business of tomorrow and provide investors with more sustainable returns on their capital in the longer term. To be able to do so successfully, we will all need collectively to change the way we think, act and invest.