To make climate change a material factor in investment analysis and decision-making, pension funds really need to raise their game, argues Rory Sullivan

To make climate change a material factor in investment analysis and decision-making, pension funds really need to raise their game, argues Rory Sullivan
In January 2010, the Investor Network on Climate Risk published a report examining how US asset managers take account of climate change-related risks and opportunities in their investment processes.

The findings were broadly similar to the findings of similar studies from the Institutional Investors Group on Climate Change, namely that relatively few investors integrate consideration of climate change risks and opportunities across all of their assets, that investors are still developing the tools necessary to analyse these risks and opportunities, and that the primary focus is regulation, with adaptation receiving relatively little attention.

The report argued that the widespread focus on issues that are financially material over the short-term has meant that many important aspects of climate change are simply not on investors’ agendas at present.

While the conclusions were all too depressingly familiar, the report also flagged the critical role that asset managers’ clients (in particular, pension funds) could play in altering this situation. In fact, forty-nine (49) per cent of respondents stated that ‘…they did not analyze climate risks because their investor clients did not ask them to’.

This suggests that ‘materiality’ – where material issues are commonly defined as those that have at least a 5% impact on a key financial indicator over a 12 month period – may not be a matter that is defined internally by an individual analyst or fund manager.

That is, the research suggests that if clients ask questions about how climate change issues are being assessed and integrated into investment decisions, if clients examine aspects such as the ‘carbon footprint’ of a portfolio, or how adaptation and other risks are being built into investment decisions, this may create pressure for fund managers to explicitly analyse these issues and build them into their investment decisions.

One of the most interesting developments in this regard has been the recent survey that Railpen has issued to its investment managers, asking them whether they have a climate change policy, whether they have a process for examining climate change-related risks and how this affects their investment decisions, what assumptions they are making about the future price of carbon, and how climate change is likely to affect their asset allocation decisions (by asset class, by sector and by geography).

Of course, asking questions is not enough. Catalysing change is likely to require that pension funds back these questions up with incentives.

The starting point could be to make climate change a standard agenda item in quarterly/annual performance review meetings, where the asset manager’s representatives have to explain the actions they have taken to address climate change-related risks in the client’s portfolio.

To have real effect, these issues will ultimately need to be built into mandates (where manager performance on climate change, or wider responsible investment issues, is allocated an explicit weighting in the appointment/re-appointment decision), and integrated into performance objectives alongside the more conventional investment performance metrics.

Ultimately, clients will need to think much more holistically about climate change and will need to look at the investment objectives they are setting, both at the asset allocation level (e.g. investments in renewable energy) and in the environmental credentials of the companies in which they are invested.

Obviously, implementing these recommendations would involve a potentially major departure from business as usual for the investment management industry, potentially forcing investors to think more long-term and to explain exactly how they take account of climate change-related risks and opportunities in their investment decisions.

However, if the Investor Network on Climate Risk study is correct in concluding that the interpretation of materiality is strongly influenced by client demand, it is clear that pension funds must take a much more proactive approach to encouraging their asset managers to act on this issue.

Useful resources:

Railpen, HSBC and Linklaters (2009), (Railpen, London).
‘Climate Change Investment Risk Audit: An Asset Owner’s Toolkit’

Spalding, K. (2010),
'Investors Analyse Climate Risks and Opportunities: A Survey of Asset Managers’ Practices' (Investor Network on Climate Risk/Ceres, Boston MA).

Rory Sullivan was previously Head of Responsible Investment at Insight Investment. He is a member of the Ethical Corporation advisory board.