Return and responsibility

Climate change has sprung onto the global political stage over the last few years, with the inauguration of Barack Obama moving it further into the spotlight. Increasing awareness of climate change has spurred the number of investors who are considering it within their asset allocation process and how it will affect their pension investments.

Research by the Carbon Disclosure Project (CDP) shows that 77% of respondents are considering climate change and sustainable investment in their asset allocations and investment decisions, while 80% agree that climate change is an important factor.

CDP chief operating officer Paul Simpson said that a growing number of pension schemes are becoming more proactive and engaging with companies on climate change issues, while more are implementing risk management processes concerning this.

"Increasing regulation in the US has focused the minds of pension funds, showing they need a strategy about how climate change can affect their funds," said Simpson. "There's been a seismic shift in the last 10 years in the understanding of pension fund trustees of the importance of climate change to long term investment returns."

According to Mercer US head of responsible investment consulting Craig Metrick, an increasing number of investors are also engaging with portfolio companies directly about disclosing information on climate change. Investors are then talking with pension managers on to how to incorporate this data into their investment decisions, which will affect their portfolios, he said.

Despite these developments, the US lags behind other regions in climate change issues. "Discussion of climate change hasn't been as prevalent in the US as it has been in Europe, but it's rising," said Simpson. "We are seeing a number of groups increasing their assets which are represented in these initiatives."

Carbon cost
Another issue is that there has not been a price on carbon in the US compared with what exists in Europe - in terms of the EU Emissions Trading Scheme - although this is likely to change following Obama's commitment to a national scheme across all the states.

Nonetheless, the US is moving in the right direction. As a large proportion of the money in US pension funds is in state funds, the political message advocated on climate change will further incentivise state pension funds to take action, according to Simpson. New regulations are already taking root, for example, with the US EPA (Environmental Protection Agency) announcing that it will regulate companies which have to report their emissions.

But pension funds may not opt to engage in socially responsible investing due to the overarching aim of reaping the best returns. For example, CalSTRS' fiduciary obligation means that its fund does not engage in socially responsible investing, although it considers environmental risk in the investment decision process. In June 2006, CalSTRS adopted an investment policy screening environmental risks, among others, which is used for all investments in the portfolio.

On the other side of the coin, climate change investments are proving popular among certain investors in the current environment. "Amid the downturn, we've had inflows in particular into a climate fund," said F&C Investment Management director, head of governance and sustainable investment Karina Litvak. The company launched its Climate Opportunities fund a year and a half ago, which invests in companies poised to benefit from mitigating or adapting to climate change.

Uncertain future
However, there are some problems which must be overcome. One such issue is the lack of long-term policy certainty with regards to climate change. Litvak said: "In order for the financial agents to facilitate economic transformation and to redirect capital to carbon friendly investment, we need to know what the future regulatory framework will be."

Aviva Investors head of SRI engagement Steve Waygood warned that if investors place all their money on climate change and neglect other social and governance issues, then investors will lose when climate change is not producing returns.

Waygood said: "The Kyoto protocol ends in 2012 and there is no global agreement after this. If the Copenhagen meeting is not successful, climate change issues will hinder the future ability of schemes to return money to beneficiaries." He added that as pension schemes have investment time horizons of around 30 or 40 years, profound negative consequences may be seen within a pension's time horizon, if climate change is not tackled.

Watson Wyatt investment consultant Jane Goodland highlighted that many trustees are still coming to terms with the potential impacts of climate change on investments. "We're moving into a phase now where there's more scrutiny as to how this works in practise and whether or not portfolios do really reflect this."

As a result, many trustees and schemes are still guided by their investment managers, as opposed to seizing the reins to proactively approach climate change. Chief executive of UKSIF (the Sustainable Investment and Finance Association) Penny Shepherd agreed: "We would like to see pension funds do more to assess their asset managers on the quality of their response to climate change. Too often, with certain notable exceptions, the pace has been set by the asset managers, rather than the asset owners."

With further regulation and a price on carbon imminent in the US, there are benefits to clients tackling this issue proactively, said Metrick. "Rather than waiting until a carbon price is set, certain positions in portfolios can start to be trimmed, and companies that are ahead of the game should be considered."

Profit versus protection
Pension funds also need to play an active role in putting measures in place for sustainable recovery, by looking at how they allocate their capital, with a view to seeking long-term return while protecting the environment from which they draw profits, added Shepherd.

Similarly Litvak commented: "At the moment we're leading the horse to water; more pension funds should do this." While pension clients choose F&C to manage money because of their ability in this area, it is F&C that highlight to them that they should take climate change into consideration, said Litvak.

Waygood noted that at present, enquiries from pension funds into climate change issues are not systematic, which suggests that the consultants as well as the trustees may be focusing on contemporary problems, such as liquidity and ensuring they are fully funded.

Yet pension funds are arguably growing in awareness and are bringing their influence to bear on asset managers to an extent. Goodland said: "If a pension fund appoints an investment manager, they can be explicit in their aim and can encourage the manager to engage on their behalf."

Waygood also added that certain pension funds are active members of climate change groups, such as the Institutional Investors Group on Climate Change, which promotes a proportionate response by governments to the issue of climate change. "Pension schemes are really in the driving seat of the IIGCC," he said.

A lack of commitment
Many pension schemes and asset managers are also bullish about the opportunities offered by climate change investments. Impax Asset Management oversees money in companies active in alternative energy, water treatment and waste management. Impax chief executive Ian Simm commented: "These three areas are set for superior growth because of the scarcity of natural resources and increased policy to tackle pollution levels."

He added that in the medium to long term, annual growth in this area should be 20%, which is far superior to the growth of the rest of the economy. "These drivers are expected to have an influence for over a decade, which is of interest to pensions and other institutions."

Another opportunity on the horizon is climate change bonds, which pension funds could invest in to secure returns that may be guaranteed by government. Shepherd added that as governments raise funds to address the current crisis, green gilts are starting to arise, in order to both stimulate the green economy and meet the liability needs of pension funds.

Ultimately, the issue of climate change is important across the whole economy, around the world. "It is in the interest of investors that companies behave in ways that both mitigate and adapt to climate change, as investors need a sustainable long term economy," said Shepherd.

 

Further information

United States environmental protection agency
The government-run agency has been responsible for environmental research and regulation in the US for almost 40 years. www.epa.gov

Carbon disclosure project
An independent, non-profit organisation that collects and distributes climate change information on more than 3,700 corporations worldwide. www.cdproject.net

CalSTRS
The California State Teachers' Retirement System is the second largest US public pension fund with assets of US$122.4bn (as of May 31, 2009). www.calstrs.com

UKSIF
The UK sustainable investment and finance association was founded in 1991 to promote sustainable development through financial services. www.uksif.org

IIGCC
The institutional investors group on climate change consists of pension funds and other institutional investors. www.iigcc.org