Approach to Environmental Risk
Climate change and the response of policy makers has the potential to have a serious impact on financial markets. Engagement, using partnerships of like-minded investors where feasible, can mitigate this risk.
This potential disruption in the market can also create opportunities. The Fund will actively look for investments which can be expected to benefit as a result of the current and long-term impacts of climate change.
There are many ways of modelling the impact of climate change which have different assumptions, and different long term impacts on the performance of asset classes and sectors. The Fund believes the appropriate response is to invest in a diversified range of uncorrelated assets in order to reduce the level of investment risk.
Paris Agreement on Climate Change
The Fund is a strong supporter of the Paris Agreement on climate change. Through LGPS Central we have signed the Global Investor Statement on Climate Change issued by the Institutional Investor Group on Climate Change, urging global political leaders to take action. A progressive policy environment which provides long-term certainty would be supportive of the Fund’s primary purpose to pay pensions.
The Global Investor Statement on Climate change calls on policy makers to:
- achieve the goals of the Paris Agreement,
- accelerate private sector investment into the low carbon transition and
- commit to improve climate-related financial reporting.
While current global policy commitments are sufficient only to achieve a 3°C temperature increase, the Fund is supportive of policy makers seeking to achieve the Paris Agreement. As part of the Institutional Investors Group on Climate Change, LGPS Central has recently asked EU leaders to take urgent action and to provide investors with long-term certainty through a net-zero emissions target to be achieved by 2050 at the latest.
The Paris Agreement contains a number of statements, the most fundamental of which is probably:
“Paris Agreement Article 2(1)a
Holding the increase in the global average temperature to well below 2°C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5°C above pre-industrial levels, recognizing that this would significantly reduce the risks and impacts of climate change…”
The assumption, therefore, is that the global economy will be taking measures that, in aggregate, are sufficient to achieve the Paris Agreement goals. This means that some industries will achieve net zero, or below net zero, while other industries (primarily those with hard-to-abate GHG emissions) will have lower, but not zero, emissions intensity.
We recognise the measurement problems associated with determining ‘alignment with the Paris Agreement goals’, and that this makes it difficult, but not impossible, to hold companies to account against their commitments. Through LGPS Central we are supporters of the work undertaken by the Transition Pathway Initiative (TPI) and the research of the London School of Economics (LSE). Using tools such as TPI, along with coordinated investor initiatives such as Climate Action 100+, we intend to hold companies to account against the strategic promises they have made to date.
We regard LGPS Central, and its underlying advisers, as competent in understanding and managing climate risk relating to fossil fuel companies and other sectors that rely on fossil fuels, and to long-term investors.
Our partners engagement programme on climate change stretches far beyond fossil fuel producers. As long as fossil fuel demand remains strong, fossil fuel supply will continue. Therefore, our engagement programme covers both the supply side and the demand side.
For example, LGPS Central is supporting 161 engagements with the most carbon intensive companies globally across sectors (including oil & gas, mining, autos and aerospace), via a collaborative investor initiative Climate Action 100+. Climate Action 100+ engagements have three key objectives:
- robust governance of climate risk,
- climate change disclosure in line with the recommendations of the Taskforce on Climate-related Financial Disclosures, and
- the alignment of business models with a 2°C pathway.
There has been much positive progress, but we recognise more needs to be done to hold companies to account relative to their climate targets and commitments. LGPS Central is a member of the Transition Pathway Initiative (or TPI) and sits on their Steering Group which develops metrics to hold companies to account. TPI, supported by its academic partner the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Political Science, provides a tool that measures both companies’ climate change management and their carbon performance (including forward trajectory relative to the Paris goals).
TPI covers heavy emitting sectors (currently 14 sectors covered) and is working on new, robust ways to measure Paris alignment with a sector-specific lens.
We fully recognise that some of the positive work undertaken by companies can be undermined by the lobbying work they perform either directly or via trade associations. We have therefore joined fellow investors, via Climate Action 100+, the Institutional Investor Group on Climate Change and the Transition Pathway Initiative, in calling on companies to be transparent about their lobbying activities, lobbying expenditure, and to review the positions taken by trade associations to ensure consistency on climate change.
LGPS Central uses Hermes Equity Ownership services to supplement their engagement and voting efforts globally. Below is a description of how Hermes monitors engagements with fossil fuel and other high emitting companies:
“The long-term outcome we seek is an oil & gas sector which invests in capital consistent with containing climate change to well below 2°C and which achieves net-zero emissions associated with its products and operations in line with the goals of the Paris Agreement, avoids pollution, always respects all human rights and operates with zero fatalities and injuries.
Key objectives on Climate Change include:
- the publication of a strategy consistent with the goals of the Paris Agreement, including long-term goals and short-to-medium term targets;
- disclosure and management of climate change risks in line with the guidelines of the Task Force on Climate related Financial Disclosures; and
- corporate public policy support for continued ambition to deliver the goals of the Paris Agreement on climate change and demonstration of aligned political lobbying activities.”
Planned actions to reduce the Fund’s exposure to fossil fuel investments
The fund has already significantly reduced its exposure to fossil fuel investments and is closely monitoring the impact of climate risk, among other factors, on all portfolio investments. Moving forward, there is a high bar to additional investment in companies deriving a material proportion of revenues from fossils fuels or being resistant to positive change. However, as mentioned earlier these decisions need to take account of the valuations of such businesses weighed with the associated risks and the ability to positively influence companies towards a more sustainable future. We do not believe that divesting from fossil fuel companies today will necessarily deliver better outcomes.
As a result of implementing our approved asset allocation the Nottinghamshire Pension Fund is gradually reducing fossil fuel investments with an increased allocation to infrastructure investments, a significant proportion of which is in clean energy, and a gradual reduction in equity investments. Within our equity investments we are looking at a number of low carbon and sustainable funds. Over time our exposure to fossil fuels will reduce as a result of these asset allocation and diversification decisions.
Planned approach to improve assessment of the financial risks of climate change
Fossil fuel companies are exposed to changes in the price of oil. Oil is a valuable commodity and can be used to produce many synthetic products and there is likely to be a long term demand. However demand for oil as a fuel, its main use, is likely to reduce over the long term as travel and energy generation become more efficient and increasingly powered from renewable sources. It seems increasingly likely that some identified oil reserves may never be extracted, becoming valueless (known as stranded reserves).
Oil and gas companies make up a significant share of global market capitalisation. Through its investment in passive funds the Pension Fund has automatic exposure to this sector in addition to any positions held in our active equity mandates. The Pension Fund’s investments in passive funds align with the Pension Fund’s Investment Beliefs, particularly in relation to the use of diversification (i.e. across all sectors) as a key technique for reducing risk, and in relation to minimising investment management fees.
It is important that the Pension Fund understands the financial risks of its exposure to fossil fuels, potentially stranded reserves and climate change which will impact on many industry sectors, especially transport, energy generation, high energy industries, farming, tourism and businesses in parts of the world directly affected by changes in weather or sea level rises. It should be noted that the financial risks of climate change are not consigned to the Oil and Gas sector alone.
Consequently LGPS Central has been commissioned to produce some climate risk analysis to enable the Pension Fund to identify its exposure, understand its financial risk and to formulate and publish a Climate Strategy.
All interested parties need to be aware of the challenge in obtaining reliable data for these calculations and the complexity of modelling these issues. Data is improving, partly due to pressure from engaged shareholders such as ourselves, but the sensitivity to assumptions needs to be appreciated in interpreting the results of this work.