THE LOW CARBON OPPORTUNITY AND THE RISKS OF MISSING OUT

Transcription

1 THE LOW CARBON OPPORTUNITY AND THE RISKS OF MISSING OUT The Hermes approach to climate risk and opportunity November 2017 By Tatianna Bosteels & Bruce Duguid, Hermes Investment Management For professional investors only

2 2 CONTENTS THE CLIMATE OPPORTUNITY PRISMS 3 ADVOCACY INVESTOR S VOICE IN THE CLIMATE TRANSITION 4 Voluntary disclosure of climate risks and opportunities 4 G20 countries and investor dialogue 5 Investor voice on EU public policy 6 EU Energy Union putting energy efficiency first 6 Supporting the UK government 6 THE HERMES APPROACH: CONTINUOUS PROGRESS 7 Our approach creating a feedback loop of investment and stewardship 7 Trees for Cities 7 Intentionality and outcomes 7 Reflection on target-setting 9 Engagement: future-proofing business models 9 Engagement progresses and focus 9 Climate engagement work 10 Public equities deepening our climate impact analysis 11 Integrated investment and stewardship approach 11 Proprietary carbon portfolio analytics tool 11 Pricing ESG risks in credit 12 Low carbon strategy 12 Private markets: governance and opportunities 13 Real estate: from intention to outcomes 13 Real Estate: energy and climate targets and outcomes 13 Delivering outcomes through active operational management 14 Sustainable place-making for climate mitigation and adaptation 14 Physical risks: Flood risk management 14 Infrastructure s longevity 15 Enhanced governance for long-term returns 15 Climate risks, resilience and opportunities 16 Infrastructure for the transition to a low-carbon economy 16 Private Equity opportunities for growth creation from the low carbon transition 17 Private equity s innovation as opportunities 17 Carbon risk monitoring 18

3 HERMES INVESTMENT MANAGEMENT NOVEMBER THE CLIMATE OPPORTUNITY PRISMS Since the Paris Agreement on climate change, we have seen a number of unexpected developments. While the EU, China and the BRIC countries continue to voice strong support for the agreement, in June 2017 President Donald Trump announced that the US government would withdraw from the Accord. While this announcement made global headlines as a landmark symbolic gesture, in practice there will be limited impact in the short term, and it could highlight the benefits of moving to a low-carbon economy. The announcement has been strongly condemned by a number of US states, cities, large corporations and investors, some of which are forming coalitions to take actions in alignment with the Paris Accord US national action plan. In the last two years, we have also seen some crucial climate change developments impacting investment management. Following the intervention of Mark Carney, governor of the Bank of England and chairman of the Financial Stability Board, the central banks of the G20 countries have stated that climate change represents a systemic risk to the financial system. In parallel, there are growing moves to define more clearly the fiduciary duty of investors to account for the longerterm impacts to investments of environmental and social issues. One example is this year s EU pension s directive (IORP), which specifically clarifies that the prudent person principle requires asset owners to pay attention to long-term factors, including environmental, social and governance (ESG) factors, in their investment decisions and those of their agents. Saker Nusseibeh Chief Executive Hermes Investment Management As stewards of significant amounts of capital and as major investors in real assets, institutional investors can play a key role in driving energy efficiency in their own public stocks and real holdings. They can also encourage investee companies, through active engagement, to become more competitive and improve the longterm investment value they deliver to investors by maximising energy productivity. On top of the regulatory pressure from the implementation of the Paris Accord in the various signatory countries, this shows that the debate on the need for investors to act on climate change has clearly moved on. The focus is now on what to do, at what speed and within which time frames. This was confirmed at the PRI In Person event, where 1,000 participants representing US$70trn assets under management (AUM) stated, with a large majority, that climate change is the number one ESG issue for the investment industry. As a result, the industry has been focused on the process and the outcomes of the FSB Taskforce on Climate-Related Financial Disclosure (TCFD). The taskforce s recommendations define a roadmap for investors that should help them understand the scale of what they need to do to manage and report climate change risks. More work is needed to define the tools investors will need to act on these recommendations, and a large number of sectoral initiatives addressing this need are ongoing. However, in our view, the catalyst for portfolio decarbonisation will be when investors better understand the risks of transition and how they affect current business models, as well as identifying carbon and climate management opportunities. It will be easier to attract mainstream investors by showing them the value of tapping into the growth potential of the transition to a lowcarbon economy, whether through new companies, innovative technologies and by adapting business models. This transition represents a game-changing opportunity. We see growing interest for low-carbon investments reflected in the growth in low-carbon products, services and technology and a budding interest from institutional investors in investment solutions that not only account for climate risks but also tap into opportunities.

4 4 ADVOCACY INVESTOR S VOICE IN THE CLIMATE TRANSITION Hermes mission is to be the world s leading provider of long-term holistic returns for savers, creating value for all stakeholders in the financial system. To us, Holistic Returns means delivering excellent long-term investment performance, but doing so with an appreciation of how our investment decisions will affect the economy, environment and society and thus ultimately clients and the beneficiaries they represent. As part of our Holistic Returns approach, we believe it is our responsibility to lead and participate in discussion and debate about the fiduciary responsibilities of institutional investors to their clients, their stakeholders and society at large. To that effect, we actively contribute to public policy and sector engagement, promoting responsible investment and ownership practices and, more pertinently, advocating for a global financial system that operates in the interests of its ultimate beneficiaries. Managing climate and carbon risks remains a key priority as the economy decarbonises, in particular by investing in opportunities that can deliver new growth areas and job creation. At Hermes, we will continue to manage our carbon risks and identify opportunities to improve the long-term financial performance of our assets. Managing climate and carbon risks remains a key priority as the economy decarbonises, in particular by investing in opportunities that can deliver new growth areas and job creation We also maintain our public policy engagement with the UK and European governments, calling for a clear policy framework to enable the scaling up of low carbon and energy efficiency investments. As part of actively promoting responsibility, in the last year we have worked with UK, EU and G20 policy makers and regulators, as well as with our industry peers. We have actively contributed to selected investor associations working on responsible property investment, including the UNEP Finance Initiative (UNEP FI), the Institutional Investors Group on Climate Change (IIGCC) and the Principles of Responsible Investment (PRI), to support the following initiatives. Voluntary disclosure of climate risks and opportunities At Hermes, we believe the FSB Taskforce for Climate-Related Financial Disclosures (TCFD) recommendations could be a game changer in enabling all investors to make more informed decisions that take into account climate risks and opportunities. We welcome the taskforce s call for investors to assess carbon risks using scenario analysis to ensure a broader level of carbon risk disclosure, including both a narrative approach and quantitative carbon footprint reporting. We are pleased that the recommendations go beyond measuring the annual carbon footprint associated with an investment portfolio. We believe this is only one part of an inquiry into climate-related risks and opportunities and does not, in and of itself, give an immediate insight into the nature or extent of these risks. A critical element of the recommendations is the requirement that companies explain the financial materiality of climate change under a range of low carbon scenarios. This will encourage both companies and investors to deploy new mitigation strategies, preserving value for long-term investors and improving the lives of beneficiaries. We are currently assessing the implications for our own and our investee companies disclosures, with a focus on how to implement low carbon scenario analysis. We believe that, in time, both companies and investors should disclose climate-related risks. Disclosure should come from two main players in the investment cycle: Disclosures by investment targets (e.g. companies) to investors Disclosures by investment intermediaries (e.g. asset managers) to their clients further up the investment supply chain, and ultimately to beneficiaries Appraising and communicating climate-related target investment risk more effectively should be the first priority because it will directly improve the understanding and management of the aggregate investment portfolio risk. As investment portfolio risks represent the aggregate of the relevant target portfolio risks, complex portfolio effects may either compound or reduce these through unforeseen correlations, feedback loops, hedging or the effects of diversification. However, we recognise that the tools to analyse these investment level risks are not yet established and more research and testing is needed: especially when assessing longer-term risks based on scenario analysis. Work is thus required to help investors understand the process and the value of scenario analysis. Indeed, given a limited knowledge of carbon scenario and scenario analysis, companies and investors will have to learn quickly to deliver this level of analysis. We welcome the large number of sector organisations offering to develop tools and methodologies to help investors implement the recommendations, such as the Global Investors Coalition on Climate Change (CERES/INCR. IIGCC, IGCC, AIGCC), UNEP-Finance Initiative, the Portfolio Decarbonisation Coalition (PCD) and PRI. However, these bodies, which all have a similar agenda, must work together to have the maximum impact. The FSB s recommendations will act as a catalyst for further change, and further help to enable both investors and companies to understand how to implement the recommendations will be welcome. At Hermes, we have initiated an internal working group looking at carbon risk and opportunity management, including 2-degree scenario planning. We aim to strengthen our internal understanding and further our analysis of carbon risks monitoring and reporting implications. Importantly, the internal discussions focus on how to implement 2-degree scenario planning and stress testing in ways that are meaningful for our investment processes across different asset classes. We will amend our carbon risk and opportunity approach and targets on the basis of our findings. We are confident that by expanding the work we already carry out in measuring carbon risk to include scenario analysis will help us, other investors and the assets themselves understand much better the scale of the carbon opportunity and more specifically on how to deliver on it.

5 HERMES INVESTMENT MANAGEMENT NOVEMBER OUTCOME #12 Our work with the Institutional Investors Group on Climate Change helps pension funds and asset managers proactively manage carbon risk. G20 countries and investor dialogue We have continued the work initiated in the lead-up to the Paris agreement to engage with countries on how best the investment industry can contribute to the implementation of their nationally determined contributions and commitments. To that effect, we have worked with the IIGCC and the Global Investor Coalition on Climate Change to engage G20 and G7 member states on their climate change positions. Our actions included sending letters calling for climate change to be explicitly acknowledged as a G20 priority, and pointing to the importance of close co-operation between the public and private sectors to get the right level of financing in place. We are pleased that Germany made climate a priority of the G20 Summit in July 2017, and while noting the US decision to withdraw from the Paris Accord, the final communique of G19 countries clearly states that the accord was irreversible. We are challenging the current economic and financial models to encourage the change required to meet the scientificallyguided climate change objectives Tatiana Bosteels, Director for Responsibility Hermes Investment Management G20 Energy Efficiency Investment Toolkit Energy efficiency has often been side-lined in energy and climate debates and regulations, and so we are pleased to see the growing recognition of its importance in delivering both energy savings and energy security, as well as economic growth, jobs and health benefits. The growing energy efficiency market now represents USD 221bn worth of opportunities, but it should be five times larger than it is today, so further G20 collaboration is needed to match the scale of the investment challenge. We have been active contributors to the G20 Energy Efficiency Investment Task Force under the Climate and Energy ministerial. The G20 energy efficiency investment toolkit, to which Hermes was the private investor contributor, was launched in May 2017 after three years of effort. The toolkit provides a set of voluntary options for policy makers to scale up energy efficiency policies and financing tools, and outlines current practices from 122 banks, institutional investors representing over USD 4trn AUM, leading public financial institutions and insurance companies. The G20 energy and climate working groups have acknowledged it as an important element in facilitating dialogue between investors and G20 members. G20 Energy Efficiency Investment Toolkit, IPEEC AND UNEP FI, May climate-change/energyefficiency/g20 energyefficiency-investment-toolkithighlights-us-221-billioninvestment-opportunities/

6 6 Investor voice on EU public policy EU Capital Market Union and Sustainable Finance By listening to the voice of investors when it consulted on the review of the Capital Markets Union, through engagement initiatives led by E3G and IIGCC and supported by Hermes, the EU recognised that work was still required to improve the sustainability of the European financial system. As a result, during 2016 the European Commission took two important steps. First, it announced that it would double the financial capacity and duration of the European Fund for Strategic Investment (EFSI) to provide at least 500bn of investments by 2020, of which at least 40% will be dedicated to climate action. Secondly, the Commission announced a Capital Market Union (CMU) revamp. As part of its review, in January 2017, it launched a high-level expert group to develop a comprehensive strategy on sustainable finance. The high-level expert group published its first recommendation in July 2017 for consultation with the industry and society during the second half of the year. High level expert group on Sustainable Finance, DG FISMA Improving the pricing of risk: Aligning the EU financial system and climate change, IIGCC, Sept Investor letter EU sustainable finance strategy, E3G, Oct 2016 Building on E3G work sustainable-finance-plan-for-the-eu EU Energy Union putting energy efficiency first During 2016 and 2017, the revision of two EU Directives related to energy efficiency and buildings provided an opportunity to drive radical improvements in the energy efficiency performance of Europe s existing building stock. As Chair of the Institutional Investor Group on Climate Change (IIGCC) Property Programme, Hermes has taken an active role in public policy engagement. IIGCC s growing recognition among EU institutions allows investors voices to be heard more effectively. The European Commission s new Clean Energy Package proposals were published in November We welcome the Commission proposal, which places energy efficiency at the front and centre of EU efforts to meet its emissions reductions targets. With these proposals, of at least a 30% EU-level binding energy efficiency target, national renovation strategies and the extension of the energy saving obligation beyond 2020, the Commission seeks to bring the Energy Efficiency Directive in line with the EU 2030 climate and energy framework. This sends a strong signal of the EU s commitment to energy efficiency and its multiple benefits, and sets a robust pathway for the uptake and finance of energy efficiency and decarbonisation objectives across the EU. However, the release in June 2017 of the Council position signalled tough tripartite negotiations ahead in the autumn of Also at the European level, we have continued to contribute to the Energy Efficiency Financial Institutions Group (EEFIG), as in 2016/17 it focused its attention on making investment in energy efficiency projects less risky and developing an evidence-based platform on the value of energy efficiency investments. DEEP (De-risking Energy Efficiency Platform), launched in November 2016, is an open source database to monitor and benchmark the performance of energy efficiency investments. The Underwriting Toolkit, launched in June 2017, aims to scale up deployment of capital into energy efficiency by clarifying the valuation and risk assessment process for energy efficiency projects. EFFIG DEEP database EFFIG Underwriting Toolkit. Value and risk appraisal for energy efficiency financing, June underwriting-toolkit Supporting the UK government An Investable UK Emissions Reduction Plan, IIGCC, March 2017 At the national level, we supported the IIGCC, which was asked by the UK Government s Department of Business, Energy & Industrial Strategy to suggest how the UK should develop a sustainable national plan to cut greenhouse gas (GHG) emissions. The IIGCC report sets out a number of core principles that a country should employ when developing an emissions reduction plan to deliver their Paris Agreement commitments, including developing a comprehensive 2050 decarbonisation strategy, and applies them in the UK context. The report provides specific measures on three key sectors: power generation, buildings/heat, and transport. An Investable UK Emissions Reduction Plan IIGCC, March category/european-climate-andenergy policy

7 HERMES INVESTMENT MANAGEMENT NOVEMBER THE HERMES APPROACH: CONTINUOUS PROGRESS Our approach creating a feedback loop of investment and stewardship Since 2015 we have been developing a comprehensive formal approach to manage our exposure to carbon risks and access opportunities from the transition to a low-carbon economy. During 2016 and 2017 we have continuously reviewed and refined our approach and continued to implement it across our investment and stewardship activities, taking account of the specific challenges faced by each investment strategy and different asset classes and learning from our experiences and industry best practice. Trees for Cities Hermes Investment Management has offset its operational carbon emissions by working with Trees for Cities. For every tonne of GHG emissions that Hermes Investment Management generates from its day-to-day operations and its business travel, it purchases verified carbon offsets from Trees for Cities, which guarantees an equivalent amount of GHG emissions is reduced from the atmosphere. The offsets have been generated by planting 3,159 trees in the open meadow known as Marnham Fields in Greenford owned by Ealing council. The carbon risk and opportunities management activities we are implementing cover our public equities and credit, private real estate and infrastructure assets, representing USD 35bn AUM as of 30 June 2017, or 90% of our AUM. Our approach has four elements: treesforcities.org/ 1 Awareness 2 Integration 3 Engagement 4 Advocacy Portfolio managers are aware of the carbon risks in their portfolios, which investments are the largest contributors and what are the associated risks and mitigation strategies Portfolio managers integrate carbon risk considerations alongside other value and risk considerations, exploiting green investment opportunities or divesting where carbon risk alongside other factors impacts value We act as engaged stewards of the investments we manage or represent on behalf of our clients. Where we hold assets with significant carbon risk exposure, we will manage directly-owned assets, and engage with public and private companies, to mitigate the carbon risk We engage with public policymakers and sector organisations, nationally and internationally, to encourage policy or best practice which facilitates the transition to a low-carbon economy Intentionality and outcomes As part of our carbon risk approach, we set specific and measurable targets against which to monitor and measure progress. In the last 12 months we have identified the most appropriate performance measurement indicators for each asset class, as set out below. We intend to report annually on our performance against these measures from In line with our commitments under the Montreal Pledge, we aim to measure the carbon footprint of our investments across all relevant asset classes. This year we have measured the carbon footprint of our public equities, credit and real estate assets, representing 80% of our AUM as of June During 2016/17 we have made good progress in collecting data on the carbon footprint of our infrastructure assets and have initiated a trial approach for our private equity investments. The indicators to measure our success in implementing our carbon risk approach are defined by asset class. For a limited number of these indicators, we have set specific performance targets for We monitor our performance using these indicators, and assess performance against the relevant targets.

8 8 Hermes carbon Risk and Opportunity key performance indicators Performance monitoring by indicators 2016 Performance Awareness Level of carbon emissions attached to investments and expended in Hermes operations, yearly This year we have measured the carbon emissions attached to Hermes operations and to our public equities, and real estate investments. IN PROGRESS: 80% AUM covered Public markets: Scope 1,2: 1.7 Mt CO 2 e & Scope 1,2,3: 4.3 Mt CO 2 e Private markets Real Estate: Scope 1,2: 35,000 tonnes CO 2 e absolute carbon emissions for landlord-controlled standing portfolio in 2016 Percentage of assets under management (AUM) for which we measure the level of carbon emissions per USD invested and breakdown by holding, yearly Listed equities and corporate credit: Carbon intensity per fund relative to benchmark in carbon emissions per USD invested This year we have measured the carbon footprint of our public equities and real estate assets, representing 80% of our AUM as of June 2017 The carbon intensity per fund relative to the benchmark has been measured for 100% of listed equities We are defining a process for credit markets Hermes operations Trees for cities offset: 1,183 tonnes CO 2 e IN PROGRESS: 80% AUM, Public equities 100% AUM scope 1,2 and scope 3 Real estate directly managed assets representing 80% AUM scope 1,2 IN PROGRESS: 100% of listed equity carbon emissions intensity measured Carbon Intensity (carbon emissions/aum): Scope 1,2 : 83 tco 2 e/mi USD vs benchmark 142 tco 2 e/mi USD Active management Real Estate: Long-term carbon emissions reduction targets in absolute and relative terms (tco 2 and tco 2 /m 2 ) reduce by 40% by 2020 from a 2006 baseline aligned with European carbon targets to 2020 Scope 1,2,3: 209 tco 2 e/mi USD vs benchmark 249 tco 2 e/mi USD See real estate performance RPI report 2017 TARGET Absolute (tco 2 ) : OFF TRACK: increase by 31% due to 200% absolute growth of assets since Annual operational target to reduce by 5% yearon-year the absolute carbon emissions (tco 2 ) of our standing portfolio, and our relative energy consumption (kwh/m 2 ) Infrastructure: Assets with a climate risk plan as a % of assets under management (AUM) ensure 100% AUM covered Engagement: Percentage of carbon in the portfolio being managed directly or engaged upon See real estate performance RPI report 2017 Engaged with 100% of portfolio businesses on their climate risks management plans, carbon reduction and energy consumption performance targets In public markets, we have engaged with 51% of the Scope 1/2/3 carbon emissions TARGET Relative to area carbon emissions (tco 2 / m 2 ): OVERACHIEVED: 57% reduction in offices and 35% reductions in shopping centres by 2016 (target year 2020) TARGET: 5% year-on-year operational absolute carbon emissions reductions (tco 2 ) of standing portfolio. OVERACHIEVED: Average of 8% reductions yearon-year for the last 8 years. TARGET: 5% year-on-year operational relative energy consumption reduction (kwh/m 2 ) of standing portfolio. OVERACHIEVED: year-on-year for the last 8 years. 14% carbon reductions between 2015/16. TARGET: 100% assets with climate plans In Progress: 100% of portfolio businesses engaged and progressing towards defining explicit climate risks and opportunity plans GOOD PROGRESS: Engagement with 51% of the Scope 1/2/3 carbon emissions. (2.2 MtCO 2 e vs 4.3 MtCO 2 e)

9 HERMES INVESTMENT MANAGEMENT NOVEMBER Reflection on target-setting We do not have quantitative carbon reduction targets in our equities and bonds portfolios since, as a mainstream fund manager, excluding fossil fuels and other carbon-intensive industries is not part of our investment strategies. Our carbon strategy for these portfolios is to be aware of the level, intensity and source of carbon risk, to factor this risk explicitly into investment decision-making and to engage with those carbon-intensive assets that we hold to identify and encourage best practice in managing their carbon risks. We believe effective engagement is key to reducing carbon. While divestment can send an important message to a company, it transfers the carbon risks rather than reduces them. We have not set targets on carbon opportunities, such as % of AUM invested in low carbon sectors, in part because it is not straightforward to define them and it is important to set the right balance. For example, setting too specific sector- or technologybased quantitative targets can lead to missed opportunities, or can be achieved through passive funds, which is not our investment approach. Market moves, new technologies and better management skills all create new opportunities. Taking advantage of the opportunities created by the low carbon transition and regulatory drivers is not always about buying best-in-class performers. Sometimes it can be better to find a laggard that has committed to change. At other times low-carbon opportunities are indirect and not captured by carbon data, such a in companies producing lightweight material for transport or service companies. Engagement: future-proofing business models At Hermes, stewardship is a core element of our investment approach. Constructive engagement is the best way to positively influence listed companies to reduce emissions and risks to the business model. Our engagements enable us to better understand the carbon performance of investee companies, identify potential areas for improvement at individual companies and across markets, and ultimately ensure that risks stemming from climate change and mitigation actions are properly managed and fully embedded in a company s strategy. Our stewardship team broadly follows a sector-led approach and therefore actively addresses the material risks from climate change that are relevant to each industry. In our engagement, we seek to encourage greater energy efficiency, better dialogue on climate risks and opportunities, and we encourage companies to prepare their business models for the energy transition. We seek to encourage greater energy efficiency, better dialogue on climate risks and opportunities Through our investment analysis of the carbon risks to our public markets portfolios, we have found that engagement is a powerful tool to address the risks, given the concentration of carbon emissions in a limited number of companies. This year we have engaged with 51% of the Scope 1/2/3 carbon emissions in our portfolios. (2.2 MtCO 2 e vs a total of 4.3 MtCO 2 e) We recognise the importance of establishing cross-sector consensus for change, which often is enhanced by collaboration with other investors. For this reason, we are active members of the Resolutions sub-group of the IIGCC and we support a range of environmentallyoriented collaborative engagements with the PRI, including one seeking to reduce methane emissions in the oil & gas industry. Hermes was the lead author of the IIGCC reports Investor Expectations of Automotive Companies and Investor Expectations of Mining Companies, which set out investors key demands of companies concerning climate action and disclosure in those sectors. Engagement progresses and focus We have seen good progress for corporate engagement on climate change in the last few years, supported by the positive momentum leading up to the ratification of the Paris Agreement. For the 12 months to the end of June 2017 our engagement has achieved the following: % We engaged 147 companies on climate change topics; Of these, 68 companies were engaged on specific objectives against which we have milestones that measure the company s progress; Out of 97 climate change objectives (some companies have more than one climate change objective), 43 made progress against the milestones we set. This equates to progress on 44% of all our climate change objectives. We are seeing constructive progress in investor advocacy in support of the momentum towards a 2 degree or lower world. In the last couple of years, we have seen more focus on opportunities and less on risk, and more focus on the demand side and less on the supply side. Improving energy efficiency is possibly the biggest single opportunity to cut emissions, for example. There is growing momentum to encourage and empower companies to support policy outcomes and be flexible to scenarios that may not align with existing business models. Companies are receptive to our view that new approaches to public policy engagement are required, with businesses lobbying for change being a particularly important part of that. Over the last few years we have supported climate change-related shareholder resolutions at oil and gas majors BP and Shell and major diversified mining companies Anglo American, Glencore and Rio Tinto, via the Aiming for A coalition of investors, whose work is now incorporated into the IIGCC. Over the last three years our engagement work has focused significantly on the extractive industries that are the primary producers of fossil fuels, as well as carbon intensive operations in their own right through energy and materials processing. However, we are now increasing our focus on the demand side of the economy, actively engaging with utilities and automotive companies. In addition, we are starting to engage with financial services companies, which have a special role in financing both the new climate economy and fossil fuel assets such as coal-fired power stations. We began this work with a review of the performance of a range of banks from a climate risk management and disclosure perspective. We also plan to play a leading role in a new collaborative engagement focusing on the 100 most strategically important carbon emitters globally.

10 10 Climate engagement work Oil & Gas Automotive Our proposal on a 2 C degree scenario analysis which we cofiled in 2016, and which gained the support of 41% of its shareholders, encouraged Chevron to publish its Managing Climate Change Risks report. As a positive gesture to the company, we withdrew a similar proposal for the 2017 AGM, although we will continue to engage with the company on the topic. This decision may have made it easier for some large asset management firms to vote in favour of a similar proposal at ExxonMobil, which resulted in the momentous majority support of 62.3% of shareholders. Mining The focus of our engagement is on ensuring companies are fully prepared for the transition to a low carbon economy, including issues such as electrification, connectivity and autonomous driving, as well as how they will meet current and future emissions standards. We lead engagement on behalf of the IIGCC with BMW, Daimler, and Volkswagen as well as engaging with other US, European and Japanese players. This year we led a client trip to visit one of BMW s manufacturing plants and to discuss its response to each of the elements in the IIGCC s published investor expectations. In Asia, we facilitated a discussion between a major automotive company and the CDP initiative, after which the company s ranking improved by one level in the Green Car Technology section. After a climate change-related shareholder resolution that we filed in 2016 was passed with more than 95% support, we spoke at the 2017 AGM of Rio Tinto and welcomed its commitment to substantially decarbonise the business by 2050 and asked the company to give investors clearer details on the vision and pathway to achieving this goal. Utilities We spoke at the 2017 AGM of Centrica, congratulating it on obtaining an A grade in the CDP index. We requested more details of the impact of low carbon scenarios on the company s strategy, asset values and capital allocation decisions. We also asked the company to consider setting long-term carbon reduction targets not only for its power generating assets but also for the much bigger emissions associated with its customers. Financial Services We benchmarked the performance of a range of international banks against the expectations of the recently-published guidelines of the Taskforce on Climate-related Financial Disclosures. This has enabled us to identify key areas of development and press for improvements. Following high level discussions with the Chair of an international bank, we are now providing review and input to its energy lending policy and will continue to encourage improved reporting on the bank s financial exposure in the event of low carbon scenarios. OUTCOME #14 Our championing of shareholder rights led to greater transparency of a global carmaker s remuneration practices, shifting its corporate governance into a higher gear.

11 HERMES INVESTMENT MANAGEMENT NOVEMBER Public equities deepening our climate impact analysis Integrated investment and stewardship approach Climate change is an important element of our broader strategy to integrate ESG factors and stewardship into all our funds. Consideration of carbon risk, where relevant, informs our idea generation, investment decisions and risk monitoring. In practice, we apply this general investment philosophy to each fund s unique investment process. Following idea generation, each investment goes through a process of fundamental analysis and valuation to validate whether it is a good potential investment. Portfolio managers and analysts can rely on a range of proprietary tools. In particular, they can use our QESG rating and QESG Dashboard to analyse companies on their environmental performance over time and against peers. We have also measured portfolio-level carbon footprint since 2015, which is now part of our portfolio monitoring process and reviewed annually. Stewardship is a core element of the Hermes investment approach, as constructive engagement can create a positive feedback loop enabling better understanding of the long-term value creation process within a business and a mechanism to measure the intended outcomes on specific sustainability goals. Our stewardship team also engages with companies on climate change, with investment teams able to use their insights to better understand companies in which they might invest. Depending on fund strategies, climate change considerations help us identify investment ideas that could benefit from a transition towards a low-carbon economy, for example in wind power or electric vehicles. However, in some geographies it is difficult to find opportunities that match our fund investment strategies. Proprietary carbon portfolio analytics tool In 2017, we developed a new tool to support the integration of climate change into investment decision-making and enable better targeted engagements. We decided to develop the tool in-house because we realised that most commercially-available portfolio tools were focused on reporting, as opposed to investment decision-making. We also wanted to combine carbon data from Trucost with our own internal carbon model, QESG score, financial and engagement data. Our tool goes beyond portfolio-level aggregate statistics and focuses on identifying patterns and outliers. In particular, we look at data with various lenses to identify companies better or worse placed to deal with climate change. For instance, we compare carbon emissions intensity trends with return on capital, to get a broader view on companies risk exposure. We have developed a module to assess the carbon valuation risk, with the aim of identifying companies that need further research by investment teams and engagement. We carried out meetings with each investment team to analyse in detail the findings from this new tool. We continue to refine our understanding of the implications of climate change for our portfolios. While our average carbon footprint intensity (carbon emissions divided by AUM) across our equities portfolio are lower than the benchmarks for scope 1/2 and scopes 1/2/3, the value of the exercise is in understanding the parameters that explain our exposure, and identifying the source of risks. Our 2016 and 2017 carbon risk exposure analysis found a number of useful guiding insights: Emissions are very concentrated within portfolios. This means that engagement with our top carbon emitters can have a large positive impact. Across our equities portfolios, 5% of equities funds, or 10 companies, are responsible for 41% of total emissions, and 10% of equities funds, or 31 companies, are responsible for 62% of total emissions. For our most carbon intensive fund, 5% of the fund, or 2 companies, is responsible for 41% of total emissions, and 10% of the fund, or 5 companies, is responsible for 69% of total emissions. 41% For our most carbon intensive fund, 5% of the fund, or 2 companies, is responsible for 41% of total emissions Sector allocation is in most cases a large driver of carbon intensity, although stock selection within intensity sectors can have a large effect as well. Investment style seems to influence carbon intensity. Only one of our funds has a meaningful value orientation. It significantly higher intensity relative to its benchmark than other funds, largely driven by exposure to utilities. The most important finding of this analysis is that the concentration of emissions in a small number of companies makes engagement potentially very powerful The most important finding of this analysis is that the concentration of emissions in a small number of companies makes engagement potentially very powerful. This gives a lot of leverage to push companies for better carbon performance, and more generally a coherent climate change strategy. This year we have engaged with 51% of the Scope 1/2/3 carbon emissions in our portfolio (2.2 MtCO2e vs 4.3 MtCO2e). In future, we will make the tool more dynamic and integrate an analysis of technology exposure, as well as scenario analysis against 2-degree pathways.

12 12 Pricing ESG risks in credit There is plenty of evidence that poor environmental, social, and governance (ESG) behaviours can erode a firm s enterprise value. This has implications for both equity and credit investors. Thus, in our credit team our investment analysis has historically considered ESG risks, including climate change, alongside more traditional operating and financial risks. However, until now it has been challenging to price ESG risks in a similar way to core credit risks. This is changing: in order to analyse ESG risks with greater precision, we have developed a pricing model to capture the influence of these factors on credit instruments. In this assessment, climate change and carbon risks are included in both the governance and environmental parameters of the analysis. In order to analyse ESG risks with greater precision, we have developed a pricing model to capture the influence of these factors on credit instruments Low carbon strategy The Global Equities team has identified five levers that asset owners can use to support the overall aims of the Paris agreement. With these levers in mind, we launched the Hermes Global Equity Low Carbon strategy in 2016 in the form of a segregated mandate. It has the explicit aim of avoiding companies that have material exposure to fossil fuels and a high carbon intensity, as well as companies that flout traditional SRI objectives. This includes companies with revenues from coal, oil and natural gas up to certain thresholds, including extraction, exploration and development. The strategy also avoids companies operating within sectors with recognised high negative social impact, including companies with material exposure to the production or manufacture of certain non-sustainable products that do not fulfil socially-responsible criteria. It also has a bias towards companies with favourable, best-in-class, ESG attributes. Each stock is analysed across multiple dimensions, factoring in market sentiment towards the company, to identify those with the most attractive combination of attributes to generate a portfolio that aims to maximise expected risk-adjusted return. The product s objective is to outperform the MSCI World Net Index by % over a rolling three-year period and with a target tracking error of 1-2%. The strategy has 105m AUM as of 30 June Our model depicts a relationship between CDS spreads and Hermes QESG Scores for the entire sample. It is important to stress that our analysis does not enable us to conclude whether better ESG behaviours cause lower spreads; rather, it establishes a correlation between the two. However, it is clear that issuers with higher QESG Scores have far tighter implied credit spreads than those with low QESG Scores, and we can now draw on this finding in analysing companies. Our investment and engagement teams collaborated to measure the ESG risks of these companies. Hermes EOS and the Responsibility team helped design the study s parameters, and we drew on the Global Equities team s proprietary system for measuring the ESG risk exposures of companies. This quantitative method combined specialist ESG research from Sustainalytics, Bloomberg, CDP and Trucost with fundamental insights gained by Hermes EOS through in-depth engagements with companies. For each company in the global stock universe, the team assigns a proprietary score for its exposure to the three ESG subcategories environmental including climate, social and governance and from this deduces a QESG Score (with Q denoting the quantitative process employed). The score not only captures a company s current level of ESG risk exposure, but also changes in various metrics that indicate the direction of travel. The QESG Scores range from 0 to 100, with a high score indicative of strong ESG policies and practices. uploads/sites/80/2017/04/hermes-credit-esg-paper- April-2017.pdf Hermes Global Equity Low Carbon Strategy The Global Equity team has identified five levers that asset owners could use to support the overall aims of the Paris agreement. Invest in companies with specific products and business strategies that support the transition to the low carbon economy (for example, producers of electric vehicles or wind turbines) Favour companies that are focusing on climate change management within their own business (for example, companies lowering carbon emissions) Allocate capital towards lower carbon intensive assets and companies less exposed to activities contributing to climate change Engagement & Active Ownership: Support efforts to limit climate change through public policy Encourage companies to consider how to reduce environmental impact and improve business performance Divest/exclude where a company is unable or unwilling to mitigate contribution to the threat of climate change

13 HERMES INVESTMENT MANAGEMENT NOVEMBER Private markets: governance and opportunities Our private market strategies, a central pillar to Hermes commercial strategy including real estate, infrastructure and private equity, have a governance structure and cover sectors that lend themselves more naturally to innovative opportunities arising from the low carbon transition and to active climate risk management. These include renewable energy, energy efficiency, demand side management and new services, technologies and products to facilitate carbon reductions. Across private markets our preferred approach to managing carbon risk is to use our rights and leverage as owners or shareholders of those assets and companies in which we are invested to influence practice and strategy. During the past year we have continued to deepen the collection and distribution of appropriate climate and carbon data and knowledge. This enables us to make more informed decisions when investing and to focus on identifying growth opportunities from our existing and prospective assets. Real estate: from intention to outcomes In our real estate funds, we mostly own and manage assets directly and since 2006 we have set long-term carbon emission reduction targets and integrated carbon management across our investment and asset management process. In 2017, we have focused on how to move from managing risk to delivering positive climate impacts, by cutting carbon emissions and scaling up energy efficiency measures. Our annual report outlines our detailed approach to managing carbon risk and opportunity as part of our responsible property investment strategy. It also describes our targets and how we monitor performance against them. Our carbon footprint shows continuous improvement in like-for-like and relative carbon emissions, although our absolute carbon footprint has increased because our portfolio has grown. On top of mitigation activities, we also manage and monitor extreme weather risks. Flood risk poses a significant threat to the longterm sustainability of assets in the UK. Real Estate: energy and climate targets and outcomes We have had carbon emission reductions targets since 2006 in Real Estate, where we have direct management control of our investment. Our Real Estate assets represent over 24% of our AUM and 80% of them are directly managed (as of 30 June 2017). In Real Estate we have set long term targets to reduce our absolute (tco 2 ) and relative to area (tco 2 /m 2 ) carbon emissions by 40% by 2020 from a 2006 baseline, aligned with European 2020 carbon targets. We also have operational targets to reduce by 5% year-onyear the absolute carbon emissions (tco 2 ) of our standing portfolio and our relative energy consumption (kwh/m 2 ). Since 2007, we have reported publicly our performance against these targets in our annual responsible property investment report. perspective/intentionality-outcomes-positive-impactinvestment-real-estate/ A comprehensive portfolio of UK real assets London Eurostar Sole operator of UK-to-Europe passenger train Hermes Greater London Partnership Providing office space within the M25 as residential conversion and business growth create demand King s Cross, London The UK s exemplar regeneration project: the completed scheme will provide 50 new buildings and 1,900 new homes on 67 acres Hermes Central London Partnership Joint-venture investing in core-plus offices generating total returns in excess of 22% p.a. since inception UK excluding London Braes of Doune, near Stirling 72MW capacity wind farm; 36 turbines Fallago Rig, Scottish Borders Fifth-largest UK wind farm; 144MW capacity; 48 turbines ASG I & II, Midlands and North England About 9,000 residential solar photovoltaic systems Thames Water Group, Thames Valley Largest UK water utility; 14m customers Anglian Water Group, East England Fourth-largest UK water utility; 6m customers Southern Water, South England Seventh-largest UK water utility; 3m customers Associated British Ports UK s leading port group with nation-wide operations NOMA, Manchester 20-acre mixed-use project in Central Manchester MEPC Silverstone Park, Northamptonshire 293-acre site being developed as a highperformance technology and logistics park The Centre:MK, Milton Keynes Regionally dominant shopping centre with about 1.2m square feet of retail space Milton Park, Oxford Centre of excellence for science and technology organisations Paradise, Birmingham Vibrant new office core in the city centre covering 1.8m square feet Wellington Place, Leeds Regeneration of 22 acres of land in central Leeds for mixed uses Factory outlets at Castleford, Braintree and Street Strong, stable income returns The Cargo Building, Liverpool 324-unit residential development in Central Liverpool Manchester Waters 164-unit residential development in Central Manchester Energy Assets UK s largest independent industrial and commercial gas meter provider Quadgas Consortium participation in National Grid s gas distribution network Key Wind farm Solar power High-speed rail Water utility Innovation park Energy metering services Port Office property Urban regeneration Residential property Retail property Gas distribution network

14 14 Since our 2006 baseline, emissions in Hermes like-for-like portfolio have fallen every year, at an average of 8% per year. For 2016, the likefor-like portfolio s emissions dropped 14%. The growing number of office properties in our various portfolios 123 in 2016 compared to 49 in 2006 explains the absolute increase in carbon emissions since Carbon emissions have increased 31% absolute (tco 2 ) relative to the baseline in office assets, while shopping centre assets have fallen 6% since Carbon intensity by lettable floor area is an important metric to monitor the progress made in sustainable lettings across the portfolio. Carbon emissions intensity is 57% lower in offices and 35% lower in shopping centres since In 2016, the downward trend in intensity continued for offices and shopping centres, with a 14% yearly reduction on During that period, carbon intensity fell in three quarters of our properties. Carbon emissions drop Yearly average since % Carbon intensity Carbon intensity in Offices 57% Reductions in % Carbon intensity in Shopping Centres 35 % Delivering outcomes through active operational management We provide context through case studies that demonstrate how we capture opportunities from improving energy efficiency and managing carbon risk. For example, a sample of five buildings typical of the varied property types in the Hermes RPM programme shows continued success in implementing an active management programme. When we bought these properties, they were energy-intensive assets. By engaging with property managers and occupiers, we have cut operational demand significantly, reducing carbon emissions by 43% across these five properties since In total, for these five properties, 3,108 tonnes CO 2 e have been saved since 2012 due to pro active energy management. Sustainable place-making for climate mitigation and adaptation Climate mitigation and adaption is naturally applicable to real estate as we invest in urban infrastructure development. Through such developments we can ensure that we encompass the needs of today s communities as well as those of future users and the wider environment. Integrating climate mitigation and adaptation measures as part of the development process offers the best way to future-proof both urban infrastructure and long-term investment returns. Physical risks: Flood risk management Flood risk poses a significant threat to the long-term sustainability of assets in the UK. Hermes is conscious of the ever-increasing risk of flooding, and seeks to mitigate the effects by regularly assessing flood risk mapping. Using the Environment Agency flood map, every year Hermes analyses the flood zone, the proximity of flood defences, and the level of flooding risk for each asset at risk within its managed portfolios. In total, four assets are at high risk of flooding, five assets at medium risk, 48 at low risk and 128 at very low risk. The high-risk assets are indirectly managed and so are encouraged to develop a flood risk action plan. By assessing the flood risk every year, we ensure we are aware of the shifting risk that flooding poses and have plans in place to mitigate that risk. For the last five years, through the Global Real Estate Sustainability Benchmark (GRESB) global sustainability benchmark, we have measured our performance against our peers and we have reported actual carbon emissions data. The way to future-proof buildings for the benefit of our investors is to make sure they are in a sustainable, socially inclusive environment. It s not just the building that s important but the amenity value of its location in terms of infrastructure and public realm. You need only look at the great estates of London to understand that they have endured because the integrity of the estate has been maintained, as much as the buildings. Chris Taylor, Head of Private Markets, Hermes Investment Management Carbon emissions reduced across five properties since %

15 HERMES INVESTMENT MANAGEMENT NOVEMBER Sustainable place-making at Wellington Place Leeds, MEPC Wellington Place is perfectly located, with exceptional transport links, and offers flexible office accommodation, outstanding amenities and green spaces. The landscaping of the built environment and the grassed open spaces of the site represent a spectacular use of land in the centre of Leeds. The stunning public square and open boulevards with biodiverse planting, along with the outside space for community events, all contribute to a pro-active approach to climate adaptation. In 2016 we saw the completion of 5 Wellington Place (75,000 sq ft) and 6 Wellington Place (106,000 sq ft), together with Tower Square, helping to meet demand of Grade A office space in Leeds. The new buildings incorporate a climate mitigation approach with a Certified BREEAM Excellent score and high energy performance thanks to an Energy Action Plan and a B-rated energy performance certificate (EPC); water use on site has been minimised, cutting water use by 55.5% compared to baseline; the waste management plan led the contractor to minimise waste to exemplary levels, with 3.88t/100m 2 of waste being generated, and 92.8% of waste being diverted from landfill; soft landing with extensive commissioning, including air pressure tests and thermographic surveys, seasonal commissioning and aftercare support with detailed handover documentation ensure the building will operate as designed. The market clearly showed the demand for sustainable places, with 6 Wellington Place fully let within three months of practical completion and the government announcing that Wellington Place will house a brand-new government hub that will see 6,000 HMRC and NHS Digital civil servants take up residence in the coming years. Infrastructure s longevity Today, decarbonisation is a clear societal trend, with the longevity of an infrastructure asset now inextricably linked to its environmental credentials. Decarbonisation has also increased the role of renewable energy in supplying the nation with power. This is an area Hermes understands well. We have a number of onshore wind farms and solar energy assets in our infrastructure portfolio. Other industries such as rail transport, ports and energy metering offer similar opportunities. In infrastructure the fact that we take direct equity stakes in operating businesses provides a platform to directly engage on and influence strategic risk and opportunity management. During 2016 and 2017 we have continued to analyse and develop a detailed profile of ESG and carbon risk and opportunities for each of our individual infrastructure assets. Enhanced governance for long-term returns For infrastructure assets, robust governance is paramount to enable ESG integration and climate risk management to be integrated effectively into strategic thinking. We aim to incorporate best practice in the structure and operations of our portfolio companies, from advocating for independent and direct board representation and robust management of conflicts of interest to undertaking independent valuations of our portfolio investments. Strengthening governance is an important focus in this asset class and we have been an active voice over the last two years engaging with the UK Government, BEIS, and sector regulators (OFWAT and OFGEM) to advocate establishing an enhanced corporate governance code specifically for essential service infrastructure assets. There is increasingly robust evidence of the relationship between well-governed companies and higher long-term returns. We believe that, in many cases, the long-term interests of the company, its stakeholders and its shareholders will overlap. Indeed, there is increasingly robust evidence of the relationship between wellgoverned companies and higher long-term returns. Short-termism and a lack of focus on ESG issues, including climate change, can erode long-term shareholder value. We promote best practice governance systems, processes and procedures that encourage companies to proactively consider ESG matters, avoid tick box exercises, effectively monitor outcomes and facilitate innovation. We strongly believe an enhanced governance toolkit for infrastructure businesses, which ensures that the interests of stakeholders (including end users, communities and employees) feature appropriately in the minds of directors, would be valuable. 55.5% Water use on site has been minimised, cutting it by 55.5%

16 16 Climate risks, resilience and opportunities Through initial due diligence before acquisition and on-going engagement with our infrastructure assets, we have been able to gain a good understanding of our assets, and assess their carbon risks and opportunities as well as the strategies in place to address and mitigate them. Of Hermes Infrastructure s direct portfolio, 98% of assets under management measure their carbon footprint. Of these, assets representing 83% of the total direct portfolio have carbon emissions targets and a carbon policy, whilst the remaining 15% are renewable energy assets that offset carbon as a primary function. We have initiated and continue to drive engagement with co-investors and companies on the topic to ensure climate risk is being considered and managed, where relevant, and opportunities are included as part of the assets business plans. We also contribute to the GRESB infrastructure sustainability benchmark, which also covers funds and assets climate change and carbon policies and performance. Of Hermes Infrastructure s direct portfolio, 98% of assets under management measure their carbon footprint. Of these, assets representing 83% of the total direct portfolio have carbon emissions targets and a carbon policy, whilst the remaining 15% are renewable energy assets that offset carbon as a primary function. Climate control review In late 2016, Hermes Infrastructure undertook a portfolio level review of climate risk, resilience and opportunities, leading to continued development of our strategic engagement priorities in this area. By benchmarking against the 2016 UK Climate Change Risk Assessment Evidence Report commissioned by the government, Hermes Infrastructure has identified: The key potential risks to our portfolio, including direct asset damage and business interruption caused by extreme weather events (including flooding, extreme heat, extreme cold and/or water shortages); The key opportunities, including higher demand for energy efficiency-related goods, services and technology, continued funding and subsidies for clean energy; The potential impacts of the decarbonisation agenda on future investments, such as how a potential carbon price increase would affect energy intensive sectors. Infrastructure for the transition to a low-carbon economy Infrastructure assets offer many opportunities to tap into the growth potential of a low-carbon economy. Over the years, while investments were not driven by an explicit climate focus, we find that regulations and market demand have led to a portfolio that includes a large percentage of asset types that contribute to the low-carbon transition, from renewables and water management to low-carbon transport and energy efficiency. We have a strong historic focus on renewable energy, having invested in four renewables fields in the UK, representing 15% of total assets that offset carbon as a primary function. The wind farm assets, Fallago Rig and Braes of Doune, and solar assets, A Shade Greener I and A Shade Greener II, offset a combined 269,000 tonnes of carbon dioxide each year. Our water assets publicly disclose their GHG emissions on their websites using the annually updated UK Water Industry Research Carbon Accounting Workbook (CAW). We have a strong historic focus in four renewable fields: Wind farm Water Solar panels Transport The infrastructure team have made significant investments in sustainable transport and the detailed due diligence included assessment of the carbon risks and opportunities of these assets. In 2015, in a consortium with Caisse des Depots et Placement du Quebec, we acquired a minority interest in Eurostar Hermes bought a 10% stake and Caisse des Depots et Placement du Quebec took a 30% stake. In the same year we acquired a 40% stake in Associated British Ports ( ABP ) in a consortium with the Canada Public Pension Investment Board ( CPPIB ). Eurostar reports on carbon emissions and progress against its set goal to reduce carbon dioxide emissions by 25% and has been certified to the Certified Emissions Measurements Scheme (CEMARS) since August Our investment in Energy Assets directly taps into the growing regulatory and market focus on energy efficiency investments. Energy Assets leases advanced metering and data recording devices, which are required to be installed as part of the UK Government s mandatory programme to replace existing older generation utility meters, in addition to providing associated metering services. Energy regulator OFGEM believes the requirement to replace older utility meters should drive real energy efficiency gains across the energy sector. Consumers, suppliers and the energy system operators will have access to detailed, real-time information in respect of energy usage and system demand profiles enabling effective demand side management and reduced energy consumption and carbon emissions.

17 HERMES INVESTMENT MANAGEMENT NOVEMBER bn ABP owns and operates 21 ports in GB, and contributes 5.6bn to the UK economy every year. ABP is the UK s leading ports group. It owns and operates 21 ports in Great Britain, and contributes 5.6bn to the UK economy every year. The ABP-owned Ports of Hull and Immingham have state-of-the-art handling facilities for biomass imports to supply the Drax power station in North Yorkshire. Drax provides about 7% of the UK s electricity supply from its generation facilities, supporting the transition away from 100% coal reliance. There is a tie-in, too, with renewable energy as a growing number of offshore wind farms require access via ABP ports. ABP, in partnership with Siemens and alongside Hull City and East Riding Councils, is promoting the development of a dynamic renewable energy sector in the Humber region, including the landmark Siemens facility, Green Port Hull. Private Equity opportunities for growth creation from the low carbon transition As a private equity investor, our investment strategy lends itself well to growth opportunities arising from the innovation needed to deliver a low-carbon economy. We invest on a globally unconstrained basis, focusing on the regions, sectors and companies that we believe present the most attractive opportunities. Using macroeconomic and targeted private markets research to inform our alpha-seeking investment decisions across both developed and emerging markets, we assess the growth trends that we believe will shape global economic activity in the medium to long term such as demographics, natural resources and, most importantly, innovation. Environmental issues such as climate change are disrupting almost all sectors and, consequently, can catalyse compelling investment opportunities. Private equity s innovation as opportunities Moving capital flows according to the Paris climate agreement s objectives and the science-based findings means there will be a tectonic shift in low-carbon investments in the medium term. Already we are seeing a large number of low-carbon innovations driven by private companies, so private equity is well-positioned to capture the upside of these markets, with our focus mainly on carbon opportunities.

18 18 Taking advantage of the opportunities created by the low carbon transition and regulatory drivers is not always about buying best-in-class performers. Sometimes it can be better to find a laggard that has committed to change. At other times low-carbon opportunities are indirect and not captured by carbon data, such as in companies producing lightweight material for transport or service companies. We have sought to pursue these in one of our funds that was established to invest in high growth potential opportunities in the environmental technology sector. In particular, the fund holds investments in the low carbon and cleantech industries focusing on energy and resource efficiency including the low carbon, circular economy, advanced materials, waste and water segments. Typical examples that arise from the low-carbon economic transition include: EcoIntense offers an easy-to-use, end-to-end software platform enabling all (geographicallydispersed) stakeholders to communicate Berlin-based EcoIntense offers an easy-to-use, end-toend software platform designed to enable companies to capture, analyse, manage and report relevant Health, Safety and Environmental (HSE) information. The product acts as a centralised communication platform enabling all (geographicallydispersed) stakeholders to communicate, capture data and manage assessment/reporting and enabling more effective demand side management of energy and utilities. As part of the wider due diligence process, we identified a number of positive operational attributes, including the use of data centres powered wholly by renewable energy sources and a robust approach to cyber security. As part of our engagement process, we also identified gaps in governance, which Hermes GPE will help to remediate, including the drafting of a formal ESG policy. Hermes GPE invested in EcoIntense as part of a consortium led by One Peak Partners and Morgan Stanley Growth Capital. Flyleather s carbon footprint 80% Smaller than traditional leather UK-based firm E-Leather provides an eco-friendly material that out-performs traditional leather, faux leathers and fabrics. Manufactured using leather off-cuts that would otherwise end up in landfill, it reduces the environmental and economic costs of producing upholstery material. E-Leather is gaining market share as operators experience the clear financial and performance benefits it offers in the aviation, bus and rail industries. Recently it has partnered with American sportswear giant Nike to manufacture Nike s latest super material Flyleather engineered specifically with the company s long-term business and sustainability goals in mind. The material is made with recycled leather fibres that are melded together with a polyester blend, allowing for more flexibility than traditional leather. Flyleather boasts a carbon footprint 80% smaller than traditional, full-grain leather and it uses 90% less water to produce, according to Nike. Hermes completed a major growth round for E-leather in September 2017, an investment we co-sponsored alongside a smaller growth fund. The fund completed its investment period in December 2015, with 118m committed across 11 funds and 10 co-investments (two now exited). While the sector has faced a number of challenges over the past five years, many of the fund s portfolio companies boast highly compelling offerings and are now growing extremely quickly. For instance, one portfolio company uses a major waste stream to produce an advanced material in demand across several markets. Another provides innovative solutions that enable large industrial and commercial entities to dramatically improve water efficiency while reducing waste water output. The adoption drivers, both economic and environmental, are highly compelling and likely to become more so as the impacts of climate change become increasingly pronounced. Carbon risk monitoring We are still investigating how best to measure the carbon risks and footprint of our more numerous and relatively small private equity investments, and how to integrate the findings into our investment processes. While typically challenging to quantify, assessing carbon risk forms an important part of our ESG review and it is a topic around which we plan to increase portfolio engagement. This year the focus of our work has been on assessing ways to best measure risks, through an in-depth review of co-investment opportunities and conducting a pilot climate risk survey. During Q3 2016, we conducted a pilot climate risk survey across our Environmental Innovation Strategy and underlying companies within the portfolio. The results revealed that 80% of fund managers assess the risks and opportunities of climate change on existing and new investments, while 60% engage and work with their portfolio companies to factor climate change risks and opportunities into business processes and strategy. 60% of the respondents said they actively assess the possible legal, financial and commercial impacts of climate change on their business, with 40% and 20% measuring their direct and indirect carbon footprint respectively. While the FSB TCFD recommendation do not apply directly to private equity companies, at the PEI conference in September 2017, participants acknowledged the need to prepare and to take advantage of the positive elements of the voluntary recommendations. Private equity general partners (GPs) and many limited partners (LPs), would welcome additional support to increase management of climate risk and opportunities, integration and disclosure in the private equity sector. In 2016 we contributed to the development of guidance on this area with the PRI and the IIGCC, aimed at institutional investors who are LPs in private equity funds or private equity fund GPs managing such funds. This year we are supporting the PRI work in developing a guide for integrating ESG into private equity.

19 HERMES INVESTMENT MANAGEMENT NOVEMBER OUTCOME #11 Our investment in King s Cross has a strong ethos of community provision: new schools, public parks and open spaces.