How do investors address climate risks?

Abstract How do investors address climate risks? Niklas Kreander 1 and Ken McPhail 2 World leaders agreed to limit global temperature rise to two degrees in Paris in 2015 in an effort to avoid dangerous climate change. Climate change will create new risks (IPCC, 2014). The Governor of the Bank of England has raised concerns about the financial consequences of climate risks (Carney, 2015). Climate change issues can impact returns (Mercer, 2015; NBIM, 2015). These risks have consequences for sector allocation for portfolios (Deutsche Asset Management, 2017). Yet many pension funds gamble on climate change (Mathiesen, 2015). Managing climate risk well is important. This paper examines how this is done among some leading institutional investors. How does one invest successfully within a two degree scenario? How do investors address climate risks? Drawing on interview evidence from leading investors in Norway and the UK we outline best practice and provide recommendations for the way forward. Findings indicate some contradictions between policy and practice for some investors. 1. Corresponding author: Niklas Kreander, University College of South East Norway 2. Ken McPhail is professor at the University of Manchester Early draft, please do not quote without permission

Introduction There is increasing consensus that the global climate is changing (IPCC, 2014; Carney, 2015). To address the many challenges related to climate change world leaders agreed in Paris in December 2015 to try to limit the global increase in temperature to two degrees. Even if this would be successful, climate risks still have significant implications for investors and others (BlackRock, 2016; Deutsche Asset Management, 2017). However, many agree that current policy pledges are not sufficient to reach the two degree goal and thus climate risks are likely to hit investors and others even harder (BlackRock, 2016; Cicero, 2016). Traditionally asset managers have considered risk and return, but environmental risk has not been part of this (ACCA, 2009). Indeed, concerns have been raised that even in recent times many pension funds and other institutional investors have not adequately addressed climate risks and opportunities (Mathiesen, 2015; Asset Owners Climate Ranking). This raises questions for insurance companies, pension funds and other investors. How should they integrate climate change related risks into their investment approach? This paper explores the question: How can a large investor invest sensibly within a two degree framework? Environmental NGOs call for divestment of the entire fossil fuel sector and for a shift to electric and hydrogen cars and more public transport. Under the two degree scenario the share of coal in electricity generation would decline dramatically by 2040, while renewable energy would increase (UBS, 2017). Insurance companies struggle with more claims from flooding and storms. How should a prudent asset manager consider these shifts and transitions in their investment portfolios? This paper explores these themes through interviews with fund managers and examining the literature. We also consider literature from the asset managers. Climate Change Climate change is the shift in temperatures, precipitation levels and extreme weather due to the greenhouse gases prevalent in the atmosphere (Standard Life, 2016). The latest IPCC report argues that it is very likely that humans have been the main cause of climate change over the last 60 years. Greenhouse gas emissions increased by 80% from 1970 to 2010 (IPCC, 2014). Because of this greenhouse gas concentrations are higher than they have been for over 500 000 years and the sea rise is faster than for over a 1000 years (Carney, 2015; IPCC 2014). This has very serious economic consequences. Insurance losses from weather related events has more than triple from the 1980s to around $50 billion in the last decade (Carney, 2015). The Economist has

estimated that value at risk from climate change to $4,2 trillion. Global GDP could decline significantly due to climate change (Stern, 2006; Blackrock, 2016). Even more serious is that more than 100 million people are at risk from water stress, heatwaves and sea level rise even if the two degree goal is achieved, if no action is taken twice as many people will be exposed (Deutsche Asset Management, 2017). Climate Change risks for investors We will briefly outline some risks and focus on the implications for investors. More detail about the risks can be found in IPCC (2014). A good economics based summary of climate change risk can be found in Hjorth (2015). There is a concern that climate risks are underpriced (AP4, 2014). Physical risk There has always been variations in weather and natural disasters. Yet scientist believe these risks have increased due to human activity (BlackRock, 2016). The two main aspects of this is more extreme weather events such as flooding, fires and storms. Second, rising temperatures and sea levels. Climate change may entail greater risk for flooding in the future 1. This can result in losses for insurance companies and real estate owners including companies in different sectors in addition to investors. Heat waves increase risk for fires and crop failures, which can claim many lives. These physical risks can vary substantially in different regions, but are likely to affect many hundred million people. These physical risks result in legal risk for firms. In Germany a farmer from Peru is challenging the energy giant RWE in court for compensation linked to climate change (Guardian, 2017). In the Philippines there could be a human rights motivated claim against large energy companies including Shell and Total from Europe (Vidal, 2016). The claim is that storm damage caused by climate change has breached the human rights of people. Insurance claims from extreme weather events such as storms and floods have surged in recent years (Carney, 2015). In Norway environmental NGOs have taken the state to court in an effort to stop some arctic oil exploration. It is likely that we will see more lawsuits related to climate change and energy and oil companies may be especially targeted in such legal action. 1 For example the Norwegian regulator NVE has produced regional reports which predicts greater levels of flooding which will mean that some areas become unsuitable for human habitation.

Political risk Taxes on carbon and restriction in use of carbon can affect especially fossil fuel and energy firms. Some countries may place heavier regulation on coal power plants. However, many other high impact sectors can also be affected by more stringent regulation, for example the cement and steel industries. Many cities in Europe imposed restrictions on the use of diesel cars in 2017. This has implications for the automobile industry as demand for diesel cars plummet. Transition risk Climate change implies many types of transitions. People will have to move to other areas and change occupation. We have seen how challenging managing the migration from the middle east and Africa to Europe has been in recent years, climate change can amplify migration by rendering areas unhabitable. Industries will need to change and adapt to climate change. In addition to obvious sectors such as automobile and real estate, transition risk is also material for banks, chemical, iron & steel, pharmaceuticals and the semiconductor industries (Deutsche Asset Management, 2017). This also involves technological risks as the demise of diesel cars and the race to develop electric and hydrogen cars show. Implications for investors Many investment portfolios may be overvalued because climate risk is not sufficiently factored in (AP4, 2014). If IPCC (2014) are right when they state that only 20% to 25% 2 of the known fossil fuel reserves can be utilized if global warming is to be limited to two degrees this has serious implications. The carbon budget suggested by IPCC (2014) mean that most coal and some of the existing oil reserves cannot be used, see also Carney (2015). This means that not only many firms with business linked to thermal coal may be overvalued but also many oil companies and many firms supplying the oil industry. For example Mercer (2015) and Deutsche Asset management (2017) estimates that the oil and coal industry will suffer at least 1% reduced returns annually, while returns could be down to 4% for oil and 5% for coal companies over a 35 year period. For example, the largest fund in Europe the 2 IPCC 2014 states that existing fossil fuel reserves exceed what can be burned by 4 to 7 times. Thus in the worst case only 15% of known fossil fuel reserves could be used (and maximum 25%) consistent with a two degree scenario (IPCC, 2014, section 2.2).

Government Pension Fund Global from Norway states that: The scientific basis for climate change is widely accepted climate outcomes may affect company and portfolio return over time.» NBIM (2015). Even in the short term (under five years) portfolios of different types can suffer losses of 10% under a two degree scenario according to modelling done by the University of Cambridge (Deutsche Asset management, 2017). Climate related opportunities for investors There is a need for a significant energy transition away from fossil fuels towards renewables. For example, Mercer (2015) estimate that annual additional positive returns for the renewable energy sector could be up to 3% annually over a 35 year horizon. Some investors think that natural gas could be the winner in the short to medium term. There is also a need to improve energy efficiency across sectors. This presents opportunities (Kapital Article Soros manager). Some financial institutions such as KLP and Pansjon Danmark invest directly in renewable energy projects. Warren Buffet have also made large investments in solar projects. Dimson et al., (2015) show that investor engagement on climate change can lead to positive change but it takes time and collaboration. Here is also an opportunity as Dimson et al., (2015) and Becht et al., (2009) have shown that engagement can both change practice and create value. Method We interview leading financial institutions on climate change in Norway and the UK. Interviews were done in Bristol and Oslo in 2016 and 2017. A first write up of the interview was done shortly after each interview. Interviews were semi structured and lasted about one hour. All interviewees had long experience of Socially responsible investment including climate change. We also specifically interviewed individuals and organisations known for expertise in the area such as the Environment Agency Pension Fund in the UK and KLP in Norway. Both have been rated as best financial institutions in their countries for addressing climate change. We have also interviewed the Council on Ethics for the Norwegian Government Pension Fund Global. We pursued purposeful sampling (Patton, 2002). We study the literature on climate change and investment. We specifically wish to include literature from Asset managers as this is important for addressing our research question. Insert Table of interviews

Findings We first discuss why some investors integrate climate considerations into their investments, then we outline some Strategies for dealing with climate change based on our interviews and the literature. For example our interviewee in the Environment Agency Pension Fund said that Climate Change was the most significant ESG risk. A challenge for investors here is lack of high quality data on carbon emissions. Our second KLP interviewee said the data quality has been terrible. Why consider climate change in investments The Norwegian financial institution KLP mentioned three key reasons for responsible investment of which addressing climate change is an important part. First, customers expect a responsible investment approach. KLPs customer base includes municipalities and health sector clients. Second, KLP believes that companies that address sustainability issues well are more likely to create value in the long term. Third, given the challenges linked to the Paris Agreement and climate change everyone needs to do their part (KLP 2017, interview). The Environment Agency Pension Fund (EAPF) mentioned that their beneficiaries work for the Environment Agency which is involved in flood defence. Their employees who wade to their hips in water in English towns because of floods expect climate factors to be considered by their pension fund also. Our EAPF interviewee also argued that considering climate change leads to risk reduction. He also noted that companies poorly prepared for climate change may be squeezed out of the market. The Norwegian Government Pension Fund (GPFG) has for a number of years had climate as a focus area, meaning that climate issues have been brought up in engagement with some firms. It is only from 2016 that the GPFG have had formal coal exclusion criteria. This was an initiative by the labour party in Norway, although environmental NGOs had suggested it earlier. 3 The initiative got strong backing in the Norwegian Parliament and the coal related criteria came into force in January 2016. For the GPFG it was a political process combined with NGO campaigning that resulted in stronger criteria for coal. Divestment/Exclusions The global carbon divestment movement has grown to over $5 trillion (Deutsche Asset Management, 2017). There is a large divestment movement of coal stocks especially. For example, KLP and GPFG 3 The original proposal had more stringent criteria including a 25% cutoff for coal, after negotiations parties agreed on a 30% cutoff. Companies with a higher turnover from coal were to be excluded.

from Norway have divested more than 60 coal companies (either coal mining companies or energy utilities for which coal power is over 30% of the power source or income). KLP stated that you get a lot of bang for the bucks by excluding coal companies. «By excluding coal we exclude 1% of the portfolio and get a 25% reduction in carbon footprint» KLP Interview 2016 However KLP also argued that excluding oil firms would be a step too big to take. KLP mainly follows a passive index based strategy so this would be impossible for their Norwegian and Europe based funds if the oil industry was completely excluded. The Council on Ethics for the GPFG is also looking into operationalizing another carbon criterion linked to an unacceptable level of emissions. We asked them in 2016 what is an «unacceptable level of carbon emissions»? Our Interviewee answered: «Nobody knows», yet the Council was working on operationalising the criterion. Other large investors part of this divestment movement include ABP, Aegon, Axa, Alliantz, Aviva, the Swedish AP4 Pension fund and the Dutch pension fund PFZW (Deutsche Asset Management, 2017). Some French institutional investors and London borough pension funds have also joined the divestment movement (PRI conference 2017). Engagement with companies and sectors This engagement also includes voting of company shares. These campaigns have really gained momentum. For example 62% of Exxon shareholders voted for a resolution calling for a shareholder resolution calling for Exxon to report on portfolio impact and scenarios consistent with limiting global warming to 2 C in 2016. A similar motion at the Occidental Petroleum AGM got 67% of the votes (www.5050climate.org). For example, GPFG, KLP, Aviva and the Environment Agency Pension fund actively vote their shares on climate change issues. AXA a French insurer meets with coal companies about climate change, if there are no improvement the coal firms risk divestment. There is a new campaign which will target 100 of the top CO2 emitting corporations in the world. Investors who have pledged to target these firms include the large US pension fund Calpers and the financial institution Schroeders (PRI Conference, 2017). KLP is a Norwegian Financial institution which has in recent years engaged with over 20 companies specifically on climate issues.

Direct investment in progressive sectors and projects KLP has invested in new solar and wind projects in Africa and South America in partnership with Norfund. These are infrastructure projects resulting in new renewable capacity. KLP decided that just excluding some coal firms would not make such a big difference and therefore committed to use the money instead to fund renewable projects in developing countries where the alternative often is coal (KLP interview, November 2017). KLP also invests in renewable energy projects in Norway and the rest of Europe. Thus KLP has invested over 20 billion NOK in renewable energy and further investments are being made (KLP Interview 2017). Pensjon Danmark and Warren Buffet also invest directly in renewable energy projects. The EAPF also do this and try to be very careful with what projects they invest in as our interviewee mentioned that there is a risk of being tied up in these investments for many years. Infrastructure investments of course have much more liquidity risk than equity or bonds. Other strategies Environment Agency Pension fund factors in shadow prices for carbon into investment models (EAPF interview, 2016). This means that even if companies are not formally excluded, for example the most coal intensive firms do not enter the portfolio. It also leads to the oil sector being underweighted. The Environment Agency Pension Fund has as a goal to reduce its coal exposure by 90% by 2020 and the oil exposure by 50% (EAPF, 2016 interview). The carbon footprint of the EAPF went down 44% from 2008 to 2015. Data quality is also a challenge (Council on Ethics and KLP interviews). Because of this KLP has worked 10 years with Carbon Disclosure Project to improve company reporting on Greenhouse Gas emissions (KLP Interview 2017). The Council on Ethics interviewee said that everyone is talking about climate change but no one has data. Another possibility is to increasingly switch to low carbon benchmarks. For example, FTSE provide such indexes for investors. The Bank of Norway has recently argued that the oil fund should exclude oil companies from a purely economic perspective (Given the large oil exposure Norway has through Statoil and its own oil reserves, Norway is more exposed to the oil sector than most countries even without any other oil investments). Engagement with standard setters and industry initiatives were also mentioned as effective tools (KLP Interview). Interviewees from NBIM have also mentioned this.

Another important aspect of the responsibility of EAPF, GPFG and KLP is transparency. They all publish their holdings and details about their voting in addition to a lot of information about climate and other sustainability issues relating to investments. Conclusions Our research indicates that institutional investors deal with the issue of climate change in different ways. The main strategies were: 1. Divest/Exclude some coal firms. 2. Engage with high impact firms and sectors about climate change. 3. Direct investment in renewable energy projects. 4. Other strategies, including using a shadow price for carbon in investment models, focusing on low carbon benchmarks and working with others to improve data quality. These strategies are not mutually exclusive and all the institutions we interviewed used more than one of the strategies. We think divestment of coal shares can reduce the carbon footprint substantially with little or no effect on the portfolio. While no one is excluding major oil companies 4, the EAPF is an example of a pension fund which has produced excellent returns while underweighting the oil sector. Engagement has the potential of changing company practice, this can be very helpful for energy companies which can move towards a less carbon intensive way of producing energy and electricity. Engagement may be more limited with firms where a large majority of revenues come from coal. Academic studies have also confirmed that engagement can change practices and have positive financial consequences (Becht et al., 2009; Dimson et al., 2015; New LSE study presented at PRI, 2017). Direct investment in renewable projects can help a shift to more low carbon economy as well as providing good returns as KLP and Norfund have shown. In addition they can provide electricity to new areas and much needed employment, especially in developing countries. The problem here can be low liquidity and a long tie in. The mandates of some investors may not allow such investments, this is so for the GPFG for example. There is great potential we believe in ensuring that more fund managers incorporate a shadow price for carbon into their investment models. This price may need to be higher than the current market 4 A Norwegian insurance company Storebrand has said it may exclude some companies involved with oilsands and the fund of the Church of Sweden has indicated it may avoid some oil firms.

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