Pension funds are beginning to be seen— and seeing themselves—as “universal owners” of a slice of the entire global economy in a new paradigm of “fiduciary capitalism.”
WHY CARE?
There are a number of compelling reasons for Canadian pension fund investors to care about climate change.
First, the competitive and financial impacts of climate change regulation are already affecting companies in the international portfolios of Canadian pension funds, in Europe and elsewhere. Also, impending regulations in both Canada and the United States will soon impact the equity valuations and credit risk of their portfolios in North America as well. And finally, with variations in samesector company risk exposures to climate change varying by as much as 30 times, fiduciary best practice simply demands it.
Research on the Carbon Disclosure Project(CDP)coupled with advisory work for investors, corporates, governments and NGOs in more than 20 countries, has resulted in in-depth research profiles on more than 1,500 companies. This research has yielded a number of insights and conclusions, which we believe to be highly material for Canadian pension fund investors.
• Global industrial restructuring toward a “low carbon” future has already begun.
• Investment risks are much more broadly (and unevenly)distributed than previously thought—both between and even within industry sectors.
• Climate risk has three dimensions, not just one. Any thorough investment analysis must consider companies’:
– Overall risk levels;
– Risk management capabilities; and
– Ability to identify and capture upside profit opportunities.
• While more investors are now paying attention, most are a long way from integrating the net climate exposure of their assets into actual investment strategies.
• Investors can make money from climate change—and some are already doing so.
OUTPERFORMANCE
There is already a rich body of finance literature strongly suggesting that companies with superior environmental management and strategic positioning are simply better-managed companies overall and therefore, better risk-adjusted investment candidates. As the “mother of all environmental risks,” climate change has naturally emerged as a primary leading indicator for companies’ environmental—and overall—management quality and therefore, for their medium-term financial performance. In order to assess the financial relevance of superior carbon management, a preliminary portfolio analysis was conducted measuring the stock performance of international “climate leaders,” benchmarked against same-sector global competitors.
In order to conduct a three-year test of the actual financial performance of climate leaders, we selected the 21 best-in-class companies from 2002, the first year of the CDP, using the same methodology that we used in constructing the Climate Leaders Index©(CLI)for the two subsequent years. We then assumed that a “buy and hold” investment strategy was in place and tracked the financial performance of the best-inclass portfolio over the three subsequent years, benchmarked against a comparably weighted, sector-neutral index of their same-sector peers.
As demonstrated, the climate leaders portfolio, comprised of the 21 best-in-class global companies from 12 designated highimpact sectors, outperformed its benchmark of same-sector FT500 peers from June 2002 to June 2005 by an annualized rate of return of 2.3%(a cumulative total return of 42% against 35%).
MONEY ON THE TABLE
Some international institutional investors are beginning to translate their concerns over the financial risks of climate change into aggressive shareholder engagement with their portfolio companies. What is somewhat surprising, however, is the relative absence of institutions taking their concerns to the next logical level— asset allocation strategy, stock selection and portfolio construction. Very few of even the most proactive public sector institutions have adopted concrete investment strategies that utilize climate risk analysis as an explicit input into actual security selection and portfolio construction. Despite compelling evidence that such analysis can both identify hidden investment risks and companies with superior strategic management, very few have, so far, taken advantage. To the best of my knowledge, none of these is in Canada. So far.
Historically, mainstream institutional investors have, almost without exception, accepted the conventional “wisdom” that the pursuit of corporate “sustainability”— that is, superior performance on environmental and social issues—could only be achieved at the cost of higher risk for investors, lower financial returns, or both. An important corollary of this argument has long held that since environmental and social factors are, at best, irrelevant to the risk/return equation and, at worst, injurious to them, fiduciaries should actually be precluded from considering them. It turns out, of course, that both the conventional wisdom and its corollary are quite wrong-headed.
The “prudent fiduciary” equation is now inexorably—and quite rightly— being turned directly on its head. Since there is now growing if not incontrovertible evidence that superior environmental performance can, in fact, improve the risk level, profitability and stock performance of publicly traded companies, fiduciaries can now be seen to be derelict in their duties if they do not consider environmental and social performance and risk factors. Canadian pension fund trustees, investment staffs, external advisers and money managers have a major opportunity today to improve their risk-adjusted returns by systematically integrating climate considerations into their investment strategies. The proverbial “20-dollar bill” is now lying, in plain sight, on the sidewalk. All pension funds need to do is bend over and pick it up.
Dr. Matthew Kiernan is founder and chief executive of Innovest Strategic Value Advisors in Toronto. mkiernan@innovestgroup.com
Climate considerations and financial performance can work together. Investors in Canada are increasingly linking company performance on environmental, social and corporate governance(ESG)factors and investment performance. By integrating ESG considerations into investmentmanagement processes and ownership practices, investors hope to protect and enhance the performance of their investments, particularly over the long term. Plan sponsors and investment managers can now utilize third-party research to identify leaders and laggards in corporate environmental performance and to assess the risks that ESG issues pose to their portfolios. Increasingly, research firms assess and/or rank corporate environmental performance, allowing investors to analyze existing portfolios and develop new products focused on environmental risk and opportunities. Some of this research allows investors to measure the “carbon footprint,” the carbon dioxide emissions of their portfolio holdings. A carbon footprint calculates the carbon emissions and carbon intensity of the underlying holdings, enabling comparisons between companies and sectors as well as the potential environmental consequences of different investment strategies. NEW OPPORTUNITIES A number of compelling developments, such as a more certain regulatory framework, international targets for greenhouse gas reductions, and the commercialization of clean technologies, are the catalysts for a range of new investment products that focus on financing the shift to a lowcarbon economy. These opportunities often include investing in new companies or in existing companies offering pollution abatement, energy efficiency, new energy sources or water technologies. Often called “cleantech,” this type of alternative investing has become an industry in itself. Among the several groups tracking venture financing, policy developments and major business deals is the Cleantech Venture Network, which stimulates investment into venturegrade companies deploying “clean technologies.” According to the Cleantech Venture Network, cleantech investments were more than US$3.6 billion in Europe and North America in 2006—a 45% increase over 2005(US$2.5 billion)—and have doubled since 2004 (US$1.7 billion). As the market grows so does investment manager research and analysis. Research can be organized by “eco-theme” such as clean energy, timber, water, carbon and materials efficiency. While products being evaluated are mainly private and public equity products, consideration may be extended to real estate and commodities. Investors who wish to address the risks and opportunities presented by climate change can undertake a number of actions such as: • Build an understanding of climate-related risks and opportunities through targeted training for trustees and/or investment staff; • Integrate climate change considerations into investment policies, strategies and governance processes; • Review and develop approaches to active ownership(shareholder engagement, proxy voting)that considers climate change issues; • Conduct a carbon audit(or footprint)to quantify and monitor the carbon exposure of investment portfolios; • Assess the capacity and capability of current and prospective investment managers to integrate climate change into their investment processes; and • Identify climate change-related investment opportunities(such as carbon trading or clean energy). Investors in Canada and around the world have become more interested in how their investment managers approach climate change and other ESG issues, and are increasingly seeking to ensure that their managers consider these issues during portfolio construction. Investment managers can be key players in bringing climate change-related analysis into the investment management process. Having rated the practices of 90 investment managers around the world, including more than 20 Canadian managers to date, research indicates that some managers are formally incorporating environmental factors into investment decision making and management processes. INVESTORS COLLABORATE A demonstration of growing investor interest in climate change and coordinated investor action on the issue is the Carbon Disclosure Project(CDP), a global initiative under which investors have joined together in asking companies to disclose investmentrelevant information concerning their greenhouse gas emissions. The CDP now has 27 signatories from Canada who collectively manage more than $1 trillion in assets—half the market capitalization of the TSX. CDP signatories globally represent more than $41 trillion in assets. This is not an insignificant influence on corporate management of climate risk. ESG issues continue to attract great interest in public, corporate and political arenas. Activity in the investment community on climate change-related risks and opportunities continues to increase and stimulates the development of analytical tools to determine which companies are best poised to deal with climate change and other ESG issues. The result is that an ever-expanding range of investment products, corporate standards and benchmarks, and collaborative investor initiatives such as the CDP are serving to improve disclosure standards and industry-wide awareness. With more active engagement and better understanding of the potential impact of ESG issues, Canadian investors can enhance their confidence in the ability of their investments to add value, as well as fulfill fiduciary obligations. Jane Ambachtsheer, national partner, global head of responsible investment, and Jenni Myllynen, associate, responsible investment, in Toronto. jane.ambachtsheer@mercer.com; jenni.myllynen@mercer.com |
Is Climate Change on the Agenda? Questions for your investment manager 1. What expertise do you have regarding climate risk? 2. How do you engage with companies on this issue? 3. How do you factor climate risk into investment decisions? 4. Can you assess the potential risk of climate change on our portfolio holdings? |
Pension funds around the world have already joined forces to address climate risk. As Canadian pension funds begin taking steps to gauge the financial risks that climate change may pose, institutional investors in some countries have already banded together to put pressure on governments and the companies in which they invest to address those risks. The United Kingdom, in particular, has been a hotbed of activity. Institutional investors there came together in 2001 after a report commissioned by the University Superannuation Scheme (U.S.S.), Britain’s second-largest pension fund, looked at how climate change could impact investments. “That piece of work pointed out there were some risks to a broad range of assets, including companies, including real estate,” says David Russell, co-head of responsible investment with U.S.S., who helped found the Institutional Investors Group on Climate Change(IIGCC). “If left unaddressed, [those risks] could hit the performance of whole economies and potentially, therefore, impact the returns we require to pay our pensions.” Now numbering 36 members, including some of Britain’s largest pension funds, as well as funds from the Netherlands, France and Switzerland, the group seeks to promote a better understanding of the implications of climate change amongst institutional investors and to encourage companies in which its members invest to address any material risks and opportunities associated with climate change. While the U.S.S. report got the ball rolling, it was the introduction of the EU Emissions Trading Scheme in 2005 that drew the attention of many British investors to global warming. “It was the first time you actually had a price on carbon. So when you look at a company, there’s actually a cost for emitting greenhouse gas emissions,” says Stephanie Pfeifer, program director for the IIGCC. “That really brought it back on the radar screens of these fund and asset managers. Climate change legislation can have an impact on investment.” The issue of climate change is now top of mind for the majority of institutional investors, both in the U.K. and in continental Europe. A survey last summer of 39 European pension funds conducted by the IIGCC and European Pensions & Investment News found that 83% agreed or strongly agreed that climate change can have an impact on their investment returns. As well, a third already take into account the risks and opportunities associated with climate change in their investment policies. Another 57% plan to consider climate change issues within the next five years. And almost 80% agreed or strongly agreed that consideration for climate change issues is in line with fiduciary duty. “In the U.S., you still have the debate about whether [climate change] is really happening or not. We don’t really have that anymore,” says Pfeifer. “I think most people agree that yes, it is happening, and now we need to find a way of dealing with it.” And when it comes to dealing with climate change, the IIGCC has a lot on the go. Included in its mandate is trustee education. In 2005, the IIGCC, together with the Carbon Trust, commissioned Mercer Investment Consulting to produce A Climate for Change: A trustee’s guide to understanding and addressing climate risk. It also held a trustee training session last fall and is planning another. The group also engages with companies about disclosing their carbon emissions and climate change strategies. Pfeifer says IIGCC is currently developing a framework for disclosure for the electricity and utility sector and will be creating similar frameworks for other sectors shortly. “We’re looking for what sort of disclosure is actually relevant for sell-side analysts,” she says. “Because some of the ways companies disclose the numbers aren’t comparable or consistent or easy to use in financial models, so we’re looking at how to improve that.” But where the group is having the most impact is on the public policy front, says Rory Sullivan, head of investor responsibility at Insight Investment, a member of the IIGCC and one of the U.K.’s largest asset managers with approximately $200 billion under management. “As an individual investor, if we think we need long-term climate change targets, it doesn’t carry a lot of weight,” says Sullivan. “But [with the] IIGCC, where there’s a group of investors who think that and say that, it provides much greater weight in terms of dialogue with government.” He points to a new climate change bill introduced earlier this year that would put in place a framework to achieve a mandatory 60% cut in the U.K.’s carbon emissions by 2050. “I’m not going to claim that investors were the primary driver for that [bill], but investors reinforced and amplified the call from other sectors of society,” he says. Most recently, the IIGCC sent a letter to the G8 heads of state ahead of their summit last month in Heiligendamm, Germany, underlining the importance of laying the foundations for a post-2012 policy. But while pension funds in the U.K. and Europe are lending their name to the IIGCC, many still haven’t figured out how to integrate climate change risk into their investment portfolios. “You have small allocations in renewable energy; you have some of the big funds employing people to look at the issue specifically. But a lot of funds have only just started to think about it,” says Pfeifer. “There’s a real tension between the short-term investment performance…and these systemic longer-term issues,” adds Sullivan. “A lot seem to have a rhetorical commitment, but it’s not clear they’re really asking their asset manager, ‘Are you integrating this?’” The U.S.S. is one of the exceptions. It’s been invested in clean energy funds since 2000 and holds investments in private equity funds that construct and finance renewable energy projects. Russell says these types of investments are a good fit for pension funds. “They are in line with the sort of returns you would get from a private equity type of investment. There is a certain level of risk associated with them; therefore, you would expect a commensurate return.” Don Bisch is editor of BENEFITS CANADA. don.bisch@rci.rogers.com |
Climate Change Collaboration It isn’t only pension funds in the United Kingdom that have collaborated to address climate risk. A look at two other initiatives on either side of the globe: The Investor Network on Climate Risk(United States) What it is: A network of institutional investors and financial institutions that promotes an understanding of the financial risks and investment opportunities posed by climate change. Who’s in it: More than 50 investors managing nearly $4 trillion in assets. Members include asset managers, state and city treasurers and comptrollers, public and labour pension funds and foundations. What it does: Organizes summits, conferences and forums to educate pension fund managers and other investment professionals about climate risks to their portfolios. It also publishes and distributes reports, such as the Investor Guide to Climate Risk, and it provides a forum for members to exchange knowledge on this complex and rapidly changing issue. Investor Group on Climate Change(Australia/New Zealand) What it is: A collaboration of Australian and New Zealand investors focusing on the impact climate change has on investments. Who’s in it: Represents 19 investors, including superannuation funds, insurance companies and fund managers with total funds under management of more than $225 billion. What it does: Raises awareness of the potential impacts, both positive and negative, resulting from climate change. It also provides information to assist the investment industry to understand and incorporate climate change into the investment decision. |
Investor Resources www.iigcc.org
A Climate for Change: A trustee’s guide to understanding and addressing climate risk. Outlines how global warming can impact pension assets, discusses the fiduciary issues involved and provides a trustee’s tool kit for addressing climate risk, including questions to ask themselves, their investment consultant and their asset managers. www.carbontrust.co.uk
Investor Guide to Climate Change: An investors’ guide to the key facts surrounding climate change. Prepared by the Carbon Trust to coincide with the launch of the EU Emissions Trading Scheme, January 2005. www.nrtee-trnee.ca
Capital Markets and Sustainability: Investing in a Sustainable Future. Prepared by Canada’s National Round Table on the Environment and the Economy, this report examines the climate change risks and issues facing investors and presents a set of recommendations related to fiduciary duty, materiality and investor short-termism. |
Large plan sponsors get results by dealing directly with the companies they invest in.
Seeing photos of the acres of forests in British Columbia destroyed by the pine beetle made Susan Enefer, manager, corporate governance, British Columbia Investment Management Corporation (bcIMC), and the rest of her team realize that climate change can seriously impact investments. bcIMC has more than $75 million invested in two forestry companies. “That’s a significant amount of dollars at risk,” says Enefer. “It’s a rude awakening to know that our dollars are at risk in a way the climate is determining.” So the Victoria-based pension fund management company, with $85 billion in assets, started talking about the pine beetle with the public companies they invested in. “We want to help companies manage the risk.”
According to the Toronto-based Social Investment Organization, pension funds are increasing their holdings in socially responsible investments. In 2006, more than $433 billion of pension assets were in such investments, which is up from $25 billion two years earlier. bcIMC is one of a handful of large pension funds and pension fund managers that are leading the way when it comes to being engaged in the current climate change issues. Two others are the Caisse de dépôt et placement du Québec and the Canadian Pension Plan Investment Board(CPPIB).
CPPIB’s formal policy on responsible investing—which was first published in 2002—sums up the motivation for looking at investing through green-coloured glasses: “Responsible corporate behaviour with respect to environmental, social and governance factors can generally have a positive influence on long-term corporate financial performance.” CPPIB, the Caisse and bcIMC have found that the most effective way to be in line with that policy is by talking. They engage the companies they have interests in by starting discussions on how to address potential problems arising from climate change, encouraging more responsible action and asking for disclosure. In some cases, proxy votes are used to push for change. They have also signed the United Nations Principles for Responsible Investing and joined investor coalitions, such as the Carbon Disclosure Project.
“Given that we’re historically a passive investor and we tend to have a long investment horizon, we think that engagement is a more effective strategy for us,” says Ian Dale, senior vice-president, communications and stakeholder relations, with CPPIB in Toronto. “Through engagement, we can effect change in companies in which we own securities.”
For example, bcIMC recently developed a policy for its real estate investments that all new buildings will be built to LEEDS (Leadership in Environmental Energy Design)standard. Enefer says if an opportunity is presented that is not LEEDS certified, bcIMC will push for it before becoming an investor or pass on the deal. bcIMC is also working on greening all of the buildings it already owns by improving the efficiency of the appliances, the lighting and even ensuring the paint on the walls is low-emission.
The Caisse also has policies for its investments including real estate, says Ginette Depelteau, senior vice-president, policies and compliance. In addition to ensuring buildings are certified environmentally friendly, one of Caisse’s subsidiaries, Ivanhoe Cambridge, has signed a green power agreement that will see 30% of the electricity for its 13 shopping centres coming solely from wind and low-impact power producers.
As for the CPPIB, it often uses proxy voting to encourage the disclosure of information related to climate change and other environmental factors. In 2006, it voted at more than 2,000 company meetings. It believes disclosure is the key to understanding the potential impacts and often persuades companies to behave better.
In some cases, these large pension fund managers make their own deals by partnering to invest directly in green technologies. bcIMC, for example, just invested in a wood-pellet manufacturing company that produces clean biomass burning.
Despite all the policies and deals, Enefer stresses that addressing climate change through investing does not trump that of ensuring pension obligations are met. “We approach these issues as a way to deliver the retirement income the beneficiaries expect,” she says. “It’s a risk management strategy as well as a return enhancement strategy.”
All of this is still in the early stages. Both CPPIB and bcIMC have not yet divested from a company because they felt the risk was too great. They are working out how to escalate discussions when a company is making little or no progress. bcIMC is considering filing shareholder proposals at annual general meetings. But there is no need for that yet. Most companies, says Enefer, are eager to work with the investors to make improvements.
That’s good news for plans without the size of CPPIB, the Caisse or bcIMC but with the desire to become more active in climate change. These three fund managers are reshaping the relationship and expectations between investor and company, which will make it easier for other plans to follow in their green footsteps.
Leigh Doyle is assistant editor of BENEFITS CANADA leigh.doyle@rci.rogers.com
Something From Nothing “Climate change has become more than an environmental challenge,” says Leon Bitton, vice-president, research and development, for the Montreal Exchange. “It has become an issue of financial risk.” With risk comes the opportunity to make money. So the Montreal Exchange is preparing to launch a trading platform for greenhouse gas emissions credits and derivatives of those credits. When the Canadian government imposes its climate change regulations around 2010, companies will be facing emission reduction targets. A market will provide the ability to hedge the cost of meeting those targets. “That’s what the Montreal Climate Exchange is about,” says Bitton. “We eventually plan to introduce a marketplace where a ton of Co2 will be traded like any other asset class, and you’ll have a price signal that will be generated by the market.” This serves two purposes, he says. First, pension fund investors will be able to more accurately assess the risk of the emissions of a particular investment. The price of emissions combined with the level of emissions from a company can aid an investor in deciding if it is a suitable prospect. Secondly, there is the opportunity to make money. After the market is established, investors in green technologies or reduction projects who are earning credits from those efforts can sell them on the market. “Investors will be able to partially finance their investments by the reductions,” says Bitton. —Leigh Doyle |
Ready for Action If your pension plan doesn’t have the size to create its own green deals but is looking for ways to participate in the movement, here are three ways to start. | Action | What it is | For More Information | | Support the United Nations Principles for Responsible Investing | A set of prescriptive policies and possible actions for incorporating ESG issues into mainstream investment decision making and ownership practices. Suggested actions include proxy voting, engaging companies on environmental issues and participating in the development of policy, regulation and standard setting. | Read the principles at: www.unpri.org | | Invest in green funds | There is no shortage of funds on that market that specifically invest in greener infrastructure projects, clean power or ethical companies. The Canadian Association for Socially Responsible Investment develops an annual institutional investment directory that lists asset managers and investment consultants with strong commitments to SRI in Canada. | Get the directory at: www.socialinvestment.ca | | Participate in investor coalitions | Get involved with other investors who want to support the green movement. Susan Enefer, manager, corporate governance, bcIMC, says: “You’ll learn a lot by just listening.” Plus, you’ll keep up to date on what’s happening in other markets. There are local, national and international groups to join. | Carbon Disclosure Project (www.cdproject.net), The Regional Greenhouse Gas Initiative(www.rggi. org), The Investor Network on Climate Risk in the U.S. (www.incr.com) or the UN Environment Program Finance Initiative (www.unpri.org) |
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Pension plan sponsors can wield their shareholder authority to affect change.
In its latest report, the Intergovernmental Panel on Climate Change concluded with “high confidence” that global warming “has had a discernible influence on many physical and biological systems.”
If there are investment risks and opportunities associated with climate change, what can trustees do to ensure they fulfill their obligations? Environmental risks, including climate change, increasingly are being recognized as part of the fiduciary duty of trustees. In the October 2005 report entitled A legal framework for the integration of environmental, social and governance issues into institutional investment, the authors argued that “…integrating ESG [environmental, social and governance] considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.”
The ratification of the Kyoto Protocol, the advent of the Emission Trading Scheme in the European Union(EU ETS)and various U.S. state initiatives make regulatory risk a reality, especially for companies with significant greenhouse gas emissions. These regimes also provide opportunities. Under the EU ETS, for example, companies investing in cleaner technologies can turn them into profit by selling permits into the market. There are various ways that pension plans can respond, but the bottom line is that trustees should become more informed and engaged owners when it comes to climate change issues. Increasingly, pension funds are choosing to do this through multilateral investor forums such as the Carbon Disclosure Project(CDP). Launched in 2002, the CDP now involves 280 institutional investors with assets of more than US$41 trillion. The number of Canadian CDP signatories has continued to increase and now includes some of the largest pension funds and financial institutions in the country, such as bcIMC, Caisse de dépôt et placement du Québec, HOOPP, OMERS and the Ontario Teachers’ Pension Plan.
PROXY VOTING
Plan sponsors have the ability to affect change via their shareholder prowess. They can file or co-file climate change-related proposals, supporting shareholder proposals through company dialogue and/or publicly disclosing the intention to vote in support of climate change proposals. At the very least, pension plans should develop proxy-voting guidelines that incorporate climate change parameters and ensure informed voting decisions.
Opportunities on these fronts continue to increase. In 2007, several climate-related proposals were filed with Canadian companies. Some were withdrawn subsequent to successful negotiations with the companies. More worrisome was the response of Canadian Natural Resources, as it omitted a proposal filed by The Ethical Funds Company requesting that the board assess how the company is managing and responding to climate change risks and opportunities, and report to shareholders. This request seemed especially important given that Canadian Natural Resources declined to participate in the 2006 CDP, leaving investors with insufficient information to assess how the company is managing climate change risks and opportunities.
There were a record 42 climate change resolutions filed with U.S. companies as part of the 2007 proxy season—nearly double the number of climate-related resolutions filed three years ago. Some of the resolutions, primarily seeking greater disclosure, received significant support. Other proposals took a different strategy. In May 2007, institutional investors with $900 billion worth of Exxon Mobil shares pushed for the removal of board member Michael Boskin due to the company’s inaction on the climate change front and his repeated refusal to meet with shareholders to discuss the issue.
Climate change issues are not going away. It’s time for pension plans and other asset owners to become more informed and engaged owners.
Michael C. Jantzi is president of Jantzi Research Inc. in Toronto. mjantzi@jantziresearch.com
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