Pandemic is no excuse to ignore climate risk

Bond investors should target companies with low emissions because issuers with high emissions may borrow heavily to deal with climate change, increasing risk.

As the world reels from the COVID-19 pandemic, the spectre of climate change may seem a more remote threat.

The desire for societies to fully reopen and for economic equilibrium to be restored cries out for focus. Climate change appears less pressing where investment decisions are concerned. Alas, this is a false economy.

Human activity continues to increase the concentration of greenhouse gases in the atmosphere. A higher concentration of these gases leads to a warmer world, changes the behaviour of the Earth’s ecological, atmospheric and oceanic systems, and threatens the quality of life and livelihood of our children’s generation.

This is not alarmist: even the most optimistic of scenarios from the Climate Action Tracker would have potentially catastrophic consequences. Reaching a global agreement to reduce emissions seems essential, yet that consensus is absent.

Investors must invest to achieve the best long-term returns, faced with possible futures which include the smooth transition to a world of net zero emissions and chaos triggered by runaway climate change.

The sheer range of climate change outcomes means that to formulate and implement investment views incorporating climate risk is undeniably an immense task. This does not make it impossible.

We advocate an approach based on the recommendations of the Task Force on Climate-related Financial Disclosures, which applies established risk management practices to climate risk. It consists of four elements: governance, strategy, risk management and metrics and targets.

Good governance means that investment managers and their clients agree how they are going to evaluate the risks posed by climate change. They could agree simply to discuss it regularly, adopt a policy of disinvestment from carbon intensive issuers, or agree upon a strategy of engaging with portfolio companies. All are reasonable and all are possible.

Having established governance procedures, clients need to be able to monitor and verify the implementation of their strategy. There will be an expectation that portfolios reflect both climate policies and the climate-affected investment decisions of the manager.

The ability to do so depends critically on defining what we mean by exposure to climate risk and on constructing measures that quantify that exposure. Without those measures, any discussion of the risks and opportunities will be anecdotal and partial, leaning too much on trust and too little on the ability to verify.

The TCFD exists to improve the quality and consistency of climate-related disclosures of companies. Better understanding and quantification of the physical, liability and transition risks associated with climate change will improve investment decisions. Notwithstanding the limitations of data, we can apply the principles of risk management to the climate exposures in portfolios.

As an example, consider an industrial company which has large GHG emissions, but having committed to a reduction in line with the 2° scenario, their expected future emissions are modest.

This company faces two key climate risks. It has large emissions, making it vulnerable to new legislation. On the other hand, the more demanding the emission reduction target, the greater the execution risk and the reliance placed on assumptions about the economic environment. Each may entail significant contingent financing risks.

These are essentially pure investment questions. How likely is a change in the legislative environment, and how vulnerable is the company to that change?

For now, a company is likely to be more heavily penalised for GHG emissions in Europe than North America. This may not persist for the lifetime of the investment. Equally, we might take comfort on execution risk if we believe the company is well run and governed.

Bond investors face a further risk. In the last decade, companies the world over have increased borrowings. Companies that have to invest heavily to transition to net-zero emissions may choose to do so by borrowing heavily. This will lead to impaired credit quality and bondholders’ returns may suffer, despite the pursuit of the societal benefit of emissions reduction.

Fixed income investors, then, would be wise to favour issuers with lower emissions than their peers. Such issuers have signalled that they take climate risk more seriously and have acted.

Our view is that this demonstrates the strong governance crucial for long-term sustainability and better returns.

Guy Cameron is chief investment officer of Cameron Hume, a fixed income investment manager based in Edinburgh.

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