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Can carbon risk be hedged?

Charles Donovan, director of the Centre for Climate Finance and Investment at Imperial College London, and Simon Wilde, senior MD at Macquarie Capital, explain why investors need to take immediate action to insulate their portfolios against climate change.

As Bank of England Governor Mark Carney highlighted in his 2015 Lloyd’s of London speech, the impact of humanity-induced climate change is a “mega risk” with “potentially profound implications for financial stability and the economy”. While the impact of rising greenhouse gas emissions has long been viewed as a serious issue, some commentators were nonetheless surprised to see a central banker intervening. Earlier that year, the G20 appointed the central banks of China and the UK to chair a working group looking at the effect of climate change on global finance. Given the long-term nature of the problem, Governor Carney expressed concern that “once climate change becomes a defining issue for financial stability, it may already be too late”.

Since that time, we have witnessed the COP21 agreement in Paris, further work by the Bank of England, and carbon risk warnings from major fund managers such as BlackRock. However, many investors continue to struggle with how to address the issues of climate change and associated financial risks.

Climate risk is the potential impact on the value of financial assets of both the direct physical effects of climate change and the indirect consequences of transitional measures taken to reduce greenhouse gas emissions. An example of direct effects is increasing storm damage from more extreme weather patterns. The insurer Lloyd’s estimates that the effect of Superstorm Sandy on New York property damage was amplified 30 percent due to sea levels having risen 20cm as a result of prior climate change – the equivalent of more than $5 billion extra costs. Other direct effects are likely to include substantial changes in agricultural productivity and supply chain disruptions associated with flooding and extreme heat events.

Large though this impact is, the indirect effects are potentially far greater and more immediate. With regards to transition risks, there are two sides of the coin: the impact of existing and future emissions reduction policies and the ongoing technological disruptions associated with past investments in low-carbon energy.

Policy issues have huge implications in infrastructure and many investors are already testing their base case investment forecasts against future changes in subsidy and tax reform. Investors must be on guard against an old (and increasingly inaccurate) narrative that clean energy is most highly exposed to changes in government subsidies. According to the International Monetary Fund, the direct subsidy to fossil fuels globally is nearly three times that to renewable energy. Add-in the implicit subsidy associated with pollution costs and the imbalance towards fossil fuels increases into the trillions. Recent analysis by the Stockholm Environment Institute indicates that in the US, now the world’s largest oil and gas producer, state and federal subsides comprise between 200 and 600 basis points of unlevered financial return. Strip these away and, at current oil prices, nearly half of new crude oil resources would become uneconomic.

Likewise, technology is driving major disruption – and presenting opportunities – in energy markets today. In power generation, the most obvious example is the ‘stranding’ of thermal assets by low-cost renewables. In Germany, whose economy is quickly becoming the pre-eminent laboratory for observing the impacts of climate risk, the major electric utilities have already undertaken radical corporate restructuring to separate their carbon-heavy businesses. In the years to come, electric vehicles may have even greater impact on the structure of both the transportation and power sectors.

But how important is all of this to a well-diversified institutional investor today, particularly in light of possible policy changes by the new US administration?

We argue that it is crucial. Even if a Trump presidency sees a withdrawal from the United Nations Framework Convention on Climate Change or reneges on its COP21 commitments, there is a clear path of travel that can be drawn from the statements of the other G20 countries – most notably the EU and China. Indeed, it’s easy to agree with President Trump: there has been a ‘Chinese hoax’ about climate change, although it has nothing to do with the science of global warming. The hoax is that by building so many coal-fired power stations at the beginning of this century, China managed to divert the world’s attention from the fact that it was simultaneously building the world’s first clean energy superpower. Research by the Institute for Energy Economics and Financial Analysis has revealed that China’s investments in green technology overseas amounted to more than $30 billion in 2016 alone – far exceeding anything invested by other countries, and marking a staggering 60 percent year-on-year rise in spending. Chinese companies are snapping up everything from solar projects to wind farms to hydropower installations and lithium production companies.

Despite these pressures building in the system, the quantum of climate risk remains debatable, as both the extent and timing of physical, technological and policy changes are uncertain. Certainly, more needs to be done to improve climate risk measurement, analysis and risk mitigation options.

Markets, however, trade on expectations, which can accelerate the impact on asset prices. As Governor Carney puts it “the speed at which such re-pricing occurs and could be decisive”. Researchers at Cambridge estimate that for a balanced institutional investor (with a 50 percent allocation to equities) the downside risk could be 30 percent, without concerted long-term governmental action. Importantly – although not uncontroversially – they conclude that, at best, only half of this risk can be hedged by portfolio allocation changes, due to its systemic nature. Other research suggests far lower, though still significant, value-at-risk estimates with a particular focus on high “tail risk”. One piece of academic research – Climate value at risk of global financial assets – has estimated a “business as usual” VaR downside at 1.8 percent on average with up to 17 percent downside in extreme cases.

Some sectors are more obviously exposed to climate risk, such as coal mining or oil production. Recent years have seen high profile ‘divestment’ campaigns, which at the end of last year included institutions and individuals who collectively own $5 trillion in assets. The COP21 target clearly implies that a significant portion of proven hydrocarbon reserves cannot be burned if warming is to be kept below 2 degrees Celsius. As well as endorsement from central banks, the stranded asset argument has seen significant divestments by investors such as the Norwegian sovereign wealth fund and Allianz. This trend has emerged in a period that coincided with declining and volatile commodity prices and hence divestment strategies have been profitable, although they remain controversial from a financial perspective.

More generally, other sectors are exposed to carbon risk, through supply chain vulnerability and commodity price volatility. Benchmark providers have sought to take carbon intensity into account, based on ESG disclosures. One example is the MSCI Low Carbon Target Index. BlackRock point out that this index has outperformed the overall MSCI ACWI since 2010, although they highlight the need for better transparency. BlackRock’s own analysis suggests the MSCI World index can be optimized to reduce carbon intensity by 70 percent at the cost of a relatively small tracking error of 0.3 percent. Yet to date, there has been little work on finding investments that have positive exposure to carbon risk that would have an offsetting effect on investor portfolios, thereby addressing the contention that such risks may be unhedgable.

Climate risk is a complex issue and there is much more work that needs to be done to fully equip investors with the tools they need to navigate a changing global climate. In the meantime, investors themselves can demand more and better disclosure, whilst making fuller use of existing information. This requires a commitment to add appropriately qualified staff and embed them in the asset selection and management processes. Collaborative approaches between investors would spread the fixed costs involved. Company-level data requires relevant benchmarks and it is in investors’ own best interest to support their development. There are examples of good practice such as APG’s Global Real Estate Sustainability Benchmark.

Portfolios themselves can be restructured to incorporate climate risk-adjusted returns, albeit there is limited consensus currently on best way to do this. Research identifying substantial tail risk suggests the importance of VaR and other measures that focus on the full distribution of returns rather than just the mean. Ideally, investments can be identified with offsetting positive exposures to carbon risk, allowing explicit hedging and risk management strategies to be adopted. Cleantech and renewable energy infrastructure allocations offer potential here, although arguably the focus on fixed bond-like returns may not always be what is required.

At Imperial College London, some of the issues we will be addressing with investors include defining plausible carbon and climate outcomes, allowing scenario analysis across portfolios – a “stress test” approach recommended by the Bank of England; assessing carbon measurement, benchmarking and risk-management options, to allow carbon risk-adjusted return inputs for asset pricing and portfolio allocation; and improving the granularity of ‘green’ as an investment attribute across asset classes, quantifying past performance of green investment strategies.

Twelve months after speaking at Lloyd’s, Governor Carney returned to the issue of climate finance in Berlin, asserting that “with investment in long-term infrastructure assets needing to quadruple, green finance cannot conceivably remain a niche interest”.

We couldn’t put it better ourselves. With new climate risk disclosure requirements being debated by regulators, investors should be prepared to go on the offensive.