The landscape for climate-focused passive investments has changed rapidly, but more work is needed to address physical risks to portfolios, as extreme weather events threaten businesses and critical infrastructure.
For institutional investors, rapid product innovation and regulatory change over the past decade have provided an ever-richer array of indexes, methodologies and other tools to protect passive portfolios against climate and other environmental risks. Asset owners can choose from multiple passive investment solutions that screen out or tilt toward issuers on the basis of their past and current greenhouse gas (GHG) emissions or the credibility of their plans to transition to net zero.
But are these offerings sufficient to limit exposure to the increasingly evident physical risks of climate change faced by businesses, portfolios and end-beneficiaries? And if not, what new tools, including data sources, are required? Further, how should physical risks be considered alongside other investor criteria and priorities?
The issue is become more urgent. Climate change was cited as a significant contributing factor to US$120 billion of insurance-covered losses from natural disasters in 2022, which include Hurricane Ian in the US, plus severe flooding in Australia and Asia, notably Pakistan.
And while COP27 put climate adaptation firmly on the policy agenda, our understanding of the risks to individual companies and assets – and their plans for addressing them – is limited. A survey of 500 firms in 33 countries, conducted for a recent report on company responses to climate risks, found that just 14% had a climate adaptation and resilience plan in place. “More concentrated efforts are needed towards climate adaptation planning and implementation,” the report concluded.
According to asset owners and managers convened in London last month by ESG Investor and Morningstar Indexes – for a roundtable discussion on ’Minimising Exposure to Physical Risks in Passive Strategies’ – the way forward for investors requires tackling complex challenges on both the supply and demand sides of the market. This involves a clearer understanding of what data sources can tell them about physical risks as well as the motivations driving their responses to those risks.
Given the centrality of solid, reliable information to navigating this new landscape, the need for good, and, equally importantly, relevant, data looms large.
Marie Dzanis, Head of Asset Management for EMEA at Northern Trust Asset Management, said: “We will demand more criteria for better data. It’s very different from anything our industry has ever done.”
Understanding and assessing the physical risks of climate change on sites, facilities and operations at multiple locations has not been required previously, on a systematic level, in the investment process. As new practices evolve, Dzanis predicted there would be an increasing demand for customisation from index providers.
Inside the black box
For Hetal Patel, Head of Climate Investment Risk at Phoenix Group, progress has already been impressive over the past decade, in terms of the development of reliable data sources to assess GHG emissions now and, thanks to nascent transition plans and frameworks, in the future. “We’ve come on in leaps and bounds,” he said. “Ten years ago, for instance, there was very little knowledge about carbon data.
“Now, not only do we have a decent coverage of basic carbon information; we have a suite of forward-looking climate metrics available to us.”
Credible data sources for mapping physical risks must not only become more available; their incorporation into indexes, and the passive investment process more broadly, needs to be well understood, said Kristina Church, Global Head of Responsible Strategy at BNY Mellon Investment Management.
“There are a lot of black box methodologies at the moment. We must ensure our clients understand the limitations of the data we are using and what decisions it is driving. That can be hard when the methodology isn’t clear,” she said.
“However, we mustn’t wait for perfection before moving ahead with these things.”
The roundtable touched on the current debate about the need for common ground among asset managers, index providers and data providers. In October, the International Investors Group on Climate Change (IIGCC) published a ‘data vendor catalogue’, which, it said, “reached out to 16 well-known data vendors, asking them to outline their offerings in relation to the Net Zero Investment Framework”, the IGCC’s guidelines for decarbonising portfolios.
The IIGCC is now developing an ‘investor expectations’ review of data vendors’, which will set out key requests to ensure vendors’ product offerings meet the evolving needs of investors seeking alignment with net zero goals. Such initiatives are expected to shed greater clarity on the data inputs into indexes designed to address physical risks of climate change.
Despite the difficulties of assessing and integrating new data sources, roundtable participants said new solutions were building on solid foundations laid by existing products and methodologies.
Rafaelle Lennox, Head of UCITS ETF Product Strategy at Franklin Templeton, said the recent improvements in this area were “immense”, adding: “Now we have a lot of transition indexes.
“The data is improving every year.”
Product innovation has been fuelled by investor demand. In Q4 2022, six of the top ten sustainable investment products globally were passive strategies, securing more than US$6.7 billion of net new inflows.
But for index and data providers, expectations are being raised. In November, the UN-convened Net-Zero Asset Owner Alliance noted that institutional investors are “operating with an incomplete toolbox”, calling for rapid development of net zero-aligned benchmarks based on ten principles, covering exclusions, forward-looking indicators, and just transition metrics.
In this context, the two standards enshrined in the EU guidelines – the Paris-Aligned Benchmark (EU PAB) and the Climate Transition Benchmark (EU CTB) – are a work in progress.
Daisy Streatfeild, Sustainability Director at Ninety One, pointed out the limitations of the index framework set out by the European Commission to encourage the development of climate-aware benchmarks, noting also the broader implications for underlying data use.
“Paris-aligned benchmarks currently don’t take account of forward-looking data on how firms are transitioning. For physical risks, the challenge is even harder because the information needs to be location-specific. Even if you do have accurate information about the physical hazards and risks for the areas in which a firm is operating, you also need to know the details of what the company is doing about them,” she said.
“I don’t think we’re there yet on either front, whether as inputs for active or passive strategies. If we’re going to constrain our clients’ investible universe to reduce physical risks, we have to be doing so based on the right data and metrics.”
Risks “very material and very real”
Intimately linked with the need for more and better data is the question of what risks ought to be measured. The roundtable examined the conventional distinction between transition risks, those associated with the pace and extent to which a business adapts to climate-change mitigation policies, and physical risks, those arising directly from the real-world consequences of the climate crisis.
It examined also the standard assumption that the former is shorter term than the latter. Nigel McKeverne, Associate Director, Commercialisation for Climate Solutions at Morningstar Sustainalytics, said the relationship could sometimes be inverted.
“Flood risk today is greater than it will be in the long term, depending on location. If we want to understand, at issuer level, potential exposure to loss and damage, that data is becoming available,” he said.
“We are looking at the probability of loss or damage against all of the assets that we can identify as being part of an issuer’s operation. A lot of progress is being made.”
But Gustave Loriot, Responsible Investment Manager at London CIV, one of the UK’s eight pooled local government pension schemes, urged greater impetus, arguing that physical risks have not been given the attention they deserve.
He said: “Net zero and GHG emissions have been high on the agenda. But physical risks have not been taken into account in the same way as transition risks. To me this is problematic.
“Physical risks are very material and very real. But there has been a lack of frameworks and regulation around physical risk. More guidance needs to be developed.”
To Lennox, transition risk and physical risk are seamlessly connected, the latest iteration, perhaps, of the old adage that the long term is made up of a series of short terms. The more firms come out with robust and thorough transition plans, the more we know about how they’re intending to handle physical risks, she reasoned.
“It’s a mistake to separate completely physical risk from transition risk,” she said. “Properly handled, transition risk can eliminate a lot of physical risk down the road. Companies with, for example, significant water stress issues have to look at where they will be decades in the future.”
She added that, while transition risks are of a more immediate concern to companies and investors than physical risks, investors’ knowledge of the latter in growing.
Seeking to dispel the notion that physical risks are not currently accorded sufficient importance by portfolio managers, Frédéric Hoogveld, Head of Investment Specialists & Market Strategy, ETF Indexing & Smart Beta at Amundi, told the roundtable: “Our climate ETF product range takes account of physical risks already.
“Climate ETFs have evolved significantly over the past ten years, from backward-looking low-carbon indices to comprehensive strategies taking into account forward-looking transition and physical risks,” he said, adding that deep granularity is needed to accurately map physical risks effectively across holdings in different sectors and geographies.
In April, the UN Environment Programme published the latest in a series of reports on the risks facing a number of key industries. In agriculture, it warned of multiple transition risks, alongside “important physical climate hazards such as temperature rise, extreme weather events, water stress, and wildfires”.
In real estate, it said hurricanes, wildfires and other physical risks posed major challenges for the industry, along with the likelihood of regulation. The sector accounts for about 40% of GHG emissions globally.
The industrials sector, responsible for about 25% of emissions, has both a key role to play in de-carbonisation and will face major transition and physical risks, according to the report. It added: “Relying on stable climate conditions to enable effective operations in complex supply chains, the industrials sector is also at risk from the physical impacts of climate change such as storms, droughts, and wildfires that will make current industrial practices more difficult or risky.”
Better information on the nature of physical risks – and on the responses of issuers – is necessary, but insufficient in the development of effective passive investment solutions. The question of motivation has assumed much greater importance, roundtable participants agreed.
Loriot said: “Doing good is good, but it is not necessarily the same thing as hedging your portfolio against physical risk. When we are building the strategies, it is important to ask ‘what is the investment case?’ Is it about building a product that will make people feel good because it will make the world a better place, or is it because through this product they are going to minimise their expected loss over the next ten, 20, 50 years?”
Patel agreed, noting the unavoidable question of profit and principles would have to be answered. “When factoring climate into their investment strategy, every investor needs to clarify ‘what is our motivation?’. Are we doing it as a risk mitigation exercise, are we trying to achieve a particular real-world impact or because we think there are returns to be optimised?
“Articulating the motivating factor is important as this will drive investment approach. An investor wouldn’t want to end up saying ‘we saved the world, but we made a terrible return’.”
Church put the ball in the clients’ court, suggesting that with the right information they could then tell investment managers much more clearly what their goals were.
“How much impact do clients want? They could request a net zero strategy, but they need to be fully aware that this may not be aligned to real world decarbonisation and therefore understand the potential impact on returns. We need to be transparent over the trade-offs. The bounds of fiduciary duty mean there is only so far investment solutions can go without policy support to deliver real economy outcomes,” she said.
Not yet joining the dots
With nature-related risks rising up the agenda in the wake of agreement on the Global Biodiversity Framework, service providers and investors must also address the tough question of whether the focus on climate change risked pulling ESG investment strategies out of shape, leaving them ill-prepared for a shift on emphasis in the sector.
Rebecca Chesworth, Senior Equities Strategist for SDPR ETFs at State Street, feared this may be the case. “Is there a risk that we spend so long on climate that when the focus shifts for example to biodiversity, we have to start all over again?”
She added: “Climate is one part of the ‘E’ and other parts are crucial as well. Should we be broader in our thinking at the moment?”
Lennox agreed. “Investors are looking at things more broadly. Climate alone is quite a narrow topic for investors. Do they really want to invest in a portfolio that is simply mitigating physical climate risks?
“Investors want broad ESG solutions. They certainly want a broad ‘E’ solution,” she said, adding that EU PAB indexes have the ability to incorporate both transition and physical climate risk, potentially mitigating both these types of climate risk “as well as reducing exposure to companies that are scoring poorly on other environmental indicators”.
While the shortcomings of the EU PAB/CTB framework are acknowledged, the review process built into its supporting legislation enables methodology improvement over time.
“Climate-based indexes will continue to evolve, especially as regulation and data mature,” said Robert Edwards, Director of ESG Product Management at Morningstar Indexes. “We fully anticipate that climate indexes to include transition and physical risk requirements in the future.”
Looking ahead, roundtable participants highlighted the need for investment solutions to consider and tackle physical risks on a number of different levels, in order to support investors and investees.
Streatfeild said: “For investors, there are likely to be short- and long-term responses to physical risks. You might decide not to invest or lend to a firm that faces particular physical impacts in the short term, based on a calculation of financial impacts. But different measures are needed to address those longer-term systemic risks. Heatmaps might suggest you reduce your exposure to India for example, but that won’t help it become more resilient.
“Pulling up the drawbridge won’t leave clients with many investment options or support the companies or regions that need investment to become more resilient against physical risks. We need to help clients to understand and manage these trade-offs.”
As investment solutions evolve, so too does the regulatory environment for sustainable investments which can lead to short-term impacts to clients, including on price.
“It’s important to pay attention to the pace of regulation. There is a possible cost to bear if I have clients in German and Dutch markets, for example, with different reporting requirements,” said Dzanis.
“When you have more costs, my concern is that they could end up with the end-investor.”
The central role of data and its uses looks set to remain. Hoogveld noted that despite the increasing sophistication of climate indexes, differences and discrepancies remain. “Assessment of physical risk remains a challenging issue, but we believe that methodology will continue to improve to help investors better manage their climate risk.”
Chesworth argued that current and future product development is building on a solid base.
“I strongly defend selling to an index strategy. Climate indices are very well designed by our partners and incorporate a high degree of effectiveness and sophistication,” she said. But she also accepted that the pace of innovation imposed responsibilities on providers toward clients.
“We are so advanced compared with where we were five years ago. We have been advancing so quickly as an industry, which is great, but investors are wondering what’s next.”
Dzanis concluded: “At this stage, we’re not connecting the dots as an industry.
“It’s a journey. We are not done.”