Never Static; Always Changing

Investors are overcoming ‘known unknowns’ to address climate and nature risks, as reflected at a Boston roundtable hosted by S&P Global Sustainable1 and ESG Investor.

When it comes to making sustainable investments, the future is uncertain, the tools are imperfect, and disclosures are far from complete. But that’s not going to stop US-based asset owners and managers from digging into the data and developing new analytics to better understand climate- and nature-related risks and opportunities in their portfolios.

“You need to be comfortable with the uncertainty and the constant transformation of our industry,” said Laura Maria Torres, ESG Research Analyst at Trillium Asset Management, speaking at a roundtable hosted in Boston in mid-October by ESG Investor and S&P Global Sustainable1. “ESG is never static, it’s always changing.”

‘Known unknowns’ about investee firms’ interactions with the natural world can stop us from taking decisions; as can the knowledge that the models and data at our disposal do not tell the full story. But it has always been the role of the investment professional to cut through the uncertainty to make a call on both risk and opportunity based on experience and evidence.

As Torres observed: “If you’re not comfortable with change, you’re not going to get anything done. The key is taking decisions, sticking with them, and then navigating as you go.”

Work in progress

For most if not all investors, the business of integrating climate considerations into investment processes at scale is a work in progress.

“It’s a big challenge for institutional investors to select frameworks and benchmarks for their climate strategies, particularly as we think of target-setting methodology, as well as capturing the data needed to measure progress. There’s rarely a perfect fit, requiring organisations to customise or pick and mix across frameworks,” observed Laura Weeks, Senior Responsible Investment Manager, Principles for Responsible Investment (PRI), who works closely with signatories across the US East Coast.

“This past year, we worked to provide net zero signatories with the opportunity to fulfil their net zero reporting requirement through their annual PRI reporting submission.  We’re also just encouraging signatories to get started. Often it seems as if signatories are doing more than they think they are.”

Despite efforts at disclosure alignment, there is still gaps between the information investors are expected to provide by stakeholders and that which is useful to analysts and portfolio managers when it comes to integrating climate exposures into investment processes.

The recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) are a near-universal reference point, but there are many hard yards on top, whether using frameworks developed collaboratively by investors or proprietary approaches.

Emma Sabiiti, Head of ESG Investment Strategy at MassMutual, described the process of calculating a baseline from which to measure progress on portfolio decarbonisation as “a heavy lift”.

“Data is the biggest challenge. There is a huge divergence in the numbers you get from different providers,” he said.

“We are at the stage of getting very familiar with providers, increasing our coverage, and understanding data quality. The priority is building coverage at present; and over time diving deeper into improving data quality as the frameworks and data universe evolve.”

Credible scenarios

Once a baseline is set, for one or more portfolios, progress on reducing financed emissions can be charted. Critical inputs include scenario analysis, to assess the financial risks arising from climate change over time, helping investors to understand impacts and set targets and milestones on a net zero by 2050 pathway.

Also important are company benchmarks developed by initiatives such as Climate Action 100+ and the transition plans of investee companies, which help to identify the leaders and laggards in key sectors, and potentially inform capital allocation and stewardship decisions.

But there are challenges across all these inputs. Under the TCFD recommendations, investors are expected to conduct scenario analysis on a regular basis. But many asset owners and managers have found those stretching out to 2050 to be too long-term, and too complex.

Earlier this year, the Universities Superannuation Scheme, the UK’s largest pension plan, abandoned long-term scenario analysis on grounds of its “many layers of data and assumptions”, with plans to replace it with shorter term scenarios developed with the University of Exeter.

“The first question for any investor is: how credible are the scenarios? What went into the blackbox? Then, how credible is it to act on longer-dated 2030 or 2050 scenarios? We’re thinking about how to leverage robust climate models over meaningful timelines to help the investment team think about climate risk,” said Sabiiti at MassMutual.

The preference for shorter-term approaches is common. External reporting on the long-term scenarios is not necessarily helpful in the shorter term from an investment perspective, according to Rebecca White, Global ESG Integration Lead at Newton Investment Management.

“We’re trying to develop short-term scenarios, bringing together focus groups from various teams, to identify and analyse a suite of plausible scenarios that can happen over the next six months to three years, in line with our investment horizons,” she said.

“The analytics team can backtest those scenarios to analyse how the market has responded. We want to use that to stress test our portfolios and say: ‘If different things did occur, how might that manifest in terms of investment return?’. It’s not perfect but tries to plug the gap as long-term scenarios are not necessarily as helpful in the shorter term from an investment perspective.”

Bob MacKnight, Managing Director, Nature & Climate Risk Solutions at S&P Global Sustainable1, admitted there are “a lot of factors to incorporate” into scenario outlooks.

“With so many permutations, if you then layer the probability of outcomes for multiple risk types under different scenarios, you can quickly arrive at very low probability but high potential impact events,” he said.

“How do you take that into account in decision-making? What range of realistic outcomes should we provide? It’s an open question right now.”

The Network for Greening the Financial System, a global group of market supervisors and central banks, recently deepened and extended its range of scenarios in response to consultation feedback which criticised the limitations of existing models. It is also developing short-term scenarios.

“It’s about understanding which scenario analysis best fits into your values, your goals, your clients’ preferences, and go with it. Nothing’s going to be perfect,” said Torres at Trillium.

Transition pathways

Understanding the transition pathways of investee corporates is a complex task. These are becoming more standardised and comparable due to regulatory requirements in some jurisdictions, notably Europe, as well as the voluntary guidance and frameworks being developed by the UK-based Transition Plan Taskforce and the Global Financial Alliance for Net Zero (GFANZ).

Even as disclosure requirements for corporates coalesce, much internal work is still required by investors to assess transition plans.

“We build tools to better equip the investment team to think about risks and opportunities. This includes a quantitative measure of transition risk to help assess what a good transition plan looks like, based on key indicators such as poor emissions performance, credibility of targets, and strength of governance and oversight, etc.,” explained White.

“The challenge is integrating such tools into the investment process. You need to be able to share it with a dispersed group, make sure it’s sufficiently flexible for them to use, but also consistent in application and output.”

Underlying these activities lies the fundamental question of how best to inject reliable and valuable data and insights on climate into the investment process, both to protect and drive returns.

John Farley, Executive Director for Responsible Investment at Calvert Research and Management, explained that the firm accesses multiple data sources to populate internal benchmarks and peer group analyses used to evaluate investee companies’ performance on a variety of ESG factors. As such, data testing and analysis is taken very seriously.

“We can’t take anything for granted. As investment managers, we have to be very transparent in terms of the data we’re using and ultimately the decisions we arrive at,” he said.

“The importance of data can’t be underestimated. But investors should give themselves permission to feel slightly challenged in regard to understanding ESG data.”

Data and beyond

According to Ivka Kalus, Chief Investment Officer at Promethos Capital, which focuses its investment approach on a small number of ESG factors identified as being strong alpha-drivers, a rigorous and granular approach to data is required just as much when identifying risks as opportunities.

“There can be confusion between rankings and data; rankings are not data, they’re opinions that use data. We look for raw data on factors like carbon intensity, water intensity, gender diversity, etc.,” she said.

S&P Global Sustainable1’s MacKnight acknowledged this important trend among investors. “We’re seeing increased demand for raw data as a service. Many sophisticated people want to drill into the specific issues relevant to their investment thesis,” he noted.

The data that investee firms are willing or required to supply in disclosures and sustainability reports can only tell you so much, roundtable attendees suggested, several asserting that fundamental analysis was critical to obtaining a deep understanding of financially material factors impacting portfolio constituents.

“There’s an increasing divergence between the data used for regulatory and client reporting and the analysis that the investment team finds useful for decision making. That suggests simply expanding reporting or disclosure will not result in lower externalities,” said Jackie VanderBrug, Head of Sustainability Strategy at Putnam Investments.

“Active managers offer a distinctive approach, as analysts and PMs are having strategic conversations regarding core issues that are financially material with companies that they have covered for many years.”

This matters more below the top tier of large US corporates, especially in the ongoing absence of a federal regulatory climate risk disclosure mandate.

“There’s a difference in data quality across regions and market caps,” said Frederick Isleib III, Global Head of ESG Integration at Manulife Investment Management.

“Small caps don’t necessarily know what information they should be disclosing. Engagement can help these firms understand what issues matter the most to investors.”

Focus on physical

Just as climate mitigation is higher up the policy agenda than adaptation, transition risks are better understood, if still imperfectly, in terms of their impacts on investment portfolios, than physical risks.

Investee companies’ plans to transition to a net zero economy might be somewhat lacking in detail, but investors’ experience of physical risk assessments are hazier still. Indeed, in terms of the relevance of locations, the importance of less-understood dependencies and the absence of granularity, physical risk disclosures have much in common with those on nature risks.

“Many companies have not yet done a physical risk assessment, perhaps because they’re not sure where to begin. And for those that have, there are multiple scenarios and levels of sophistication, which can lead to different conclusions in terms of financial impact,” said Isleib at Manulife.

Among investors, there is a sense that corporates are not supplying a comprehensive or connected view of their vulnerabilities to the physical impacts of climate change, perhaps because these are only just becoming apparent, as the incidence of extreme weather events increase, or due to a lack of disclosure guidance.

“Once firms have quantified the potential financial impact of their physical risks, the next thing to understand is the implications for capital allocation. We’re not seeing the follow through on that, in terms of the adaptation measures that firms are executing on. For example, if you are next to an ocean, how will you enhance your structures to be able to handle certain water flows?” posited Isleib.

“Some companies don’t believe that they’re impacted by physical risk, because they haven’t yet thought through all the scenarios. In water-stressed areas, if there are limits on water usage when there are a high number of heat days, how are you going to cool your facilities? What’s the financial impact to you if the price of water escalates?”

‘Hidden’ risks

For Calvert’s Farley, analysts have a key role in filling in some of the gaps. “Physical risk is an area where fundamental analysis comes in; and it becomes a lot easier to digest if you think of it as idiosyncratic versus systematic,” he says. “It’s going to be much more important in some companies than others, requiring individual company analysis to see how it plays out.”

Boston-headquartered investor network Ceres has produced a number of reports on the financial impact of physical risks on portfolios. According to Programme Director Cynthia McHale, some investors have flagged that if they’re doing a granular, bottom-up analysis of physical risks to companies, they can sometimes miss systemic risks impacting specific regions or sectors.

Another challenge is that physical risks can ‘hidden’ within the financial system, for example, some regional banks have big commercial real estate loan portfolios that are concentrated in a particular region,” she added.

“Climate-related physical impacts are on the rise — threatening banks’ loan portfolios and institutional investors in ways that are hard to predict and that have not been properly managed.”

The idiosyncratic and sometimes hidden nature of some physical risks obliges investors to maintain a flexible approach, augmenting internal capabilities and direct disclosures with different data sources, sometimes influenced by location, sector or size of assets.

“As well as direct information from companies, it’s important to verify data and develop specific views using multiple sources. A small cap company may not be the most reliable source, so there’s likely to be a lot of triangulating our way into understanding these exposures,” said Farley.

Call of nature

If the record of investee companies in sharing vital information on the physical risks of climate change leaves room for improvement, the challenge is of another magnitude when it comes to assessing the financial materiality of nature risks.

“The question for investors is how to capture a factor like biodiversity, which is way too complex to rely on a specific data point, so it requires some kind of translation or standards,” said Kalus at Promethos.

The disclosure situation is changing, in no small part due to the guidance provided by the Taskforce on Nature-related Financial Disclosures (TNFD), which has been publishing recommendations on an iterative basis up to September. This ‘software release’ approach has allowed feedback and familiarity to grow, often via pilot projects by both corporates and institutions seeking to establish their most significant exposures.

“The way that you get companies to enact positive change is to demonstrate return on invested capital,” said Farley, noting the early involvement of corporates in nature-related reporting.

While the signing of the Global Biodiversity Framework (GBF) in Montreal last December significantly raised the profile of nature risks and disclosures for corporates and investors, the role of the natural world in tackling the climate crisis meant that many were already exploring inter-connected issues.

In particular, investors have long been aware of the ways in which firms involved in the global food system are impacting water usage and the rate of deforestation in established carbon sinks such as the Amazon and the Mekong Delta.

Here, the regulatory forces are already coming into play, ahead of reforms by signatory nations in line with the goals of the GBF. But these drivers of change are only slowly being felt in the private sector.

“It can be difficult for investors to make the connections to financial materiality. But the EU Deforestation Regulation has done just that,” says White at Newton.

“The power to fine firms up to 4% of annual turnover is material. But then there is the question of enforcement.”

Regulatory pressures

For investors with global reach, pressure to report on nature risks is already rising, with implications for measurement of these risks. Reporting requirements under France’s Article 29 already oblige investors to report on their biodiversity risks, despite the fact that information from investee firms remains scant.

There also remains uncertainty about the effectiveness of some of the metrics being deployed. The widespread adoption of mean species abundance (MSA) in Europe as a portfolio-level measure of biodiversity is concerning for some.

“At Newton, we would prefer to see a move toward greater specificity, as this is less likely to mask the nuances of biodiversity,” added White.

The sheer complexity of the task of understanding business interactions with nature across sectors and biomes can be overwhelming, roundtable participants admitted. The temptation to try to boil down this complexity into simple scores is understandable.

Trillium’s Torres advises a targeted approach to understanding nature risks and impacts, with a clear focus on materiality and action.

“It’s important to look at the impacts from companies that are exacerbating biodiversity loss. If a company’s use of hazardous chemicals is causing water or soil pollution, causing plant species to die within the region, then we need to address its use of those chemicals within its operations. It’s important to measure the impact but also to understand the cost.”

Further, location-specificity becomes part of the conversation in a way that has not been necessary when considering the carbon footprint of portfolios. Getting to grips with these realities is likely to lead to new demands from investors, not only in terms of third-party solutions, but also skillsets and collaborations.

As Putman’s VanderBrug noted, this also holds true for corporates. “Talking to corporate leadership teams, it is clear that positive action on ecosystems often requires collaboration from multiple organisations in a particular geography,” she said.

“In addition to looking at an individual company’s numbers, it can be useful to know what they’re doing with other parties to learn and make a difference in the most vulnerable ecosystems that they operate in – even if it is a small portion of what they’re doing overall.”

The challenges remain significant, as investors reassess their investment processes to ensure end-beneficiaries are protected against risk and exposed to opportunity on a fast-changing planet. They are aware of the hard yards, but they are building on decades of experience and an ever-improving understanding of how climate and nature factors impact enterprise value – and vice versa.

MassMutual’s Sabiiti spoke for many when he observed: “My slogan internally is don’t let perfection be the enemy of good. Just get started, get moving.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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