M CONSULTANT · the audience on the day was the insurance industry, Summerhayes was clear that the...

MYCONSULTANTNEWSLETTER

JUNE 2018

1MYCONSULTANT Newsletter June 2018

CLIMATE CHANGE & INVESTING: THE CURRENT STATE

OverviewClimate change and its potential impacts is one of the world’s greatest challenges. It is a problem that also suffers from, as Bank of England Governor Mark Carney phrased it, the “tragedy of the horizon” given the true impacts will be felt over a time horizon that extends over multiple generations and beyond that of most investors.

While climate change is a long term issue, there are potential investment risks and impacts in the shorter term. In fact, according to the World Economic Forum, environmental and weather-related risks are both highly likely and expected to have a significant impact as per the outcomes of their Global Risk Register. Environmental risk represents four of the top ten most likely and highest impact risks, as shown below.

The regulatory view of this was succinctly put by APRA’s Geoff Summerhayes as follows:

“While climate risks have been broadly recognised, they have often been seen as a future problem or a non-financial problem.

The key point I want to make today, and that APRA wants to be explicit about, is that this is no longer the case. Some climate risks are distinctly ‘financial’ in nature. Many of these risks are foreseeable, material and actionable now.

Climate risks also have potential system-wide implications that APRA and other regulators here and abroad are paying much closer attention to.”

A challenge for all parties is that the impacts, risks and opportunities related to climate change are likely to be nuanced at the individual asset or company level, and vary across asset classes, industries and geographies.

Currently JANA holds the view that high quality investment managers are best placed to assess and manage this risk, like they do other material financial risks. However, there is a clear industry trend to lift the level of assessment, monitoring and communication of how these climate-related risks are being managed from a portfolio perspective. This article provides an update on the latest regulatory and policy views, climate change risks and opportunities, and JANA’s view on how asset owners can monitor and manage the investment impacts of climate change.

Tim Conly Senior ConsultantTim is the Head of Responsible Investment Research at JANA and a member of the Australian Equities Research Team. In addition to research, Tim consults to a range of implemented consulting and advisory clients, covering corporate superannuation funds, endowments and charities. In his consulting role he is actively involved in setting investment strategies, providing asset allocation and investment manager advice and providing investment input on a myriad of other investment matters.

Tim has spent over 10 years in the finance and investment industry and during this time he has always had key responsibilities that included account management and client servicing. Prior to joining JANA, Tim worked with NAB Asset Management as a Senior Investment Analyst and his responsibilities in this role included relationship management, manager research and performance analytics. He filled a pivotal role in managing the relationship with various ratings agencies.

Tim holds a Masters of Applied Finance from Macquarie University and a Bachelor of Commerce from the University of Melbourne.

Source: World Economic Forum. Global Risk Register 2018

Top 10 risks in terms of Likelihood

Top 10 risks in terms of Impact

Weapons of mass destruction

Extreme weather events

Natural disasters

Failure of climate-change mitigation and adaptation

Water crises

Cyberattacks

Food crises

Biodiversity loss and ecosystem collapse

Large-scale involuntary migration

Spread of infectious diseases

Extreme weather events

Natural disasters

Cyberattacks

Data fraud or theft

Failure of climate-change mitigation and adaptation

Large-scale involuntary migration

Man-made environmental disasters

Terrorist attacks

Illicit trade

Asset bubbles in a major economy

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Economic

Geopolitical

Environmental

Societal

Technological


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Regulatory & Policy LandscapeThe integration of Environmental, Social and Governance (‘ESG’) factors into the investment process is now considered mainstream across investment managers and asset owners, as there is strong evidence that appropriately addressing and managing these risks will improve risk-adjusted returns over time.

Climate change has traditionally been captured as one of the ‘E’ risks, however recent guidance from policy makers globally has essentially unbundled this and looked at climate change as a standalone risk. Key developments in this space over recent years include:

> United Nations COP21 ‘Paris Agreement’ , to which Australia is a signatory, outlines the required commitments to limit global warming to 2° Celsius above pre-industrial levels. This officially came into effect in November 2016, with 196 out of a possible 197 countries signing up to the agreement.

> As per United Nations protocol, these signatures need to be ratified by the relevant nation state. Australia signed up to the Agreement on 22 April 2016 and ratified this on 9 November 2016. While the US President Donald Trump has announced that the USA would withdraw from the agreement, other countries have continued to ratify the agreement, with 170 countries that are party to the convention having ratified the agreement to date.

> Financial Stability Board Task Force on Climate-Related Financial Disclosures (TCFD) report was launched in December 2016, with the aim of developing voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors that show how resilient these businesses are to the transition to a low carbon economy. JANA considers the work of the TCFD as an important development, with the expectation that it will lead to more comprehensive and standardised reporting of climate-related risk exposure in future.

> ‘Climate Change and Directors Duties’ legal opinion from Mr Noel Hurtley SC was published in October 2016. This opinion outlined the belief that there is no legal obstacle to Australian company directors taking climate change and other sustainability risks into account (where material to the future of the business). Further, neglecting to consider material climate change-related risks may expose directors to claims that they are not properly undertaking their duties.

> Australian Prudential Regulatory Authority (‘APRA’) Executive Geoff Summerhayes speech tilted ‘Australia’s New Horizon: Climate Change Challenges and Prudential Risk’ in February 2017. Summerhayes gave a speech to the Insurance Council of Australia, and while the audience on the day was the insurance industry, Summerhayes was clear that the need to focus on climate-related risks extended to all APRA regulated-entities, including asset owners like superannuation funds.

It is clear from the global policy initiatives that the investment industry must also adapt to the challenges of climate change. These developments have outlined how climate change risks are like other material financial risks, in that they have potential impact on investment risk and return and thus need to be monitored and managed appropriately.

Climate Change Impacts, Risks and Opportunities As outlined earlier, a challenge for all parties is that the impacts, risks and opportunities related to climate change are likely to be nuanced at the individual asset or company level and vary across asset classes, industries and geographies.

For an asset owner, how to take a top down view to managing a problem with so many variables is currently the focus of a significant body of work. To provide some context, the below diagram from the Intergovernmental Panel on Climate Change outlines the challenge.

Source: Intergovernmental Panel on Climate Change, Fifth Assessment Report 2013 .

The TCFD report looks at ‘Climate-related Risks, Opportunities and Financial Impact’, and divided climate change risks into two categories, being:

> Physical Risks relating to the physical impacts on climate change, such as the impact of rising temperatures or increased weather events; and

> Transition Risks relating to the transition to a lower carbon economy as outlined in the Paris Climate Agreement, such as policy, technology and market-related changes designed to aid the transition.


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The following has been developed by the TCFD to provide a framework to consider these risks and opportunities:

Transition Risks

Policy and Legal

Technology

Market

Reputation

Opportunities

Resource Efficiency

Energy Source

Products/Services

Markets

Resilience

Expenditures

Revenues

Physical Risks

Acute

Chronic

Assets & Liabilities

Capital & Financing

Risks Opportunities

Strategic Planning Risk Management

Financial Impact

Income Statement Cash Flow Statement Balance Sheet

Climate-Related Risks,Opportunities,

and Financial Impact

Chart 2: Manager views on the investment risk of climate change over varying time frames

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Final TCFDReportReleased

Companies already reporting under other frameworks implement the Task Force’srecommendations. Others consider climate-related issues within their businesses

Organisations begin todisclose in financial filings

Climate-related issues views as mainstream businessand investment considerations by both users and preparers

Greater adoption, further development of information provided(e.g. metrics and scenario analysis), and greater maturity in using information

More complete, consistent, and comparable informationfor market participants, increased transparency andappropriate pricing of climate-related risks and opportunities

Broad understanding of the concentration of carbon-related assets in thefinancial system and the financial system’s exposure to climate-related risks

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The vision is that individual companies will start reporting in this framework, which can then bubble up to the top and assist in determining an asset class or portfolio’s exposure to this changing environment. This is a multi-year project, and voluntary, but it provides a clear path forward and sets the foundations for a global approach. The following is the intended activity and milestones over the next five years:


MYCONSULTANT

In the immediate future, policy risk appears to be the dominant risk. An example of policy risk for global investors is the inconsistent approach to carbon pricing as outlined by the below map:

Source: World Bank. State and Trends of Carbon Pricing 2018

ETS implemented or scheduled for implementation Carbon tax implemented or scheduled for implementation ETS or carbon tax under consideration

ETS and carbon tax implemented or scheduled Carbon tax implemented or scheduled, ETS under consideration ETS implemented or scheduled, carbon tax under consideration

Carbon intensive investments are most exposed to these policy risks in the current environment. Assets directly or indirectly exposed to this type of policy risk could include:

> Companies with significant fossil fuel reserves, particularly coal and oil;

> Industries that have high energy needs;

> Inefficient coal-fired power plants;

> Infrastructure assets that rely on the coal or oil industry, such as ports and regional airports in mining areas;

> Manufacturers of inputs to the coal or oil industry; or

> Operators of freight rail cars and ships for transporting and storing outputs from the coal or oil industry.

It is important to consider that there are also potential beneficiaries because of the climate transition. Potential beneficiaries of policy change could include:

> Renewable energy assets;

> Uranium/nuclear energy assets;

> Companies with solutions to the problems (whether it be related to energy production, energy efficiency, green technologies etc.);

> Assets that are “greener”, for example property or green bonds, where the owner/issuer may be less exposed to negative policy risks.

A key for investors is understanding how this risk or opportunity is priced into these assets, as it is the mispricing of climate change impacts that creates the unrewarded risk and opportunity for investors.

Climate Change Risk Monitoring Institutional investors have sought to measure and monitor portfolio exposure to climate change risk in four key ways:

> Vulnerable Industry Exposures A simplistic approach to better understanding a total portfolio’s exposure to climate change risk is to identify the level of exposure the portfolio has to industries and assets that are expected to be most directly affected by climate change and related policy.

> Carbon Measurement Carbon measurement seeks to capture information on emissions of the Greenhouse Gases (GHGs) for the underlying investments in a portfolio. This is most easily captured for listed equities and the bonds issued by listed companies.

> Stranded Asset Exposure The quantum of coal, oil and gas reserves currently owned by sovereign entities and companies is far in excess of what can be utilised if the world is to limit global warming to the 2°C target set under the Paris Agreement. ‘Stranded Assets’ is a term used to refer to fossil fuel assets that may not ultimately be utilised as a result of policy change and the move toward a less carbon intensive economy.


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> Scenario analysis related to potential portfolio level or asset class level impacts of the physical and transition risks. This approach involves identifying potential climate change scenarios, estimating the impact these scenarios would have on each asset class and then modelling how the portfolio would perform in each scenario. The performance of the portfolio in each scenario can then be contrasted with the estimation of return from existing modelling undertaken to provide an indication of the vulnerability of the portfolio to climate change risk. Given impacts of climate change vary greatly across assets, companies and regions, this is inherently complex as assumptions made about variable model inputs are difficult to quantify. Resultantly, most models today tend to take a very high level view. Should the TCFD recommendations be implemented across the globe, this should allow a more nuanced assessment of climate change exposures in portfolios.

As outlined previously, the impacts are nuanced at the individual asset level and as such there is no universal standard of how to measure and assess these risks.

As such, JANA is of the view that no single approach provides a robust, comprehensive approach to measuring portfolio level climate change risk. An additional challenge is that a number of these tools are still in their infancy and may rely on information voluntarily and inconsistently disclosed by companies.

Climate Change Risk ManagementThe key approaches taken to managing climate change risk globally are outlined below.

> Divestment of most at risk sectors/assets: This remains very uncommon in Australia, with divestment largely limited to exclusion-based options and funds.

> Decarbonisation approaches within equities: Decarbonisation generally involves tilting the portfolio away from companies that have either higher carbon emissions, intensity and/or a greater level of exposure to stranded assets. The objective of decarbonisation is to reduce the risk posed by climate change while still investing in a product that provides an equivalent market exposure to a non-low carbon product.

> Risk hedges: This approach to managing portfolio risk to climate change involves actively investing in assets that are expected to benefit from a move to a low carbon economy and climate change related policy action.

> Engagement: Many of the risks presented by climate change can be mitigated to some extent by proper planning and adaptation/mitigation strategies. A risk management strategy involves engaging with portfolio companies and assets regarding the actions they are taking in response to the risks presented by climate change and encouraging further action to be taken as required.

> Integrated risk management: The vast majority of institutional investors continue to undertake an integrated risk management approach to manage climate change risk. Most institutional investors continue to invest entirely through specialised, active investment managers, which are expected to consider all investment risks when making investment decisions, including climate change risk.

Given the nuances between asset classes, and even individual investments within those asset classes, JANA is of the view that this risk is currently most robustly managed through an integrated risk management approach consistent with how other material financial risks are managed

There should be appropriate processes in place to monitor these managers and have comfort that the risks are being assessed and managed accordingly. This is something that JANA integrates into our extensive manager due diligence and monitoring process.

The JANA ApproachLike many other investment risks, we believe climate change risk is best managed at the asset level in the context of investment decision making by specialist investment managers.

JANA is of the view that specialist investment managers with proven credentials are best placed to assess and manage this risk, and as such, manager due diligence, selection and monitoring is key.

JANA’s ESG and climate change related efforts are therefore primarily focused on assessing and monitoring investment managers, as well as ensuring both our managers and our clients have appropriate policies and procedures in place.

An overview of our manager evaluation process as it relates to these risks is as follows:

> JANA seeks to understand a manager’s philosophy in relation to ESG and how this translates into consideration of ESG factors in their investment process, including:

– ESG questions are included in our due diligence questionnaires;

– Questions are asked directly when meeting with the investment manager;

– We assess the integration of these issues into investment decision-making through indirect questioning regarding portfolio holdings and buy/sell decisions; and

– We discuss stewardship activities, including proxy voting and corporate engagement.

> Managers are explicitly assessed on their approach to ESG as a component of JANA’s manager evaluation process. Managers that do not meet minimum requirements are not considered investable.

> Most importantly, JANA seeks to understand how effective managers are in assessing ESG risks and their impact on future returns, rather than how well they promote their capabilities.

To assist in our manager evaluation and monitoring process, JANA has integrated climate change risk into our research and advice process, and is looking to continuously strive to be best practice in this area. JANA can assist our clients in developing their internal stewardship practices and policies.

Manager approaches to managing climate change risk vary, with few clear patterns. JANA has surveyed our extensive network of investment managers to understand how they are approaching this, with the main techniques being:

> Portfolio level risk management;

> Avoidance of most at-risk assets; and

> Requiring a higher risk-return premium to compensate for the increased risk.

JANA previously surveyed a large number of investment managers, with results published in our MyConsultant article titled Climate Change Risks: What are your managers doing?

The number of managers using external research or data providers for climate change information/data specifically was higher than we expected at 72%, with 24% measuring their carbon footprint.


MYCONSULTANT

SummaryClimate change is one of many key issues that should form part of an ongoing comprehensive strategic risk assessment adopted by all institutional investors, with recent regulatory and legal guidance reinforcing the need for most asset owners to act on this issue. While climate change risk is often thought of as a top-down, thematic risk, the underlying risks and opportunities presented by climate change and related policy risks are asset specific in nature, with significant variance in the degree to which different assets may be impacted, even amongst closely related assets. This makes top-down focused risk management approaches problematic, with significant reliance on broad assumptions not appropriate for some underlying investments. This approach also makes it extremely difficult to assess the degree of valuation risk posed by climate change at the asset class and portfolio level.

On that basis, JANA believes the current practice of sustainability risks, including climate change, being managed by the appointed investment managers is appropriate given that due diligence of individual assets prior to acquisition is part of the critical risk control process. Investment managers are arguably best placed to weigh climate-related risks and other investment risks against the expected return for each investment considered for their portfolios. Importantly, we note that all other asset-specific risks, be they ESG related or financial, are typically managed by investment managers on behalf of the asset owner. Hence, the proposed approach is therefore consistent with a typical asset owner’s broader risk management approach.

Investment managers will need to improve their disclosure and commentary to asset owners on this issue and JANA is working with the relevant managers to ensure that this occurs. There is naturally increased scrutiny of investments that are highly exposed to the physical and transition risks. The question of how to measure and monitor exposure to a challenge as vast and varied as climate change, with significant unknowns, is complex, however the global financial community is starting to navigate through this maze. For further information please contact your JANA Consultant, or email the JANA Responsible Investment Research team at [email protected]

Disclaimer: This material is not for circulation to retail investorsThis information is provided by JANA Investment Advisers Pty Ltd (ABN 97 006 717 568, AFSL 230693) (“JANA IA”), Level 6, 255 George St, Sydney 2000. This document may not be copied or redistributed without the prior consent of JANA IA. This document is intended for use only by persons who are ‘wholesale clients’ within the meaning of the Corporations Act. The information is directed to and prepared for Australian residents only. Returns are not guaranteed and actual returns may vary from the returns discussed in this communication. Securities mentioned in this article may no longer be recommended by JANA IA. Any service or investment referred to in this communication is not a deposit with or liability of, and is not guaranteed by, JANA IA.

While due care has been taken in the preparation of this document, no warranty is given as to the accuracy of the information. Except where under statute liability cannot be excluded, no liability (whether arising in negligence or otherwise) is accepted by JANA IA for any error or omission or for any loss caused to any person acting on the information contained in this document. A137246-0717

We did note that separate climate change policies are still rare (2%), with most incorporating climate change into their existing ESG or Sustainability policy documents.

Of the 250 managers JANA surveyed, the majority of respondents consider climate change and related policy a risk to their asset class as summarised below:

Chart 1: Do you think that climate change and associated policy/regulation represents a risk for investors in your asset class?

We then asked the managers to indicate how significant they view climate change risk to be over varying time frames. Infrastructure managers viewed the risk to be nearer term and higher over the medium to long term relative to other asset classes, which given the long term physical nature of most infrastructure assets appears to be appropriate.


Transition Risks

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M CONSULTANT · the audience on the day was the insurance industry, Summerhayes was clear that the...

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