Climate-related financial risk has long been mispriced within investment markets. We see parallels with the Black Swan theory that focuses on the unpredictable, the improbable and the unfamiliar. As long-standing sustainable investors, we believe decarbonisation is predictable, probable and familiar. Yet this “Green Swan” event remains mispriced, with an unfathomable disconnect in asset prices and climate risk across the value chain. Decarbonisation is gaining pace, and investors are at risk of an inevitable and sharp correction in asset prices. The market rout on 9 March 2020 provided us with a stark insight of the capital at risk should the global economy decarbonise faster than the market is anticipating.
In the Jupiter Global Sustainable Equities strategy we recognise that the risks and opportunities for shareholders, the environment and society are inextricably linked as financial markets re-evaluate how business can both survive and thrive into the future.
Game changing policies – the predictable
Many catalysts could spur mass decarbonisation. We recently saw the direct consequence of a geopolitical fallout with the crash in oil price triggering severe stock market declines, exacerbated by a nervous market that was already navigating the deep uncertainty of coronavirus. Whether it be due to a geopolitical fallout between Russia and Saudi Arabia, or regulation, it is inevitable that the market will move to decarbonise quickly.
Closer to home, on 27 February 2020, the Court of Appeal found that the UK government had failed to take into account commitments made under the Paris Agreement when assessing the expansion plan for London’s Heathrow airport. The ruling that this was unlawful is likely to be seen as a landmark judgement and a key inflection point for capital allocation decisions going forward. Climate-related risk analysis is no longer a measure of prudence or virtue – it is now a legal obligation. The inevitable policy responses are likely to happen faster than currently expected, paving the way for an accelerating impact on businesses and investments.
Access to capital is certain to become more difficult as banks move to decarbonise their portfolios, and credit markets will inevitably extend their focus to climate risk.
Markets are not pricing in the impact of climate risk on businesses and investments
In 2020, for the first time in history, the World Economic Forum found the top five global economic risks as all being related to the environment.
Source: World Economic Forum, The Global Risks Report 2020
As the planet struggles to cope with extreme weather, burgeoning populations and diminishing natural resources, the investment industry must re-evaluate how business can both survive and thrive in this changing world. After almost a century of singular capitalism, a new economic system (regenerative economics) is needed for any form of capitalism to continue to prosper – one that delivers shared prosperity on a thriving planet. What is clear is that we can no longer separate the needs of key stakeholders, and the balance between these stakeholders will ultimately determine economic stability and corporate efficacy. However, while environmental, social and governance (ESG) considerations feed into stock analysis for many banks and brokerage firms, few have created a cohesive approach to how those co-dependent stakeholders should be reflected in asset price valuation across bonds and shares.
The UN-supported Principles for Responsible Investing (PRI), an organisation that includes around 500 global asset managers, recently released a report warning that the realities of the climate crisis will inevitably catch up with governments across the world. The report highlighted that there is a real risk that the policy response needed to meet global emissions goals – or even to keep the status quo – may be more sudden and more sweeping than many investors and businesses have considered. The PRI also noted that “financial markets today have not adequately priced in the likely near-term policy response to climate change”.
“The question for investors now is not if governments will act, but when they will do so, what policies they will use and where the impact will be felt. The [Inevitable Policy Response] project forecasts a response by 2025 that will be forceful, abrupt, and disorderly because of the delay.”
Principles for Responsible Investing, “What is the Inevitable Policy Response?” 20191
Practicalities – the probable
In 2007, Professor Lord Nicholas Stern, Chair of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics, said that climate change is “the greatest market failure the world has ever seen”. The current trajectories confirm this decade-old declaration – policy and markets have not reacted swiftly enough to meaningfully correct the trend to ever higher temperatures over the last century (see figure 1).
Figure 1: Current policies are not reducing emissions fast enough
Governments are beginning to respond and we have seen regulation accelerate. The UN Climate Change Conference COP26, which is due to take place in Glasgow in November 2020, should hopefully act as a potential catalyst for meaningful developments in multilateral policy agreements.
Individual savers are also becoming increasingly aware of the impact of their investments, with flows to sustainable funds accelerating. For the global economy to address the needs of these environmental stakeholders, share prices need to start reflecting the embedded climate-related financial risk of these issues.
If you want to manage an issue, then you have to start by measuring it
Plastic pollution, water scarcity and wealth inequality all carry financial risks, but our focus in this article is on carbon due to the magnitude of its impact on climate change. Carbon also provides years of groundwork to help quantify and ultimately price the associated risk.
The Task Force on Climate-related Financial Disclosure (TCFD) was set up in 2015 to develop consistent and increased reliable information on climate-related risks. The purpose was to strengthen the stability of the financial system, contribute to greater understanding of climate risks and facilitate financing the transition to a more stable and sustainable economy. The TCFD has created a framework which lays the groundwork to build carbon-pricing mechanisms which will enable the market to quantify the level of direct climate-related risk in financial terms.
“Increasing transparency makes markets more efficient, and economies more stable and resilient.”—Michael R. Bloomberg, Chair of TCFD
In general terms, companies that have a higher carbon output than their peers are likely to have higher costs which will lead to a competitive disadvantage. Meanwhile, businesses that decarbonise faster should be in a stronger position than their peers.
Case study: Cement
To illustrate the magnitude of the impacts, it is helpful to understand carbon-pricing effects in essential but carbon-intensive sectors. The cement sector, for instance, is an example of an industry we rely on heavily as a society and provides us with a tangible example of the direct impact that carbon emissions could have on future cash flow.
If cement were a country, it would be the third largest carbon dioxide (CO2) emitter after the US and China.2 It was first meaningfully introduced by the Romans in 200BC, as documented by Vitruvius in De Architectura, and, apart from an interruption in the Dark Ages, has been vital to our infrastructure ever since. Respectfully misquoting Monty Python: “What has cement ever done for us? Apart from roads, schools, housing, hospitals…” Moreover, there is no clear, scalable, disruptor on the horizon to take its place.
A key risk to this industry is the loss to future cash flow. For now, cement companies are free to expel CO2 into the air without incurring direct additional costs. But given the pressure worldwide to reduce emissions, there is a risk that this will incur hard emission costs in the future. Figure 2 illustrates the potentially crippling impact emissions costs would have on cash flow for companies in the cement industry. There is a wide dispersion on the level of impact to the financial stability and operational resilience of the company. Company 3 has minimal risk, indicating a company with strong carbon management. This suggests it benefits from a progressive, high quality management team, running a resilient business model which has sought to mitigate future hard emissions costs.
Figure 2. Incremental carbon costs (after tax) model
Process – the familiar
Assessing the long-term material risk of climate change to businesses, and the opportunities arising from this, is fundamental to our investment process. Given the complexity of this risk, we use environmental considerations as a tool, and not as a screen. We focus on two factors: the risk; and the opportunity relative to peers and geographical norms.
- Policy acceleration – socio-economic governing bodies are beginning to realise we are not reducing emissions fast enough. The climate crisis is no longer just an issue for future generations to worry about; it is the defining challenge for our world today. Peak warming is overwhelmingly determined by cumulative CO2 emissions. To stabilise temperatures at any level, whether it is 1.5°C above pre-industrial levels (the Paris Agreement aspirational goal), 2°C (Paris Agreement central aim) or even 3°C, net CO2 emissions need to be reduced to zero. Most governments, environmental groups and businesses now understand this, with the Intergovernmental Panel on Climate Change calling for a 40% reduction of all fossil fuel usage in the next 10 years.3
- Physical impact of extreme weather events that are likely to get worse – on the whole, businesses, infrastructure, technology and people are not currently prepared. In a striking illustration of just one potential impact for developed markets, Gillian Tett recently highlighted in the Financial Times that climate risk complacency could even deliver another mortgage default crisis in the US, given chronic flooding is expected to hit an increasing share of houses every couple of years.4
Yet there is evidence that companies are starting to embed climate-related risks into their corporate strategies. In August 2019, the Business Roundtable commitment of 200 of the world’s most successful companies included broader stakeholders in corporate strategy. Industry behemoths, including Repsol and to a degree BP, have announced strategic overhauls, while others, such as Barclays and Exxon, are having these issues brought to them through shareholder resolutions. As the next decade paves the way for clear Net Zero Targets across industries, we see attractive opportunities to invest in companies leading that transition.
Seeking to mitigate climate risk and find opportunities for our investors and the climate
In the Jupiter Global Sustainable Equities strategy, we aim to identify the highest quality companies who are spearheading the transition to a more sustainable world economy. We believe companies who manage their business for all stakeholders are better positioned to ultimately benefit. This approach has resulted in a low carbon global portfolio.
Assessing the long-term material risk of climate change to businesses and the opportunities arising from this is fundamental to our investment process. Given the complexity of this risk, we use environmental considerations as a tool, and not as a screen. We focus on two factors: the risk and the opportunity relative to peers and geographical norms.
The products, services and future strategy of our holdings matter the most
The positioning of a business through its behaviour, or products or services is a fundamental consideration of our investment process. We believe how a company has invested historically to mitigate its Scope 1 and 2 carbon emissions5 , and whether its products or services and internal operations are aligned with the transition to a low-carbon economy (as represented by the 2°C climate goals agreed at the 2015 Paris COP21 conference), are key indicators of higher quality risk management and a resulting opportunity from a competitive positioning perspective.
The Jupiter global Sustainable Equities strategy has 88.1% lower carbon footprint compared to its global benchmark As at 30 September 2019, the total Scope 1 and 2 emissions attributable to the Jupiter Global Sustainable Equities strategy based on the respective ownership in the underlying companies (termed “financed emissions”) was 172.1 tCO2e, corresponding to an emissions investment efficiency of 17.6 tCO2e per £1m invested. This was 88.1% lower than the MSCI All Country World Index benchmark, which had financed emissions of 147.9 tCO2e per £1m invested 6
How do we report climate risk in our strategy? Our approach embeds the philosophy of the Task Force on Climate-related Financial Disclosure (TCFD) framework to understanding the materiality of climate-related risks
The TCFD outlines four categories of climate-related risks and opportunities:
Policy and Legal Risks – constraint of adverse climate impact and promotion of adaption
Technology Risks – improvement or innovation
Market Risk – commodity, product or service risk
Reputation Risk – customer or community perception
Profitable, predictable … and happening fast
We think a Green Swan event in the form of decarbonisation is probable, predictable and familiar and is likely to happen much faster than previously projected. Due to the magnitude of risk that climate change presents to the global economy and human society, we believe that it is imperative for investors to evaluate climate risk in their portfolios. Through the Jupiter Global Sustainable Equities strategy, we seek to address the risks to investors’ savings arising from these long-term trends, as well as capture the opportunities.
The two crucial areas that investors need to be aware of: policy acceleration and the physical impact of climate change. An acceleration in policies to mitigate climate change will likely lead to material consequences for the value of investments. The oil feud fallout of this month affords us a glimpse of what this could look like on a structural basis.
Additionally, the physical risks arising from extreme weather are accelerating: from wild bush fires to submerged towns, the impacts on asset pricing are likely to have wide-reaching effects. Companies that have strong climate change management strategies, that address the transition to low-carbon sources of energy, are more likely to offer long-term sustainable returns, while also helping to mitigate climate change.
Jupiter’s environmental and social credentials
Jupiter has a longstanding commitment to sustainable investment. Founding partners of UKSIF in 1998, a Climate Disclosure Project signatory in 2000, and a 2008 signatory of the UN Principles for Responsible Investment, we have deep-rooted credentials to our corporate commitment of environmental and social considerations. We understand our biggest potential impact to environmental matters is through our stewardship of the companies we invest in, via the funds we manage, and we have committed to a significant collective of initiatives to bolster our individual stewardship efforts. We also continue to strive to reduce our direct environmental footprint and were one of the first asset managers in the world to become RE100 compliant.
From a social perspective, we are a proud supporter of Investment 20/20, which our CEO Andrew Formica co-founded. We are also signatories and active members of several social inclusion initiatives, including Women in Finance Charter, 30% Club and the Diversity Project.
2Source: The Royal Institute of International Affairs, Chatham House, “Making Concrete Change” report, June 2018.
3The Intergovernmental Panel on Climate Change special report: Global Warming of 1.5°C, 2018 https://www.ipcc.ch/sr15/
4‘Climate change could cause a new mortgage default crisis’, Gillian Tett, Financial Times, 26 September 2019 https://www.ft.com/content/7ec25f94-e04f-11e9-9743-db5a370481bc .
5‘Scope 1’ carbon emissions are all direct emissions from an organisation’s own activities. ‘Scope 2’ carbon emissions from the production of electricity used by the organization.
6Tonnes of carbon dioxide equivalent. A measure that compared the emissions of other greenhouse gases relative to one unit of CO2.
7Stranded assets are defined as an asset that has become obsolete or non-performing. This includes fossil fuel supply and generation resources which are no longer able to earn an economic return as a result of changes associated with the transition to a low-carbon economy.