The New York State Common Retirement Fund (Fund) the third largest pension plan in the United States, recently published their Climate Action Plan following the recommendations of their first ever Decarbonization Advisory Panel. The panel was charged with recommending how to prepare the $210 billion Fund to identify and manage the risks of a changing climate and capitalize on opportunities in the transition to a low-carbon economy.
The panel recommended aligning the Fund’s portfolio with a “2-degree or lower future by 2030 in accordance with climate science consensus,” as well as creating a “climate solutions” investment allocation, and developing minimum standards by sectors to begin the transition to a low-carbon portfolio.
While the recommendations from the panel were geared towards the Fund, how the Fund implements them will have profound implications for the companies in which they invest and those sectors more broadly.
Below, we put forward and discuss a few high-level questions that the panel begins to address. Non-financial companies can use these question and answers to gauge your level of understanding on how climate change may impact your business, think about where your organization stands, and what questions you can start asking today.
If I’m not an investor, what does the Decarbonization Advisory Panel’s work mean to me?
Over the next decade, if investors aim for 100 per cent sustainable assets by aligning their entire portfolio with a 2-degree or lower future, they will start assessing your organization’s climate change awareness, and mitigation and adaptation performance. Organizations should be prepared to answer questions from investors. The panel’s work is an example of how the financial industry is thinking of approaching considerations of climate-related financial risks and opportunities and can be used to inform corporate climate strategies.
Why the need for urgent and bold action on climate change?
The panel chose not to reinvent the wheel, but relied on the consensus of the scientific community. The body of evidence and thought on this were both strong and clear and key points from the panel’s report are:
- The science is clear: “2°C of warming will cause significant environmental and economic damage”. To avoid significant value damage, warming needs to stay below 1.5°C, which requires cutting global carbon emissions significantly by 2030 and achieving net zero by 2050.
- Pace of progress is slower than needed: Global carbon emissions are at a record high, and have begun to climb again in 2018
- Need for action by 2030: By 2030, the planet will be locked into temperature rises that may put a Fund’s value at significant risk.
- Policy ambition gap: There is a gap between the Paris Agreement goal and current policy trajectories. This may result in abrupt and disorderly impacts on global markets when governments escalate regulations.
How should I think about climate-related financial risks?
“Climate change is a phenomenon. It is not a discrete risk factor or even a set of risk factors. Simply put, climate change will fundamentally change the economic systems and thus is a material impact on investing,” said our Senior Advisor and Chair of the Decarbonization Advisory Panel, Joy-Therese Williams, at NY State Senate Public Hearing.
Climate-related risks can be viewed in two broad categories: physical and transition risks.
- Physical risks result from chronic and acute changes in climate patterns (e.g. drought and hurricanes).
- Transition risks stem from the shift to a low-carbon and resilient economy (e.g. liabilities, regulation, consumer choice, and innovation shifts demand away from fossil fuel industries).
Based on the science, the panel believes enough warming is already “baked into the system” to cause significant disruption and impacts to portfolios from physical risks, regardless of the speed or scale of the transition to a low-carbon economy. Therefore, corporates, may need to consider both mitigation and adaptation to climate-related financial risks. These may include building more resilient supply chains and distribution channels or changes to workforce policies to accommodate disruptions and promote climate-friendly activities. Having these plans in place will ease conversations with investors and provide them useful information.
Other notable considerations:
- Uncertainty in climate risk should not stop acting on climate change because being too early in avoidance of the risk of permanent loss is much less of a danger than being too late.
- ESG ratings should be regarded with caution in the context of climate change, because they do not necessarily capture an organization’s climate-related performance.
Will there be opportunity for companies to access more funding, as investors look to start creating a “climate solutions” allocation?
Investors may aim to create a new “climate solutions” allocation of investments that actively support the transition or address adaptation problems. Eventually, investors can leverage the accumulated data and relationships, combine it with existing and new efforts across all asset classes, to support the implementation of a sustainability overlay across the entire portfolio. Investors may build in-house capacity on climate solutions, allowing dedicated teams to build a robust pipeline of deals and vet opportunities against a broader set of considerations that vary from traditional investment practices. If corporates can explain their strategies and capital expenditure plans from a climate lens, they may find more favourable reception by investors.
The panel reported that opportunities for investors may include:
- Superior risk adjusted returns and portfolio protection when pursuing investments that account for the impacts of physical and transition risks. Companies with robust climate strategies, operations, metrics, governance and incentives are expected to outperform the market.
- Global investment in clean energy and low carbon opportunities must increase by five times to stay under 1.5 degrees Celsius. This investment gap allows investors to capitalize on strategies that maximize resource efficiency across areas. Examples include, transportation, circular economy and climate resilient infrastructure.
- Enhanced leadership position by establishing investment standards that ambitiously recognize and cope with climate change risks
And, so, investors are increasingly turning to companies to help them tell this story.
How might investment processes and products change? What considerations should be kept in mind?
Investors are much more educated about climate change than ever before. Corporates who understand climate risk and opportunity are able to provide investors with meaningful information will be well-placed to keep the trust of their shareholders and attract debt and capital. Investors are increasingly using the following as a suite of tools to input into the investment decisions.
- Evolving minimum standards. Minimum standards may be selected and established by investors, and can be applied across investment products, third-parties, asset classes, sectors or regions. Existing methodologies such as the Climate Action 100+ may be used for funds to communicate expectations around sustainable assets and climate solutions to managers. Funds may not support corporates that do not meet and are not making progress toward minimum standards.
- Enhanced climate risk modelling. Investors may build internal capacity to assess real assets and to undergird risk methodologies for new index products. Therefore, corporates should expect increased scrutiny in this area for their sector.
- New investment products. This may include best-in-class index products (e.g. low-carbon index, or an index built on minimum standards), direct or co-investment opportunities in climate infrastructure and real estate, or sustainable lending facility. This may be an opportunity for listed corporates that present well on climate change in these areas.