We're delighted to feature this guest blog post from Henrik Wold Nilsen of Storebrand Asset Management, providing some insight into climate aware investing and the rapid pace of change. Henrik recently joined Simon Jones for an episode of our podcast Hymans Robertson On... where they discuss climate change and how it's being considered within the investment management industry. You can listen to the episode here.

Now, over to Henrik...

I manage a range of climate-aware funds, not just because it aligns with my principles and those of Storebrand Asset Management (a member of the UNEPFI Net Zero Asset Owner's Alliance), but because I believe climate change is a significant financial risk that investors should seek to mitigate.

Shortly after the Paris Agreement was signed, we began designing a climate-aware strategy. We wanted to go further than optimising for ESG characteristics and specifically target climate-risk. We worked closely with a seed investor in Sweden to create a fund that could replace passive equities as a core portfolio holding with low relative risk but a clear climate-motivation. 

Climate science is rapidly evolving and I follow developments closely. My concern is that the investment industry is preoccupied with finding a simple, tick-box solution to climate risk – in reality, the complexity and uncertainty around climate science needs to be reflected and accounted for in a suitable investment solution.

For example, integrated climate models, such as those used by Intergovernmental Panel on Climate Change (IPCC) in their most recent 1.5°C report, are extremely sensitive to inputs like discount rates and assumptions about future developments in technology.

We can draw similarities here with pension fund liability modelling. If the discount rate is too high then we, perhaps dangerously, assume that we don't need to do anything now. We can rely on future returns to close the funding gap.

When it comes to climate modelling, a high discount rate allows us to believe that we can meet the targets of the Paris Agreement (keeping temperatures to well below 2°C above pre-industrial levels) by continuing to emit CO2 into the atmosphere for many years.

The models do this by assuming that Carbon Dioxide Removal (CDR) via Carbon Capture and Storage (CCS) technology (which, in short, removes CO2 from the air and pumps it underground) will be available in the second half of the century at very large capacity and rather a low price. But this is something of a 'silver-bullet' in that, although the technology exists, it is totally unproven at scale and there is presently very little investment in future capacity. IPCC is clear on this issue: "CDR deployed at scale is unproven, and reliance on such technology is a major risk in the ability to limit warming to 1.5°C"

Climate modellers are aware of this, and the risk of path dependency from overly relying on CCS at too high a discount rate is likely to gain more attention in the next round of analysis over the coming years. Our pathways to the future need to be drawn with environmental and scientific integrity, rather than silver-bullets. If we are going to come close to meeting the Paris Agreement, we need to start reducing our reliance on fossil fuels, right across the economy and fast. Yes, we will require bio-energy and CCS, but we also need to prepare for change; the status quo for our energy use is not an option.

This is important for portfolio construction because the path to our low-carbon future is not likely to be smooth. There will be both risks and opportunities as we transition to a net-zero economy.

Storebrand is a strong advocate of engagement and using our influence as asset owners. We engage actively both directly with companies, particularly on climate-related and human rights issues, and through collaborative forums, such as Climate Action 100+. However, engagement takes time and what we face with climate change is not a distant risk, it is an emergency.

I don't believe that the majority of oil and gas companies will make the transition effectively. Their current capital expenditure decisions are not reflective of an industry that believes in the Paris Agreement, as demonstrated in a recent report by Carbon Tracker. Therefore, if we believe that the Paris Agreement will be achieved and we want to align ourselves with that outcome, there are companies that we must avoid to eliminate the risk of owning stranded assets.

Carbon exposure is not restricted to the energy industry. Our whole economy is built on fossil fuels and so we need to understand where else the risks lie in our portfolios. We optimise the fund for carbon exposure, tilting away from companies with the highest and towards those with the lowest. But this is still not enough – the way carbon exposure is reported by companies means that just relying on these numbers can lead to unintended portfolio risks if you blindly follow carbon data. We examine full lifecycle emissions, as much as possible, to consider the use of products across value chains and limit climate risk as best we can. We also think about other externalities, such as environmental damage from plastics, that are likely to lead to increasing regulation and higher costs, representing another investment risk.

Finally, our climate-motivated clients are not only interested in avoiding problems and risks – they want to fund the green transition and benefit from the opportunities. These investment opportunities cover climate mitigation via renewable energy, energy efficiency, low-carbon transport and recycling, as well climate adaptation via access to water.

The result is a strategy which has not just tracked the index since inception, but where the negative screen as well as the overweight in climate solutions have had significant positive contributions to the excess return. This is in line with Storebrand's longer term experience which demonstrates that, over a 15 year peirod, the integration of ESG considerations is not detrimental to returns.

Interesting papers to read on this topic:

Johannes Emmerling et al 2019 Environ. Res. Lett. 14 104008

IPCC 1.5, Fig SPM.3b of Summary for Policymakers, page 14

Anderson & Peters 2019 Science Vol 354 Issue 6309

Breaking the Habit – Why none of the large oil companies are "Paris-aligned", and what they need to do to get there, Carbon Tracker 2019