PASSIVE INVESTING 2020 - Addressing climate change in investment portfolios - 2020 SURVEY - Addressing climate change in ...
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2020 SURVEY PASSIVE INVESTING 2020 Addressing climate change in investment portfolios
Foreword
DWS is pleased once again to sponsor this stakeholders, linking our business interests as
important research, and I personally wish to an asset manager, the fiduciary interests of our
thank the authors for their steadfast efforts clients, and the interests of government and non-
in getting this work completed as the world governmental organisations and wider society.
grappled with the lockdown stage of the
Covid-19 pandemic. The report demonstrates DWS was one of the early signatories to the
the continuously rising relevance of passive United Nations-backed Principles for Responsible
strategies for pension funds, as well as the Investment (PRI) in 2008, and in recent years we
importance of sustainability. have transformed our business to make it one of
the world’s leading providers of environmental,
The Covid-19 pandemic, and the economic fallout social and governance (ESG) asset management
it has produced, is yet another reminder of how products and solutions.
fragile our societies are, and how, on a global
basis, we must build more resilient economies. One of my key aims as chief executive is to
Climate change is one important aspect of this, accelerate that transformation and to put
and it is heartening to see from this report how sustainability at the heart of everything we do.
pension funds are reshaping their portfolios To that end, we created a Group Sustainability
in recognition of the fact that climate-related Office to further drive our sustainability goals.
investments and performance-driven asset It is vitally important to us that we help our
management are not mutually exclusive, and that, clients achieve positive environmental and social
in fact, they increasingly go hand-in-hand. It is also contributions. This is part of our core values.
encouraging to see that the majority of pension
funds intend to increase their passive climate- I hope you find this report illuminating. These
related allocations over the next three years. are exceptional times, and the 2020s are shaping
up to be the decade of zero interest rates, of
This is no surprise to us here at DWS. We have algorithms, and of sustainability. The more
long recognized the fundamental shift towards knowledge we have now, the better prepared
sustainable investment that is taking place now, we will be for the challenges, and opportunities,
and the responsibility asset managers have to be that lie ahead.
the conduits of positive change. We also recognize
how important it is to align the interests of all
Best wishes
Asoka Woehrmann
CEO, DWS
IAcknowledgements
“Historically, pandemics have forced humans to break with the
past and imagine their world anew. This one is no different.
It is a portal, a gateway between one world and the next.”
Arundhati Roy
Indian novelist and political activist
Financial Times, April 3rd, 2020
This 2020 global survey is part of an annual allocation issues that pension plans and their
research programme by DWS and CREATE- managers have faced in an ever-changing market
Research. It is designed to highlight the forward environment over time.
trends in passive investing.
Second, DWS, who supported the publication of
This year’s survey looks at how pension investors this report without influencing its findings in any
are using passive funds to deal with opportunities way. Their impartial arms-length support over the
and risks associated with global warming and past three years has enabled us to share valuable
how their approach will be affected by Covid-19. insights with all the players in the investment
value chain in multiple pension jurisdictions.
On this occasion, I am deeply grateful to four
groups of organisations and people who have Third, IPE, who helped carry out the annual survey
made this report possible. in this programme and its editor, Liam Kennedy,
for guidance and support over the years.
First, the 131 pension plans who participated
in our global survey. Forty of them were also The final group comprises my immediate team:
involved in our post-survey structured interviews, Lisa Terrett for conducting the survey, Anna
thereby adding the necessary depth, colour and Godden for desk research and Dr Elizabeth
nuance to our survey findings. Goodhew for editorial support.
Their unstinting support over the years has After all the help I have received, if there are
helped us to develop an impartial research any errors and omissions in this report, I am
platform that highlights forward-looking asset solely responsible.
Amin Rajan
Project Leader, CREATE-Research
IIContents
Foreword I
Acknowledgements II
1 Executive summary
Introduction and aims 2
Survey highlights 4
Key findings 5
1 Climate-related funds target a double bottom line 5
2 Climate-related passive funds follow a twin track approach 9
3 Climate-related passive funds sit in the buy and hold portfolio 11
4 It’s too soon to judge the outcomes of climate-related passive funds 12
2 Suppressing the curve on greenhouse gas emissions:
What are the key drivers and blockers?
1 Key drivers 16
2 Key blockers 20
3 Key asset classes 22
4 Key manager selection criteria 24
3 Passives remain anchored in the core portfolio:
How will the market dislocation affect passive funds?
1 The Covid-19 crisis 28
2 Expanding scope in a shrinking overall base 29
3 Passive investing is set to grow 36
Other publications from CREATE-Research 39
Disclaimer 40
Author: Prof. Amin Rajan
First published in 2020 by CREATE-Research and DWS
Telephone: +44 (0) 1892 78 48 46 Email:
Mobile: +44 (0) 7703 44 47 70 amin.rajan@create-research.co.uk
© CREATE-Research, 2020
All rights reserved. This report may not be lent, hired out or otherwise disposed of by way of trade in any form,
binding or cover other than in which it is published, without prior consent of the authors.
IIIExecutive summary 8
Executive summary – Introduction and aims
Introduction and aims
Covid-19 is a devastating reminder of the fragility Their current market prices do not fully reflect the
of life on Planet Earth. environmental damage they cause. Rather, they
inflict uncompensated costs on wider society via
It will be a key defining force of our age, alongside greenhouse gas emissions, rising sea levels, ocean
global warming. acidification and so on.
Recent TV footage of empty roads, cleaner air Markets have hitherto been slow to fully price in the
quality, animals coming closer to cities and risks they pose to the financial viability of the global
people working from home has starkly revealed economy and social stability of individual nations.
once again the unbalanced relationship between
humans and nature. Indeed, focusing on short-term returns would
create “potentially catastrophic systemic risks”
Resilience is the new watchword worldwide. warned the leaders of three of the world's high-
Unprecedented economic support from policy profile pension plans: Japan’s Government Pension
makers to protect lives and jobs has been timely. Investment Fund, the California State Teachers’
This has also turned the spotlight on the role of Retirement System (CalSTRS) and the UK’s USS
companies and their investors in tackling two Investment Management.
side effects of today’s turbo-charged capitalism:
economic inequalities and environmental Issued on 13 March 2020, their joint statement
degradation. had added poignancy, coinciding as it did with
the fastest stock market falls in history as Covid-19
A series of recent extreme weather events – from went global. The statement also confirmed that
devasting bush fires in Australia, to hurricanes in many pension plans have been future-proofing
the US, to heat waves in Europe and severe floods their assets by factoring risks and opportunities
in Japan – has alerted the world to the damage associated with climate change into their
caused by their rising frequency as well as severity. portfolios of passive as well as active funds ever
since the 2015 Paris Agreement to limit global
Scientific studies attribute them to Anthropocene: warming to 2°C above its pre-industrial level.
a new epoch in which humans are a key factor
in climate change. The World Economic Forum’s Hence, this study does a stock take on the current
2020 annual report found that, for the first time state of their allocation, focusing on climate-
in its 15-year history, the natural environment related passive funds.
dominated today’s top five risks.
Our last two pension surveys in this annual
For investors, global warming presents both risks DWS–CREATE series have shown how passive
and opportunities via three distinct channels: investments are being integrated into core
recurring extreme weather events; accelerating portfolios. This survey turns the spotlight on
innovation in green energy; and growing societal how climate change features in this foundational
pressures to divest from fossil fuel assets that have change by highlighting:
long imposed negative externalities.
“You can never plan the future by the past.”
Edmund Burke,
Irish statesman
2• the key drivers of investments into climate- These questions were pursued via a global survey
related passive funds and the level of of 131 pension plans in 20 jurisdictions with a
allocations so far combined AuM of €2.3 trillion. Their background
• the strategies being used in the process and details are given in Figure 1.0. The survey was
how they are likely to change over the next followed up by 40 interviews with senior executives
three years to assess the impact of the Covid-19 crisis on their
• the outcomes so far, the constraints that need asset allocation.
to be overcome and the lessons that have
been learnt. The rest of this section presents survey highlights
and our four key findings.
FIGURE 1.0
Which sector does your pension plan cover,
and what is the nature of your plan?
% of respondents
Sector: Nature:
51% Pure DB plan
12% Hybrid
39% Public
6% Mix of DB and DC
31% Pure DC plan
61% Private
Source: CREATE–Research Survey 2020Survey Highlights (% of pension plan respondents)
CLIMATE-RELATED PASSIVE FUNDS: ALLOCATION
26% 21% 54% 65%
Already have an Already have a Recognise that Expect to increase
allocation in excess mature portfolio climate change their allocations
of 15% in their total of climate-related is material to over the next
passive funds passive funds investment returns three years
CLIMATE-RELATED PASSIVE FUNDS: IMPLEMENTATION
81% 60% 70% 66%
Target superior See data and Select asset Expect their
risk-adjusted definitional managers on the asset managers
long-term returns problems as a basis of their to have proven
and negative constraining factor track record on stewardship
fat-tailed risks ‘green’ agenda capabilities
PASSIVE FUNDS IN GENERAL: RECENT TRENDS
70% 89% 57% 27%
Treat traditional Treat equities as Expect their Expect their
cap-weighted their favourite allocations to ESG allocations to smart
index funds as underlying asset funds to grow in beta funds to grow
their favourite class of choice excess of 5% per in excess of 5% per
vehicle of choice annum over the annum over the
next 3 years next 3 yearsExecutive summary – Key findings
Key findings
1. Climate-related funds target signed a landmark agreement to combat global
a double bottom-line warming by phasing out fossil fuels and investing
in ‘green’ energy.
a) The current scorecard and its drivers These developments have triggered regulatory
action in many pension jurisdictions, as climate-
Three seminal events in 2015 heightened pension related investing has become a foundational trend
plans’ interest in climate investing. in institutional portfolios in two forms: as a key
theme in portfolio construction; and as a key topic
The first was Bank of England Governor Mark in shareholder engagement. This report focuses
Carney’s speech ‘Breaking the tragedy of the mainly on the former.
horizon’. It warned that financial markets remained
oblivious to the catastrophic long-term impact of Starting with total investment portfolio (Figure 1.1,
climate change. left chart), it is clear that 22% of our survey
respondents have allocations in excess of 15%
Soon after that, the United Nations adopted 17 when it comes to all climate-related strategies. At
Sustainable Development Goals. Climate change the other extreme, 19% have no allocations at all
featured in at least three of them. Asset owners currently. In between, 43% have allocations less
and asset managers are enjoined to be part of than 5%; and 16% have between 6% and 15%.
their delivery.
However, the picture looks somewhat different when
Finally, at the end of 2015 came the Paris climate the focus shifts to that part of the total portfolio
change conference, COP21. Around 200 nations that covers only passive funds (Figure 1.1, right
FIGURE 1.1
What is the approximate share of all climate-related funds in the following
types of your pension plan’s investment portfolios currently?
% of respondents
Total investment portfolio Portfolio covering only passive funds
19%
22% 26% 56%
5%
6%
0%
43%
11%
12%
0% 1-5% 6-10% 11-15% Above 15%
Source: CREATE-Research Survey 2020
5Executive summary – Key findings
“Investing in climate change is a fact of life and a matter of time.”
Interview quote
chart). 26% of respondents have allocations in climate change as delivering good risk-adjusted
excess of 15% at one extreme, and 56% have no returns in the long run. 54% believe that climate
allocations at all at the other. change is increasingly becoming material to
securities pricing and value creation – albeit from
Thus, while the total investment portfolio has so a low base – as our societies transition to a low-
far attracted 81% to climate-related investing, the carbon future.
corresponding passive portfolio has attracted 44%,
implying a slow-motion inevitability. 49% cite that physical risks from extreme weather
conditions and transition risks from the disruptions
The key reason behind the difference is that to the existing fossil fuel business models are also
climate change remains an inexact science for presenting opportunities.
investors. Hence, initially, they have preferred
to invest with specialist active managers who These drivers are further reinforced by regulatory
have long developed an infrastructure of skills, pressures (43%) and technological advances
technology and data to build up a good track towards ‘green’ energy and ‘green’ transport (51%).
record in theme investing. Besides, some of the Regulators now regard climate awareness as vital
underlying asset classes – like private equity to good corporate governance.
and infrastructure – are in illiquid markets where
indices remain a rarity. Underlying these numbers is a new imperative: as
economies have grown and progressed, new forms
Another reason is that, in the last decade, passive of risk have emerged. Global warming is the most
funds were especially favoured for riding the serious and pressing. Thus, in deference to rising
prolonged market momentum sparked by central societal concerns, pension plans are enjoined to
banks’ ultra-loose monetary policies. It is only in go beyond a green ‘do-gooder’ reputation into
the last two years that their appeal as a vehicle the realm of long-term risk management to reflect
for pursuing special themes – like environment – the duration of their liabilities. In sum, investing
has become more evident for pension investors, in climate change is seen to be about achieving
especially as index providers have also shifted a double bottom line: doing well financially and
up a gear with improved offerings. doing good socially.
A number of drivers are behind changing With such concerted forces, the ecosystem of
investor perceptions. financial markets is expected to pivot towards
climate risks over time, even though the Covid-19
Taking them in turn, as shown in Section 2 crisis will divert investor attention in the near term,
(Figure 2.1), 62% of our respondents now see as we shall see later.
“Financial markets are often slow to price in big outcomes until they
are faced with them.”
Interview quote
6Executive summary – Key findings
FIGURE 1.2
In which stage is your pension plan currently with respect
to the following types of investment portfolios?
% of respondents
Passive funds in general Passive funds related to climate change
11%
43% 21 %
8%
15%
17%
64%
21 %
Already mature Implementation phase Close to decision making Awareness raising
Source: CREATE-Research Survey 2020
b) The current evolution of passive investing (Figure 1.2, right chart). Only 21% already have
a ‘mature’ portfolio currently, with 15% in the
Pension plans’ allocations to passive funds has ‘implementation’ phase, and a markedly higher
been rising since 2005 and accelerating in the last 43% still at the ‘awareness raising’ phase.
decade, as active funds struggled to beat their
benchmarks while central bank policies distorted The perception that passive funds merely follow
market valuations. The rise has taken passives into a simple low-cost rules-based style that mimics
investors’ core buy-and-hold portfolios, covering its chosen broad indices remains ingrained in the
assets in the deep, liquid and efficient markets of investor psyche, especially in the US. This holds that
America and Europe. such funds do not exercise their voice often enough
to influence their investee companies’ carbon
Looking at the life cycle of adoption, 64% of our footprint and lift the quality of their beta assets
respondents currently have a ‘mature’ portfolio of due to over-reliance on proxy-voting advisors.
passive funds in general, and a further 17% are in Perceptions aside, there are two other factors
the ‘implementation’ phase. Only 11% are still in behind the slower implementation of climate-related
the ‘awareness raising’ phase (Figure 1.2, left chart). passive funds, as shown in Figure 2.2, Section 2.
In contrast, the adoption of passive funds directly 60% of our respondents cite the lack of a robust
related to climate change has been notably slower template with consistent definitions and reliable
7Executive summary – Key findings
“The ‘passive’ label implies a level of dormancy that does not
reflect various active ways in which investors seek decent returns
from their passive funds.”
Interview quote
data as a key constraint. There are now over 150 on a cluster of three mutually reinforcing forces.
major data vendors worldwide, using proprietary Financial markets are slow to price in climate risks,
scoring systems often yielding a radically different according to 59% of survey respondents. As a
assessment of the same company. result, there is a lack of investment opportunities,
according to 41%. This means that climate-related
The company data they provide vary according to investing has yet to develop a long-enough track
their approach. Some are mandatory and audited. record, according to 32%.
Some are voluntary and self-reported, with no
independent audits. The result is significant white Hence, for our survey respondents, investing in
washing: companies only reporting when they climate change so far has been an adaptive journey
have something favourable to say. Nor are these up a steep learning curve, relying on learning-by-
vendors subject to any regulatory oversight akin doing. This, in the belief that climate change will,
to the traditional credit rating agencies. In any before long, emerge as a compensated risk factor –
event, so far it has proved hard to obtain data on like the traditional ones such as quality, value, low
three core concepts in climate-related investing: variance and momentum.
materiality, intentionality and additionality.
Currently, markets have already started to price
Respectively, they seek to assess how material risks in sectors such as power generation, where
climate change is to a company’s financial the economics of renewable energy is constantly
performance: does the company intend to do improving. While climate change may be proxied
anything about it; and will the company really by factors such as quality and value, it still brings
act in a way that delivers a double bottom line – an additional benefit: a more defensive portfolio by
societal benefits in addition to financial benefits? capturing negative fat-tail risks (Case study 1a).
Yet another major constraining factor centres
Case study 1a: The elusive charm of quarterly capitalism
Markets are slow to price in climate risks due to Those carbon producers unable to migrate to green
today’s ‘quarterly capitalism’: investors tend to value energy risk ending up with stranded assets exposed
quarterly earnings to the detriment of long-term value to a significant loss in value well ahead of their eco-
creation. Thus, markets tend to focus on the shark nomic life. On the upside, there are also new opportu-
closest to the boat. nities emerging with the rise of renewable energy.
For their part, in the name of prudence, investors We therefore look at risk in a forward-looking way by
tend to demand a long track record of returns before envisaging scenarios. Just as it is foolhardy to drive
making allocations. In our experience, waiting for a car by looking in the rear-view mirror, it is wise to
strategies to be tested by time or events means anticipate change and act on it. The challenge that in-
waving goodbye to all the upsides. Today’s alpha is vestors face is how can capital markets amplify rather
tomorrow’s beta. than undermine the goals of the Paris Agreement?
A Swedish pension plan
8Executive summary – Key findings
2. C
limate-related passive funds The second track, in turn, relies on two overlapping
follow a twin-track approach approaches.
Four vehicles underpin our respondents’ current One of them takes a more holistic view of climate
approach to climate-related passive funds. They risks and opportunities. It aims to over-weight
have a modest tracking error range against their companies that are positively exposed to low-
chosen parent indexes (Figure 1.3). They follow carbon transition and under-weight companies
two distinct tracks: plain vanilla core funds and that are negatively exposed, while maintaining
specialist high impact funds. broad market exposure. This in the belief that
successful investing is as much about avoiding
FIGURE 1.3 losers as picking winners.
What are the main strategies used to invest in climate-
related passive funds currently and which ones will The second approach is based on the so-called
be used over the next three years? Transition Pathway Initiative, created by asset
% of respondents owners and supported by asset managers
worldwide. It aims to focus on companies with
0 20 40 60
a high impact on climate change. It assesses
them on the basis of how well prepared they
32 %
Core climate- are for the transition to a low-carbon world. The
related indexes
32 % assessment relies on three criteria: companies’
management of greenhouse gas emissions; the
risks and opportunities related to their transition;
Sustainable
development 26 % and their carbon performance against international
goals-related targets and national pledges made as part of the
indexes 55 %
Paris Agreement.
Smart beta
10 % Currently, all the identified approaches are employed
strategies
by our survey respondents using climate-related
based on
climate change 32 % passives (Figure 1.3): with 32% focusing on core
funds, 29% on green finance indexes, 26% on
SDG-related indexes and 10% on smart beta funds.
Green finance 29 %
or green bond
indexes 34 % However, looking over the next three years, the
bulk of the increased allocation is likely to be
channelled into SDG-related indexes (55%), smart
Currently Next 3 years beta funds (32%) and green finance indexes (34%).
Source: CREATE-Research Survey 2020
This projected growth pattern reflects the growing
demand for customisation and double bottom line
The first and the simplest track aims to exclude benefits. These three portfolio strategies are deemed
high environmental polluters, such as fossil fuel better suited to target positive externalities: such
producers and the power utilities that rely on them, as reduced emissions, faster innovation in clean
in order to reduce the carbon footprint of the energy, lower energy costs and more efficient use
portfolio. Core climate-related indexes fall into of energy resources (Case study 1b).
this category.
9Executive summary – Key findings
Case study 1b: The rise of green bonds
The UN estimates that annual financing of $3-5 trillion environmental impacts – mostly in the transport
will be needed to meet its Sustainable Development and energy sectors.
Goals by 2030. Given the scale, the bulk of the money
Their early adopters have been mainly in Belgium,
will have to come from the private sector. We need to
China, France, Germany and the Netherlands. But
catch up on the years in which we procrastinated.
the coverage will likely broaden and deepen in Europe
This has turned the spotlight on green bonds. Equity with the EU’s commitment to enact the Paris Agreement
markets have started to play a role in reducing global into law.
warming. But bond markets have lagged behind in
We have a small allocation to green bonds in our
delivering the targeted financing, even though their
passive portfolio, as a defensive move, since the un-
growth has been exponential. From a base of zero in
derlying collateral is strong. We think this market will
2010, the global issuance is set to top $300 billion in
take off as the European Central Bank includes green
2020. So far, over half of the total has been issued
bonds in its future quantitative easing programme.
by sovereigns and quasi sovereigns, with the rest by
public utilities and financial services. The proceeds
partially or fully finance projects with tangible A German pension plan
In the process, the passive funds in use will continue In contrast, fixed income arguably does not offer
to be underpinned by three asset classes, as shown the same degree of engagement opportunities
in Section 2 later in the report in Figure 2.3. beyond the initial screening stage, although recent
guidance from the UN PRI is making a positive
So far, equities have been and remain the dominant difference. Currently, 36% of our respondents rely
asset class, cited by 86% of our respondents – a on fixed income to pursue their climate-related
number that is likely to rise to 89% over the next agenda and the number is likely to rise to 39%
three years. This pole position is influenced by over the next three years.
the fact that the mandated transparency and
liquidity of equity markets make them an ideal Finally, 50% of respondents rely on listed real
vehicle for pursuing newly emerging investment assets when constructing their passive vehicles,
themes like climate change and other Sustainable a number that could fall to 46% over the next three
Development Goals. Another advantage favouring years. The decline reflects the negative impact
equities is the opportunity they offer to exercise a of the Covid-19 crisis on one key component of
stewardship role via AGM attendance, proxy voting this asset class: real estate. ‘Rent holidays’ will be
and year-round conversations (including virtual) inevitable in large swathes of the retail and leisure
with investee companies. sectors. The office sector may be hit, too, if remote
working becomes the norm after the crisis.
“Specialist indices have longer-term focus and more variable
performance; unlike core indices that mimic the parent index.”
Interview quote
10Exe cu t i v e s u m m a r y – Key f in din gs
3. C
limate-related passive funds sit They prefer to remain invested in quality assets,
in the buy-and-hold portfolio so as to gain more by losing less and outperforming
over a full market cycle. They are all too aware
A key feature of climate-related passive funds is that valuation mirages can often occur, as
that they essentially rest on a long-term perspective evidence shows that capital markets do not
(Figure 1.4, left chart). 81% of our respondents recognise predictable risks until it’s too late. Their
invest in them to target good risk-adjusted long-term risk measure is no longer the standard deviation
returns by investing in companies who are future- of returns but a permanent impairment of capital.
proofing their business models against climate risk. Their liquidity needs are no longer dictated by the
Additionally, 62% are targeting a more defensive need for periodic opportunism but by the time
portfolio with lower risks. profile of their liabilities.
Behind these numbers lie three considerations: For now, the tracking error that is tolerated for just
global warming is material to a company’s business such an approach remains notably low (Figure 1.4,
performance; the current generation of risk models right chart). It shows that nearly three quarters of
is not suited to predicting negative fat-tail far-off our respondents prefer a tracking error of less than
risks that have no historical precedents; and markets 1%. At the other extreme, 6% are willing to accept a
are beginning to price these risks, especially since tracking error of above 5%, mainly for green bonds
the recent collapse of the Pacific Gas & Electric focused on energy and transport infrastructure.
Company after raging fires in California last year. Examples of benchmark agnostic funds are few
It showed that valuation mirages can often conceal and far between – for now.
predictable risks until it is too late. So far, only the
risks that are visible, especially visceral ones, have The implied caution primarily reflects the fact that, at
tended to attract attention. this early stage, our respondents are dipping their
toes in the water and raising their comfort level
This growing focus on the long term is becoming about what is, after all, a nascent phenomenon for
an important feature of passive portfolios in them. Low carbon vehicles with low tracking errors
general. As Section 3 shows, the holding periods that don’t seek outperformance pretty well deliver
of various passive vehicles have been rising lately. as expected. But the reason behind caution is more
For example, 86% of our respondents now hold nuanced, as we shall see below.
traditional index funds for more than two years.
The corresponding figures for smart beta is 73%
and for ETFs is 60% (Figure 3.5). At least one in
every five respondents expects these periods to
rise over the next three years.
“' Time in' the market is more important than' timing' the market.“
Interview quote
11Exe cu t i v e s u m m a r y – Key f in din gs
FIGURE 1.4
What benefits are targeted by your pension What is the extent of the tracking error that your
plan’s climate-related investments in general? pension plan is willing to accept in your climate-
related passive funds?
% of respondents
0 20 40 60 80
6%
14%
6%
Good risk-
adjusted long- 81 %
term returns
A more defen-
sive portfolio
with lower 62 %
portfolio risk 34%
40%
Lower portfolio
volatility 8%
0% 0–0.9% 1–2.9% 3–4.9% Above 5%
Source: CREATE-Research Survey 2020
4. It’s too soon to judge the outcomes baseline outcomes. In other words, they are seeking
of climate-related passive funds a free option on carbon, which gives an upside as
markets start to price in carbon risks and downside
There is a paradox in the results from Figure 1.4. On protection against capital loss if it does not.
the one hand, our respondents see climate investing
as a long-term endeavour. On the other hand, they The implication is that the index constructors have
have low tolerance for a high tracking error. to be pretty smart in their choice of constituent
companies, if they are to deliver added value on
The apparent contradiction is explained by the fact top of baseline benefits.
that they see low tracking error as only setting a
baseline performance expectation in line with the So, when asked to describe the outcomes of their
chosen parent index. However, by reorienting their investment in climate-related passive funds so far,
portfolio to include climate ‘winners’ and exclude 39% cited ‘positive’, 61% said ‘too soon to say’
climate ‘sinners’, our respondents expect to see and 0% cited ‘negative’ (Figure 1.5, left chart).
some demonstrable upside, without sacrificing
“Cost is being replaced by stewardship capabilities as the
key differentiator, when choosing an index manager.”
Interview quote
12Exe cu t i v e s u m m a r y – Key f in din gs
FIGURE 1.5
Which of the following best describes the How is this share of climate-related passive invest-
outcomes of your pension plan’s investment ments likely to change over the next 3 years?
in climate-related funds so far?
% of respondents % of respondents
0% 0%
39%
35%
61%
65%
Positive Too soon to say Negative Increase Remain static Decrease
Source: CREATE-Research Survey 2020
Those who cited ‘positive’ included early movers chart). 65% expect it to ‘increase’, 35% to ‘remain
who enjoyed the upside that came from being static’ and 0% to ‘decrease’.
ahead of the pack. Even after the market correction
in March 2020, they were able to retain a part of The positive expectations are predicated on the
the upside. view that the European Union’s action plan on
sustainable finance may be delayed, but not
Those who cited ‘too soon to say’ had sustained derailed, by the Covid-19 crisis. The EU’s
drawdowns in their portfolio across the board latest initiative on delivering two landmark
but have nevertheless retained their allocations benchmarks for equities and corporate bonds
as long-term ‘lock-aways’ or as a device for has been widely welcomed.
uncovering portfolio blind spots. This in the
belief that, as the global economy suffers an The first of these – called ’The Paris-Aligned Bench
unprecedented recession of unknown duration mark’ – targets a 7% year-on-year reduction in carbon
due to Covid-19, investors will focus on selective emissions plus a 1.5°C limit to global temperature
themes that may emerge as isolated bright spots rises by 2050. It excludes fossil fuel companies.
in the otherwise fluid investment landscape.
The second one – called ’The Climate Transition
This is further corroborated by expectations of Benchmark’ – has similar targets but permits fossil
changes in the share of climate-related passive fuel investment as part of the transition process.
funds over the next three years (Figure 1.5, right
13Exe cu t i v e s u m m a r y – Key f in din gs
“Companies that reduced carbon footprints the most have
outperformed the laggards lately.”
Interview quote
Notably, unlike previous benchmark models, these For their part, as shown in Section 2, our
will be overseen by the regulators. They also go respondents are constantly refining their
well beyond the existing climate benchmarks in manager selection process by paying special
one crucial sense: they not only have a carbon- attention to three criteria: managers’ track record
reduction target, but they also have a long-term on the green agenda; their business culture; and
plan with a clear end goal. Major index providers their stewardship and voting track record – now a
are now exploring ways to onboard the EU’s key point of competition (Case study 1c).
suggested benchmarks.
Collectively, they are seen as vital: first, in dealing
However, Covid-19 arrived just as the climate with what is often described as the ‘uncertainty
movement appeared to be gathering strong of uncertainty’ – not knowing how physical and
momentum. In 2019, both the UK and France transition risks will evolve to shape market dynamics
agreed to net zero emissions targets. Greta as it prices climate risks; and second, in ensuring
Thunberg became a household name. Central that finance has to give something back to society
bankers began to talk about ‘climate stress tests’ as well as make a profit.
and ‘green quantitative easing’. The European
Commission promised to deliver a new Climate
Law, committing Europe to net zero emissions
by 2050. Hence, momentum is unlikely to diminish.
Case study 1c: Going beyond box ticking and dry data
The question we wrestle with is how do you convert a Following the Global Reporting Initiative Standards,
company’s carbon footprint into a simple neat metric, if engagement needs to focus on narrative disclosure:
the math behind it is unreliable? the real-life stories of challenges, actions and
outcomes that lie behind the dry numbers on carbon
Hence, we want our passive fund managers to take
footprint. As investors, we need a vivid picture of the
their stewardship role seriously. Since they cannot
unfolding reality and progress on the ground with
walk away from poorly performing companies, they
concrete examples.
are obliged to stick to what they hold.
Rampant greenwashing has shifted the burden of
So, we expect our managers to exercise an activist role
proof to our passive fund managers. They have to go
via regular engagement with investee companies – to
from words to numbers and real-life examples behind
raise the quality of our beta investments by building up
them. Narratives can be a powerful influence on
intellectual capital on how climate change is playing
investment thinking.
out on the ground.
A US pension plan
14Suppressing the curve on
greenhouse gas emissions
15Su p p re ss in g t h e cu r ve o n g re en h ou se ga s emissio n s: What are t he key driver s and b lo cker s?
What are the key drivers
and blockers?
Pension investors’ forays into climate-related passive funds are driven mainly by the belief
that global warming is material to a company’s business performance as well as its exposure
to stranded assets. Investing in companies that are adapting to climate change is likely to
generate decent returns. Technological advances that create cost effective green energy
and public policies that promote their adoption are also expected to turn climate change
into a compensated risk factor over time.
So far, however, allocations to climate-related passive funds are modest in scale. The key
barrier has been the lack of a robust template with consistent definitions and reliable data.
Most of the available data on corporate carbon footprints are self-reported, raising questions
about their reliability. This makes it hard to both spot good investment opportunities and
build up a long-enough performance track record. As a result, capital markets have been slow
in pricing in climate risks.
‘Green’ investments have been mainly confined to equities and, to a lesser extent, fixed
income and real estate. Their coverage is expected to rise over the next three years, on the
whole. Equities were the first asset class to have climate-related indices, when they first
emerged thirty years ago and they have been subject to various refinements since then.
Equity investing also offers two advantages that are valued by our respondents in their
stewardship role: voting at the AGM and year-round engagement.
Three criteria are used in selecting asset managers: first, their capacity and track record in
delivering the ‘green’ agenda of their clients; second, the alignment between managers’
business culture and this agenda; and third, their stewardship and proxy voting track record.
Greenwashing remains a big concern. The idea that passive funds are merely lazy owners of
companies is no longer acceptable. Stewardship is seen as a key point of competition among
index managers, as shown by our 2019 survey, Passive investing: The rise of stewardship.
1. K
ey drivers
one in every three respondents. Some of them
As shown in Figure 1.3 in the Executive Summary, overlap and thus fall into three distinct clusters,
climate-related passive funds come in various as described below.
guises. They have a moderate range of tracking
error to their parent indexes. a) Performance potential
Against this background, our survey identified 62% of our respondents see climate change as
a number of drivers of pension plans’ interest in delivering good investment returns in the long term.
investing in climate change (Figure 2.1). Seven 54% believe that climate change is increasingly
of them stand out, being identified by at least becoming material to how securities are priced
16Su p p re ss in g t h e cu r ve o n g re en h ou se ga s emissio n s: What are t he key driver s and b lo cker s?
FIGURE 2.1 and their value creation. 49% believe that physical
What is driving your pension plan’s interest in
and transition risks are emerging and there is a
investing in climate change?
pressing need to manage them. Physical risks arise
% of respondents
from extreme weather conditions. Transition risks,
in turn, arise from technological advances that will
0 10 20 30 40 50 60 70
disrupt the business models of fossil fuel producers.
Seeking good
long-term invest- 62 These respondents hold that the transition to a
ment returns low-carbon world started in earnest following the
Paris Agreement. This opens up opportunities to
Recognising the invest in businesses whose potential has yet to
growing materiality 54 be recognised by the markets. As a result, they
of climate change
can expect to harvest good risk-adjusted returns
Transitioning through two avenues.
towards green
energy via techno- 51
logical advances
The first one is via the mispricing of assets,
while markets are inching towards factoring in
the carbon risk, as highlighted by this year’s
Managing the
physical and 49 World Economic Forum in Davos. The assembled
transition risk business and political leaders envisaged a world of
runaway and unimaginable chaos due to extreme
Responding to
regulatory
weather events, causing wildfires, flooding,
pressures on
43 hurricanes, typhoons, droughts and crop failures.
carbon footprint
Their frequency and severity have increasingly
Responding to the
aspirations of your 38
made it difficult for the affected regions to have
plan members a V-shaped recovery, as happened in the past.
Instead, the regions have been experiencing rising
Managing
frequency and intensity in the last decade.
reputational risk 35
Hence, the wheels of change are evident in capital
markets. Climate risk is now being priced in in
Fulfilling standards
of international sectors such as power generation where the
19
initiatives economics of renewable energy are constantly
improving with technological advances and
Aligning with regulatory push.
your pension
plan's vision of a 16
greener planet
“Success in investing is often
Source: CREATE-Research Survey 2020 as much about avoiding losers
as picking winners.”
Interview quote
17Su p p re ss in g t h e cu r ve o n g re en h ou se ga s emissio n s: What are t he key driver s and b lo cker s?
That leads us to the second avenue for harvesting risk, the inclusion of the latter in a portfolio could
good returns, as identified by our respondents: the still deliver a key side benefit: a more defensive
gradual rise of climate change as a compensated portfolio (Case study 2a).
risk factor.
b) Regulatory push and innovations
Many of our respondents have long remodelled
their portfolios by allocating assets to risk factors Nearly 200 countries signed the Paris Agreement
like quality, value, size, low variance and momentum; in 2015 to limit global warming to less than 2°C
as popularised by the five-factor Fama–French Model. above the pre-industrial level: the ceiling beyond
This in the belief that market-beating returns originate which irreversible damage and extreme weather
from simple systematic exposure – conscious or events will kick in, according to most climate
unconscious – to these or other factors. scientists. The signatory countries have submitted
plans to reduce greenhouse gas emissions in
It is now believed that climate change is emerging so-called nationally determined contributions.
as a separate compensated risk factor in Europe;
but not in the US or Asia Pacific – yet. The issue In hindsight, two measures enacted in 2016 have
has not been clear cut. It has aroused debate, even proved game changers: Article 173 in France’s
though only 6% of our respondents believe that Energy Transition Law, requiring mandatory
climate risk is captured by other risk factors, as carbon reporting for companies as well as
shown later in Figure 2.2. pension investors; and California’s Insurance
Commissioner’s ruling that insurance companies
Even so, a pragmatic consensus is emerging: doing business in his state have to divest from
namely, even if factors like quality and low companies that derive 30% or more of their
variance are good investible proxies for climate revenues from thermal coal holdings.
Case study 2a: The changing ecosystem of markets
The ecosystem of financial markets has traditionally been we can’t afford to wait for the performance data to
dominated by a raft of measurable metrics: P/E ratio, emerge, even though it is correlated with the tradi-
price-to-book, debt-to-equity, leverage and earnings. tional quality factor.
However, such measurable indicators are now being The reason is that the traditional risk factors do not,
burnished by observable factors – such as floods, in our view, capture long-horizon negative fat-tail
droughts and wildfires – to show that markets’ risks. At the very least, the inclusion of climate risks
ecosystems can no longer ignore the harsh fact: that gives us a more defensive portfolio. And in the pro-
investment returns now crucially depend on sustainable cess, their market values have been rising.
economies and sustainable societies.
But we think it also ensures that our investee com-
The abrupt bankruptcy of Pacific Gas & Electric panies are repositioning themselves against extreme
Company after California’s deadly fires last year climate events or stranded assets, as we migrate
was a salutary reminder. towards a low-carbon future.
In our portfolio, we use risk factors that have been
tested by time and events. But with climate risk, A French pension plan
18Su p p re ss in g t h e cu r ve o n g re en h ou se ga s emissio n s: What are t he key driver s and b lo cker s?
“The European Union’s ‘Green Deal’ is a potential game changer.”
Interview quote
Since then, the European Union has delivered With such concerted efforts, it is hard to believe
legislative proposals designed to promote green that the ecosystem of financial markets will not
finance for investors and their asset managers. pivot decisively towards climate risks over time.
At its core, this package seeks to embed c) A new narrative for a new age
environmental, social and governance factors
into the investment process and risk models. It Finally, two other noteworthy drivers of climate-
also aims to deliver full transparency around related investing in Figure 2.1 are: responding
outcomes; along with a clear alignment of to the aspirations of plan members (38%) and
interests across the entire investment value chain. managing reputational risk (35%). Both rest on
the rise of a new societal value system.
Lately, the EU has gone a step further and
proposed two landmark climate benchmarks Under it, public awareness of the role of human
for equities and corporate bonds, as described activity in global warming has been increasing
in the Executive Summary. and with that has come rising expectations of
what people want from companies and their
For its part, the Financial Stability Board – a shareholders. Via a raft of global initiatives, pension
transnational group of regulators – has assembled plans are now enjoined to exercise a ‘duty of care’
a task force to work on standards for climate reporting in the whole sphere of climate change.
by companies. They have issued guidelines to
companies and their investors to provide climate- The media has been quick to turn the spotlight
related information in their annual filings, along on abuses that tarnish the reputation of the
with actions being taken to mitigate climate- companies concerned and their shareholders alike.
related risks.
The latter are often painted in social media as
This dovetails with initiatives by the US Sustainability financial bandits with no regard for their social
Accounting Standards Board; as pension regulators responsibilities, as happened with two high-profile
worldwide now seek to ensure that climate risks are disasters in the US: BP’s Deep Water Horizon oil
factored into investment portfolios. Unsurprisingly, spill in the Gulf of Mexico in 2010 and Volkswagen’s
therefore, 43% of our survey respondents cite emission cheating scandal in 2014. Both events
regulatory pressures as a driver in Figure 2.1. served to underline an important point: even global
brands can be exposed to existential risks and inflict
In a chain reaction, such pressures are not only reputational damage on their shareholders.
driving investor behaviours, they are also promoting
technological advances towards fuel efficiency and As societies have evolved and progressed, new
alternative renewable sources of energy, according forms of risk have emerged. Rising concern about
to 51% of survey respondents. climate change is the latest and most severe that
modern societies face.
Such advances centre on renewable power and
electric grids. They also focus on electric vehicles
and the development of more efficient power “Nuclear power is classified as
storage batteries.
‘clean’ in France and ‘risky’ in
neighbouring Germany.”
Interview quote
19Su p p re ss in g t h e cu r ve o n g re en h ou se ga s emissio n s: What are t he key driver s and b lo cker s?
“Before 2025, governments may be forced to tax fossil fuels
to the point where it is no longer economically viable to
develop them.”
Interview quote
FIGURE 2.2
That apart, as the post-war Baby Boomer generation
What are the factors currently constraining your pen-
enters its golden years, the membership of pension
sion plans from investing in climate-related funds?
plans will be dominated by millennials who will be
the largest employee group in all pension markets % of respondents
in this decade. Various research studies show
0 10 20 30 40 50 60 70
that, to over 80% of them, what matters most is
not investment returns today or tomorrow but Lack of consistent
definitions,
those over their lifetime. These need sustainable methodology
60
societies as much as sustainable economies. and data
Financial markets
slow to price 59
climate risks
2. Key blockers
Lack of quality
That the identified drivers have created strong investment 41
tailwinds behind climate-related investing is not opportunities
in doubt; however, the size of allocations has been
moderated by a number of factors (Figure 2.2). Lack of a
Four of them were identified by at least one in long enough
32
performance
every three survey respondents. They fall into track record
two clusters.
Political and
regulatory 29
a) Climate change remains an inexact science uncertainty
for investors
Difficulty in
60% of our respondents cite the lack of a robust delivering double 18
template with consistent definitions and reliable bottom line
data as a major constraint.
Climate risk is
already captured
To start with, there are now over 150 major data 6
by other risk
compilers worldwide, using proprietary scoring factors
methods that often yield radically different
assessments of the same company. Source: CREATE-Research Survey 2020
Their ratings differ due to divergence in: the Furthermore, most of the data are self-reported
scope of the data they cover; the methods used by the companies covered, with no audits by
to compile the data; and the weights accorded independent assessors in many cases. Reporting
to different dimensions of the data. Nor are data is voluntary. The result is whitewashing:
vendors subject to the same regulatory scrutiny companies only reporting when they have
as the traditional rating agencies. something favourable to say. The problem is
reportedly easing under regulatory pressure.
20Su p p re ss in g t h e cu r ve o n g re en h ou se ga s emissio n s: What are t he key driver s and b lo cker s?
Data vendors are forced to rely on the ‘big data’ arise when creating mathematical models that aim
revolution to become less reliant on voluntary to detect investment opportunities as well as risks
corporate disclosure to ensure that companies in global warming in what is essentially a dynamic
are doing what they say they are doing, duly phenomenon with numerous moving parts.
recognising the ‘noisy’ nature of big data.
At each stage of the exercise, asset managers
Finally, data vendors have yet to develop a robust have to make assumptions, which may or may not
methodology on three foundational concepts be correct. The underlying causal relationships
that lie at the heart of climate change investing: they seek to detect may or may not remain stable.
materiality, intentionality and additionality, as The resulting forecasts they seek to build on may
described in the Executive Summary. or may not be robust. The whole process is like
climbing a steep learning curve, relying mostly on
Unfortunately, the challenges don’t end there. learning-by-doing. But there are investors who are
There are other substantive difficulties to be making a virtue of necessity (Case study 2b).
overcome at the asset management end. These
“In fixed income, issuers’ disclosure on climate change remains
very poor, apart from a few instances of excellence.”
Interview quote
Case study 2b: Taking a contrarian stance
We take a pragmatic view that data problems are At the dawn of stock markets, the quality of corporate
nothing more than disguised opportunities to deliver data was weak and sparse. But, over time, a new in-
alpha by exploiting the resulting market inefficiencies. frastructure of data, standards, expertise and metrics
Given our size and reach, we have three advantages: has evolved.
a deep talent pool, practical expertise in shareholder We expect a similar evolution around climate
activism and membership of global initiatives such as change investing.
Climate Action 100+ and the Carbon Disclosure Project.
However, it would be naïve to assume that better
We use these strengths to filter out noise from the data will make life easier or enable managers to pick
available data and use them to construct climate-re- the right stocks. After all, despite stringent regulation
lated customised indices in our passive portfolio, in around the authenticity of corporate financial data
partnership with our passive managers. We believe in all market jurisdictions, they still take contrary
that such inefficiencies will be a key source of alpha positions based on the same information about the
for high-conviction investors like us that have long same company.
thrived on first mover advantage.
A Dutch pension plan
21Su p p re ss in g t h e cu r ve o n g re en h ou se ga s emissio n s: What are t he key driver s and b lo cker s?
b) F
inancial markets are slow to factor The second point to emerge from our interviews is
in climate risks that, as fiduciaries, many pension trustee boards
are enjoined to invest in strategies that have been
History shows that financial markets rarely price tried and tested by time and events. Besides, many
in big outcomes until they are faced with them. plans lack the governance structures and skill sets
to exploit the prime mover advantage associated
59% of our survey respondents believe that markets with climate risks.
are slow to price climate risk (Figure 2.2). 41% say that
there is a lack of quality investment opportunities. The final point to emerge was the role of
And 32% state that the short history of climate- governments that were signatories to the Paris
related investing has not built up a long-enough Agreement. They have been too slow to implement
track record to inspire confidence. Behind these the required carbon pricing to a level that is high
numbers lie three explanations that emerged from enough to slow down the pace of global warming.
our post-survey interviews.
The latest available data from the OECD shows
First, since the 2008 crisis, markets have been that, at the current rate of progress, the prevailing
overly distorted by the central banks’ quantitative prices will only cover the cost of carbon emissions
easing programmes. These have suppressed by 2095. The current pace is simply not fast
volatility and effectively put a floor under asset enough to accelerate innovations in renewable
values. The 24-hour news cycles have shortened energy. In this context, the withdrawal of the US
investors’ decision horizons, putting more from the Paris Agreement is viewed as a major
emphasis on the here and now. setback, even though some individual states in
the union have decided to go it alone.
They have also undermined markets’ historical
role in channelling people’s savings to enterprises
that can create wealth, innovation, jobs and skills. 3. K
ey asset classes
Rising short-termism risks turning investing into a
chase for the next rainbow. In light of the blockers identified in the last
subsection, it is clear that climate-related
The time-honoured notions of risk premia, time investing remains a nascent phenomenon –
premia and mean reversion have been progressively for now. That is further corroborated by its
sidelined. The market correction during the Covid-19 asset class coverage (Figure 2.3).
crisis is expected to reverse the trend, as investors
have realised that investing is essentially a long-term So far, three asset classes have attracted
game in which true value always triumphs. notable levels of allocations among our survey
Artificial boosts to asset prices from monetary respondents: equities, fixed income and real
authorities have always ended in tears. assets. Each is considered separately below.
a) Equities
“Markets still underestimate
the risks that extreme weather Equities have been the most favoured asset classes,
with 86% of respondents using them as a vehicle
events pose.” to invest in climate change. The figure is likely to
Interview quote rise to 89% over the next three years.
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