Climate change issues in fund investment practices

SPECIAL ISSUE ON GOVERNANCE Climate change issues in fund investment practices Ole Beier Sørensen and Stephanie Pfeifer ATP, Hillerød, Denmark; Insti...
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SPECIAL ISSUE ON GOVERNANCE

Climate change issues in fund investment practices Ole Beier Sørensen and Stephanie Pfeifer ATP, Hillerød, Denmark; Institutional Investors Group on Climate Change, London, United Kingdom

Abstract There has been a marked development in the way that institutional investors address environmental, social and governance (ESG) issues in their investment practices. For public and private investors alike, these issues have now become part of mainstream investment practices, reflecting a greater understanding that they represent material risks and opportunities that must be addressed as part of fiduciary duty. Some ESG issues require an approach that goes far beyond the traditional simple screening approaches that the early niche funds employed. This is illustrated through a detailed discussion of investor practices on climate change, which must include an assessment of long-term risks and opportunities and of the strategies that have been put in place to address these. It is also argued that as the role of policy and regulation is critical to shifting the economics in favour of low carbon investments, a structured dialogue between investors and policy-makers is critical to ensuring that institutional capital is mobilized to support the policy goals of limiting climate change whilst still allowing investors to operate in line with their fiduciary responsibility. issr_1411

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Keywords investment policy, environment, social responsibility, governance, pension fund, international

Addresses for correspondence: Ole Beier Sørensen, Chief of Research and Strategy, ATP, Kongens Vænge 8, DK-3400 Hillerød, Denmark; Email: [email protected] Stephanie Pfeifer, Executive Director of IIGCC, c/o The Climate Group, Second Floor, Riverside Building, County Hall, Belvedere Road, GB-London SE1 7PB, United Kingdom; Email: [email protected] Ole Beier Sørensen is also Chairman of the Institutional Investors Group on Climate Change (IIGCC). The authors thank Pam Gachara, Danielle Guayat, Rob Lake and David Russell for constructive assistance, comments and suggestions that helped shape this article.

© 2011 The author(s) International Social Security Review, Vol. 64, 4/2011 International Social Security Review © 2011 International Social Security Association Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA

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Introduction

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Growing attention is being focused on how institutional investors are taking into account environmental, social and governance (ESG) issues in their investment practices. There is mounting evidence that these issues impact shareholder value over the longer term, and that they are being addressed increasingly by mainstream institutional investors rather than — as was previously the case — by a small number of niche investors only (Sparkes and Cowton, 2004; Eurosif, 2010). This is reflected in a number of developments. Many institutional investors have adopted ESG policies and there are signs that the ultimate responsibility for these has become consolidated at senior management and/or board level (Eurosif, 2010; IIGCC et al., 2011). A range of new service industries focused on ESG issues, including sustainability indices and benchmarks for companies’ performance on ESG issues, are being set up.1 In addition, numerous initiatives have been built to support investor collaboration on specific ESG issues. Examples include the ICGN2 (International Corporate Governance Network), the regional and national Social Investment Forums (for example, EuroSIF)3 and the Carbon Disclosure Project (CDP),4 which requests companies to report on their carbon footprint on behalf of investors. Specifically on climate change, three regional investor networks have been established: the IIGCC5 (Institutional Investors Group on Climate Change) in Europe, the IGCC6 (Investor Group on Climate Change) in Australia and New Zealand, and the INCR7 (Investor Network on Climate Risk) in North America. A primary objective of these networks is to facilitate a dialogue between investors and the policy community on climate change issues. In addition, many investors have signed up to the United Nations Principles of Responsible Investment (UN PRI), which were launched in 2006 and provide a voluntary framework by means of which investors can incorporate ESG issues into their decision-making and ownership practices.8 Moreover, several countries have adopted legislation 1. For example, the Jones Sustainability Index and the FTSE4Good Index. 2. . 3. . 4. . The CDP is a framework whereby companies can measure and report on their carbon footprint. The CDP covers more than 3,000 companies and is the leading source globally of company-specific information on climate change-related issues. 5. . 6. . 7. . 8. The principles of responsible investment were launched at the initiative of the then UN Secretary General Kofi Annan. Since its inception, the UN PRI has turned into an independent private network of international investors — the PRI — working together to put six Principles into practice (). The Principles reflect the view that environmental, social and corporate governance (ESG) issues can affect the performance of investment portfolios and therefore

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requiring pension funds to “publicly state the degree to which they take into consideration social and environmental aspects in their investment decisions” (Louche, 2010, p. 219). The remainder of this article is structured as follows. The next section considers the major factors that have driven the increased focus on ESG issues. This is followed by a section on how institutional investors are addressing ESG issues in their investment practices and decision-making. The next section considers how this is related to investors’ fiduciary duty. The article then discusses climate change as a particularly critical ESG issue and goes on to consider how investors are addressing climate risks and opportunities in their investment analysis before looking at the barriers they still face. Final conclusions are then presented, wherein it is noted that the need to address ESG issues is as important for the investment practices of public social security and sovereign wealth funds as it is for private institutional investors.

Integrating ESG issues into mainstream investment practices There is probably no single factor alone that can explain the mainstreaming of ESG into investment practices. A wide range of financial, political, social and regulatory factors are likely to have contributed to this development (UNEP FI, 2005; Louche, 2010). For example: • ESG issues now occupy a much broader space in public debates. In most constituencies there is a much greater understanding that weak performance on ESG issues may incur large financial, social and political costs. • Non-governmental organizations (NGO) are contributing to increased public awareness on ESG issues. • The penetration of electronic media, particularly social media, is raising public awareness of ESG issues. • In many constituencies, regulation has been passed that requires companies to report on strategies and performance on ESG issues. • It is becoming clearer that consumer preferences may be affected strongly by reputational damage to companies when ESG issues are not addressed adequately, which in turn can affect companies’ market positions adversely. • Many institutional investors need to take client preferences on ESG issues into account. Companies can suffer serious reputational damage because of poor conduct on ESG issues in investee companies. must be given appropriate consideration by investors if they are to fulfill their fiduciary (or equivalent) duty. The Principles provide a voluntary framework by which all investors can incorporate social responsibility issues into their decision-making and ownership practices and so better align their objectives with those of society at large.

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The critical point is that performance on ESG issues can influence the profitability of companies and other investments. This recognition is shared increasingly by institutional investors generally and translates into a common investment belief: good performance on ESG issues pays off over the longer term.

Addressing ESG issues in investment practices

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Conventionally, the most common ways to integrate ESG issues into investment practices have been by means of screened and best-in-class approaches and engagement with companies. Screened approaches involve either excluding companies (negative screening) or including companies (positive screening) in investment portfolios based on a range of ESG criteria. Positive screening can involve the identification of “industries of the future” — for example, companies focused on renewable energy or clean technologies. Sparkes and Cowton suggest that these are seen to offer “the dual benefits of a commitment to sustainability plus the hoped-for financial benefits of investing in industries with significant long-term growth prospects” (2004, p. 48). In a best-in-class approach, the investment universe is not formally delineated, but companies within the same sector are compared and ranked in terms of their ESG performance. Investments are then made in those companies with the best ESG performance (Michelson et al., 2004). Many investors also engage with companies on ESG issues. They use their rights as shareholders, either individually or collectively, and their influence to encourage improved corporate performance on ESG issues (Higgs and Wildsmith, 2005; Sparkes and Cowton, 2004; Sullivan and Mackenzie, 2006). There is much to suggest that while screening, particularly negative screening, has been popular with retail investors and with many large European institutional investors, many institutional investors in the United States have taken the view that negative screening can incur a performance penalty (Sparkes and Cowton, 2004). Therefore, some of these investors have preferred to engage directly with companies (Friedman and Miles, 2001). Typically, investors will screen their investment portfolio on an on-going basis in order to assess whether or not the assets held comply with their ESG criteria. Standard practice is to sign up with one or more service providers for ESG screening and research services. Where one or more defined criteria have been breached, the matter will be investigated further with a view to verifying the information and the allegations made. Where the allegations are confirmed, the investor will raise the issue with the company in question and will try to establish an engagement process with the view to resolving the issue. A “solution” may take many different forms, from immediate changes in practices to programmatic strategies providing a solution over a longer period of time. However, if an engagement process cannot be established, or if it cannot produce a satisfactory result, then the investor will International Social Security Review, Vol. 64, 4/2011 © 2011 The author(s) International Social Security Review © 2011 International Social Security Association

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disinvest from the company as and when market conditions allow and eventually the company may be excluded from the investment universe. Whilst this model may represent the ideal, the reality may be more complicated and implementation styles will differ. Typically, investors will invest in many different asset classes and, particularly for listed equities, in a large number of individual companies in which they will hold a very small share of the total. This reduces the individual investor’s influence within the company. Some investors try to solve this challenge by outsourcing the engagement process to an external service provider or through collaborating with like-minded investors. A large number of pension funds outsource their asset management. Hence, the operation of a specified ESG policy becomes part of the package delivered by the external asset manager. Yet, as a platform for conducting a structured engagement process, this may be less than ideal, owing to the indirect nature of the relationship and the (often relatively short) time horizon of the external asset manager’s mandate.

Fiduciary responsibility and ESG issues Pension funds — public and private — and most other institutional investors invest on behalf of a large number of individuals, their beneficiaries, who have their pensions and savings invested with these funds. They are bound by a fiduciary responsibility, which means that they have to act prudently and cannot invest in a specific asset or adopt particular investment styles or preferences if this involves foregoing return opportunities on a systematic basis.9 An important question, therefore, is whether it is consistent with the overall objectives of pension institutions and other institutional investors — their fiduciary responsibility — to focus on ESG issues in their investment practices. This question has often been asked based on the assumption that addressing such issues hampers long-term investment returns.10 However, the evidence base does not bear this out. For example, a 2004 report commissioned by UNEP FI suggests that there is a strong business case for considering ESG issues in investments (UNEP FI, 2004). A 2007 report by the UNEP FI Asset Management Working Group (UNEP FI, 2007) also builds a robust case that sound integration of ESG factors does not compromise investment performance, and in many cases enhances it. On balance, it is difficult to uphold the argument that the incorporation of ESG issues into investment practices impacts returns negatively. Furthermore, there are numerous cases to demonstrate how insufficient performance on ESG issues has had a significant negative impact on 9. For a short discussion on fiduciary duty, see UNEP FI (2005, p. 19). 10. For a discussion of the rationale for integrating considerations on ESG issues into investment practices, see UNEP FI (2005, pp. 27-29).

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companies and their market position. The “links between ESG factors and financial performance are increasingly being recognised” (UNEP FI, 2005, p. 13). The legal dimension — the question of whether or not the integration of ESG considerations into investment practices is compatible with fiduciary duty — was investigated across nine different jurisdictions by the international law firm Freshfields Bruckhaus Deringer LLP in 2005 on behalf of UNEP FI (UNEP FI, 2007). The conclusion from that analysis is clear in stating that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions” (UNEP FI, 2005, p. 13). The 2005 study was reassessed in 2009, with similar results found (UNEP FI, 2009). It therefore becomes part and parcel of fiduciary responsibility to understand, assess and address (where deemed material) all relevant investment risks, including those with a short-term financial impact and those that could have an impact in the future. This means that it is in line with fiduciary responsibility to consider ESG issues when making investment decisions and integrating these into the overall assessment of risks and opportunities if they represent material risks for the investor. However, it means also that investment institutions cannot make investments on ethical considerations alone if this means systematically foregoing returns in the longer term (unless this is specified by their clients). Individual investment decisions will be based on an analysis of wider risk and return factors, which may include ESG factors. Historically, private institutional investors led developments on the integration of ESG issues into investment practices, but the past 10 to 20 years have witnessed a large number of public social security funds and sovereign wealth funds beginning also to address ESG issues as important risk and opportunity issues. Some of these funds have played a leading role in recent years.11 Consequently, following the acceptance of ESG issues as a risk management concern, there is nothing to suggest that addressing this should be any more important to private institutional investors than to public pension funds and sovereign wealth funds.

Climate change: A risk management issue Whereas the impacts of some ESG issues, such as human rights, labour rights, adherence to law and order and performance on reporting standards, can be assessed effectively, the impacts of other ESG issues will only be felt in the longer term. The impact of climate change is an important example.

11. The Norwegian Pension Fund, the Danish national pension fund (ATP), and the Swedish buffer funds (AP1, AP2, AP3 and AP4) are prominent examples.

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Climate change is considered to be the most significant environmental issue facing the world, with broad agreement within the scientific community that anthropogenic emissions of greenhouse gases have dramatic impact on the global climate. Rising concentrations of these gases in the atmosphere since the beginning of the industrial revolution, primarily as a result of the combustion of fossil fuels and land-use change, are amplifying the natural greenhouse effect. The effects of continuing climate change include rising temperatures, more frequent and more extreme rainfall patterns, resulting in intensified droughts and floods, rising sea levels threatening coastal regions and cities and increasingly frequent and intense hurricanes and severe storms (IPCC, 2007).12 These challenges are further heightened by population growth and economic development, increasing the pressure on natural resources as more and more people adopt carbon-intensive lifestyles. Unless action is taken to contain the rise in greenhouse gas emissions, serious disruption to the world’s climate, ecosystems and economies is likely. According to the Stern Review (Stern, 2006), climate change is the greatest market failure the world has ever seen in the sense that this externality — i.e. the effects of greenhouse gas emissions — is not factored into standard financial assessments of businesses and their sustainability. An international political process has been established with a view to providing a global agreement on climate change to reduce total global emissions by 50 per cent by 2050 (compared to 1990 levels) and emissions in developed countries by 80 to 95 per cent.13 Countries around the world are taking action at national as well as regional level to implement policies that reduce greenhouse gas emissions and support low carbon growth. The investment risks stemming from climate change as well as climate policy are significant. They range from the actual physical impacts of climate change, to stronger future regulatory responses aimed at curbing greenhouse gas emissions and increasing energy efficiency, to political and social conflicts. Political effects such as regulation on greenhouse gas emissions, a price on carbon, energy efficiency requirements and energy standards for appliances may change market conditions in favour of low carbon technologies. Market effects such as demand for new types of products, changes in consumer preferences and increased emphasis on energy 12. Green house gases cover a wide range of gases that reduce radiation from the planet and cause global heating. Carbon dioxide (CO2) is the most important of these gases because of its volume. Other gases are emitted in smaller quantities, but are far more aggressive — among them ammonium, trifluoromethane (HFC-23) and methane. 13. The international political process is framed by the so-called Conference of the Parties and the United Nations Framework Convention on Climate Change (UNFCCC). The process was launched in 1992 as the basis for a global response to climate change. With 195 Parties (i.e. nation States), the Convention enjoys almost universal membership. The ultimate objective of the Convention is to stabilize greenhouse gas concentrations in the atmosphere at a level that will prevent dangerous changes to the climate system.

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efficiency may change the marketability of specific technologies or products. Social effects such as conflicts over resource scarcity — most notably, water — and insufficient adaptation measures to increasingly scarce key resources may seriously affect investors.14 A strong global political consensus is being built around the need to develop a low carbon economy and to reduce carbon emission levels significantly. Many countries are emphasizing the benefits to be had from “green growth” and are putting in place low carbon emission, energy security and green-growth strategies. This means that climate change presents a range of investment risks and opportunities for investors. The way in which these risks and opportunities will materialize depends to a large degree on policy responses to climate change as well as the design and timing of such responses. A recent analysis by Mercer sought to capture this complexity through the definition of four different scenarios (see Box 1). The scenarios suggest that climate change and the policy responses to climate change will have far reaching implications for capital markets as well as individual assets and therefore for investors. However, the scenarios also suggest that these impacts are influenced strongly by the nature, design and timing of policy responses. Therefore it is critical for investors — including public social security and sovereign wealth funds — to understand and address the long-term risks and opportunities presented by climate change and to take policy responses into consideration. In investment analysis, it is critical to understand these risks and to assess the ability of individual companies to manage them.

Addressing climate change in investment processes Investors are increasingly paying attention to climate change and integrating the issue as a risk element into investment analyses and practices, particularly in those asset classes that are most likely to be affected (IIGCC et al., 2011). Investors are building the necessary capacity to understand the implications of climate change — for instance, through making use of a range of information and research to better assess specific risks related to particular investments. In one example, a group of investors commissioned research on the long-term strategic implications of climate change for their portfolios and on their long-term tactical asset allocation (IIGCC et al., 2011; Mercer, 2011). Asset owners who have accepted climate change as a risk management issue are becoming more proactive in considering climate change when appointing new external fund managers

14. See for example, Stern Review: “Severe deterioration in the local climate could lead, in some parts of the developing world, to mass migration and conflict, especially as another 2-3 billion people are added to the developing world’s population in the next few decades” (2006, p. 92).

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Box 1. Policy responses to climate change: Four scenarios depending on the nature and timing of policy responses Regional divergence. In this scenario, some regions respond actively to the need to reduce emissions while others do not. This means that there is a high degree of economic transformation and investment in some regions, but the level of uncertainty increases for investors owing to the disparate nature of policy responses across different regions, increasing market volatility. Delayed action. In this scenario, “business as usual” continues up to 2020, when rapid policy measures will be introduced, resulting in a high degree of economic transformation led by public regulation. This will necessitate high levels of adjustment costs to comply with regulations. Eventually, the level of uncertainty regarding climate policy will decline creating a stronger investment backdrop. Stern action. This scenario suggests that there will be a swift agreement on a global framework and a high level of coordination in policy efforts internationally, resulting in a high degree of economic transformation across the global economy. This presents new investment opportunities as well as risks. By engendering lower policy uncertainties than found in the other scenarios, investors would be able to predict policy pathways to a reasonable degree, and new technology investments will be the major drivers of positive transformation. Climate breakdown. In this scenario, policy, business and consumer behaviour remain unchanged, carbon emissions remain high and there is little economic transformation. As a result, there would be potentially high risks for investors over the long term, particularly in regions, assets and sectors that are most sensitive to the physical impacts of climate change. Source: Mercer (2011).

(although formal assessments are still relatively uncommon). A growing number of asset owners are also asking their investment advisors and consultants to consider climate change in the advice they provide. For their part, investors are considering investment opportunities deriving from climate change, including investing in sectors such as clean energy, low carbon technology, energy efficiency and environmental services. The most immediate reasons for integrating climate change into investment decision-making are regulation (e.g. emissions trading schemes) and investment opportunities supported by government incentives (e.g. in renewable energy). This highlights the importance of strong, credible public policy frameworks. In other © 2011 The author(s) International Social Security Review, Vol. 64, 4/2011 International Social Security Review © 2011 International Social Security Association

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areas, the prospects of the physical implications of climate change will be enough to stimulate interest. Usually, the business case for climate-related investments depends on policy incentives designed to create a level playing field for new technologies that currently may be too expensive to be immediately competitive with conventional technologies. An example in this regard are government support schemes that help to stimulate the market in the field of renewable energies and support the scale of deployment required to bring new technologies down the cost curve. Institutional investors routinely now consider climate change (or greenhouse gas emissions) as an integral part of their investment decisions in sectors that are exposed to climate change regulation. For example, within Europe, the “cost of carbon” is a standard part of the investment analysis in those sectors (e.g. electricity generation, aluminium, steel, cement) that are covered by the European Union (EU) Emissions Trading Scheme. For property investments, Australian investors in particular are paying attention to the physical risks of climate change, which is driven partly by their recent experiences of extreme weather events. In Europe, institutional investors have taken a lead on energy efficiency in the property sector.15 The integration of climate change risks and opportunities into investment practices is also becoming more prominent in private equity and infrastructure investments. The longer-term investment horizon for these assets makes them particularly sensitive to unexpected climate-related policy changes and technological advancements. A growing number of investors are addressing climate change issues as part of their corporate governance activities and using their influence to encourage companies to take a more proactive approach to responding to climate change. Investors have implemented programmes of direct engagement with companies to encourage them to improve their reporting on climate change issues. Some have gone further by encouraging companies to take a more proactive approach to managing the risks and opportunities presented by climate change, to reduce significantly their greenhouse gas emissions and to support public policy efforts that seek the same. It is clear that the level of attention paid to climate change depends on the asset class, sector and perceived materiality of the issue. Although climate change is seen increasingly as a standard part of the evaluation of listed equities and real estate investments, this is less the case for other asset classes; for example, for fixed income. Investors focus particularly on the sectors and activities that are expected to be affected most by climate change or climate policy, including energy, heavy industry, mining, infrastructure, forestry and agriculture. A few investors will avoid high emission sectors or activities all together, but most will try to assess the risks to their individual investments. The level of attention paid to climate change will depend 15. The Green Building Council is formed by a number of large European institutional investors focused on these aspects.

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also on the investment horizon, the liquidity of the assets and the size of the investment. A shorter investment horizon implies smaller climate change risk. Similarly, if the asset is easily traded, investors are less likely to pay attention to the impacts from long-term risks resulting from climate change.

Barriers to addressing climate change in investment decisions Significant barriers remain to the fuller integration of climate change factors into investment analysis. First, many investors still lack the knowledge and resources to address climatechange-related risks and opportunities across their portfolios. Second, climate change disclosures — in particular, on current and expected future greenhouse gas emissions — remain inadequate for investors’ needs. Inconsistencies in the quality of the data provided, limitations in the scope of reporting, and a lack of clarity around uncertainties in the reported data all hamper the ability of investors to rely on the data. Third, the full integration of climate change risks and opportunities into investment decision-making is impaired by the short-term nature of investment mandates. The consequence of the need to deliver investment performance over periods of 3 to 12 months means that investment managers, inevitably, are incentivized to focus much of their attention on shorter-term rather than on longerterm value drivers. Fourth, the long-term physical risks of climate change — for example, as a result of changes in weather patterns — are problematic to value as well as being at odds with the prevailing short-term incentive structures in the investment community. Without the incentive of greater pension fund demand, investment managers will continue to focus their attention on short-term risks and opportunities. Fifth, the most significant barriers to integrating climate change into investment analysis are regulatory uncertainty, the limited scope of regulation, and frequent changes to the regulatory regime, which mean that market signals are not sufficiently strong to impact investment decisions.

The critical role of public policy Addressing climate change requires substantial investment in low carbon infrastructure, renewable energy, energy efficiency, transport and other activities relevant to climate change mitigation. Estimates suggest that around 80 per cent of all investments related to climate change must come from private companies and investors (UNFCCC, 2007) and current fiscal difficulties in many countries reinforces the role of non-public sources of finance. Institutional investors, © 2011 The author(s) International Social Security Review, Vol. 64, 4/2011 International Social Security Review © 2011 International Social Security Association

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including pension funds, therefore play a crucial role in overall global efforts to address climate change. Given that institutional investors are fiduciaries and cannot invest in assets unless they expect to make an appropriate risk-adjusted return, it is critical in many cases that policy frameworks mitigate investment risks and/or support climaterelevant investments. Public policy is critical to mobilizing institutional capital at the pace and scale necessary to avert dangerous climate change. Investors are responding to this need for strong climate policy, for instance, by participating in the IIGCC and the other regional networks, which provide collaborative platforms for engaging with policy-makers and supporting the development of appropriate long-term policy frameworks. At the international level, investors have used these platforms to call on policy-makers to provide clear policy signals and strong, stable policy frameworks that will shift the risk reward balance in favour of low carbon assets (IIGCC et al., 2010). Investors have encouraged governments to set credible and ambitious greenhouse gas emission targets for developed countries, and to involve developing countries in reducing global emissions, with technological and financial support from industrialized countries.16 At the national and regional level, investors have called on policy-makers to deliver an integrated climate and energy policy. Development programmes for the energy sector — especially, ramping up renewable energy investments and investments in grid and other energy infrastructure — and policies incentivizing high energy efficiency standards in appliances, transport and in property are particularly important.17 In addition, public policy measures can support the move of low carbon technologies down the cost curve through funding research and development, early stage implementation, and deployment, which will stimulate the development of markets of scale. It is critical that institutional investors have confidence in the policy regime. Some of the investment opportunities currently being structured are large publicpolicy driven infrastructure projects; for instance, offshore wind farms, solar installations and grids. Such investments are very long term and not necessarily liquid. Therefore, investors will only invest in these if they understand clearly the financial risks involved, including the operational, technological and political risks. A particular challenge in this respect relates to so-called retroactive changes, where policy frameworks are changed in a way that substantially impacts existing

16. For example, the networks, together with UNEP FI and with the support of UN PRI, issued an international investor statement and called for political action prior to the global climate summit in Cancun in December 2010. The statement was signed by over 260 investors with USD 18 trillion in assets under their management. 17. See, for example, the IIGCC policy paper directed at the EU (IIGCC, 2010).

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investments.18 In relation to making long-term investments, there is probably nothing more damaging to investor confidence as the risk of retroactive policy changes. In short, what investors need is TLC — transparency, longevity and certainty — providing a transparent process that gives a reasonably certain rate of return over a long timeframe (see Deutsche Bank, 2009).

Conclusions There has been a marked development — particularly over the past decade — in the way that institutional investors address ESG issues in their investment practices. Whilst ESG issues were a factor only for a niche group of investors a couple of decades ago, now these issues are being considered as part of mainstream investment practices. This reflects a better understanding that ESG issues can represent material risks and that addressing them is therefore part and parcel of fiduciary duty. Once ESG factors have been accepted as a key risk management issue, there is nothing to suggest that addressing such factors should be more important to private institutional investors than to public social security funds and sovereign wealth funds. The political and financial contexts, institutional capacities and professional skills may vary, but the risk management issue is the same. There has been a growing realization that long-term issues, such as climate change, require an approach that goes far beyond the traditional simple screening approaches that the early niche funds employed or that some other ESG issues still warrant. Such issues require an assessment of the risks and opportunities (over the short as well as the long term) and of the strategies that have been put in place to address these factors. This has resulted in institutional investors increasing their capacity to understand these issues — for example, through conducting or commissioning research. Climate change stands out as a particularly important ESG issue as it is global in nature, has the potential to impact all sectors, and most of its impacts will be felt over the longer term. It is also a critical risk element in new large-scale investments as well as a risk factor in the performance of existing assets. This suggests that climate change may require an investment approach above and beyond the one that has been used for traditional ESG issues. It could be argued that traditional screening approaches, particularly negative screening, are more difficult to apply in relation to addressing climate change risks, as these are difficult to quantify and their 18. A prominent example in recent years has been the changes made in 2010 by the Spanish Government to policies supporting the build up of solar power capacity in Spain. These policy changes affected existing investments quite strongly and they are believed to have affected investor confidence regarding large-scale policy driven infrastructure investments negatively — not only in Spain, but globally.

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impacts will materialize over a long period of time. Climate change is a systemic risk in the longer term and therefore a risk-based approach must focus on a company’s strategy as much as — if not more than — on its current performance. This means that investor engagement with company management must focus on longer-term risks and opportunities and strategies to address these climate-related issues. Addressing climate change requires substantial investments in low carbon infrastructure, renewable energy, energy efficiency, transport and other activities relevant to climate change mitigation. Therefore, institutional investors play a crucial role in overall global efforts to address climate change. However, investors’ ability to play this role effectively is to a large extent decided by policy frameworks, as these are critical to shifting the economics in favour of low carbon investments. This has clear implications for public policy-makers. It is critical that policy frameworks allow investors to invest in line with their fiduciary responsibility where the success of important policy objectives — for example, climate change mitigation — requires institutional capital. If this requirement is not met, institutional capital cannot be mobilized at the scale and pace necessary. Therefore, a structured and sustained dialogue between investors and policy-makers is essential. The call from institutional investors is not necessarily for specific targeted “green” support programmes, but rather for policies that can support the mainstreaming of such investments and allow investors to integrate such considerations systematically into investment decision-making.

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Climate change issues in fund investment practices

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© 2011 The author(s) International Social Security Review, Vol. 64, 4/2011 International Social Security Review © 2011 International Social Security Association

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