Are schemes ready to mitigate carbon through their investments?

COP26 guidelines list the four themes as: accelerating the phase-out of coal, curtailing deforestation, furthering electric vehicle adoption, and generally encouraging greater investment in renewables.

For all of these, data is key to this informing investment decisions, explains Chandra Gopinathan, senior investment manager for sustainable ownership at Railpen.

“Real world decarbonisation involves emissions data collection, identification of material emitters across portfolios and engagement with them to accelerate emissions reductions,” he says.

The suite of available solutions across these four areas (and beyond) is significantly reduced if pensions are restricted to either passive solutions or to listed markets, or to both

Julius Pursaill, Cushon

“We have proprietary tools in conjunction with third-party data providers to monitor emissions and our own framework for climate risk and transition assessment across portfolios.”

Markets ‘underappreciating carbon risk’

It is important for pension funds to gain a strong understanding of carbon and apply the price of this risk exposure to their portfolios. This is largely because of the evolving carbon price market, according to Nikesh Patel, head of investment strategy at Kempen Capital Management.

“We believe that markets are significantly underappreciating carbon risk and the impact it may have on global equity prices,” he notes.

He adds: “Higher carbon prices, in the range of $75 [£55], could lead to a fall of between 4 per cent and 20 per cent in global equity valuations over several years. This presents clear risks to pension schemes.

“We estimate that pension schemes that adopt a climate-positive portfolio could add 20 per cent to returns over the next 10 years, even compared with a lower carbon/sustainable equity approaches.”

Some carbon mitigation strategies are easier than others to invest in. The strategies of renewable energy and the phase-out of coal are complementary. However, the popularity of the former does raise challenges, Patel says.

“Questions are starting to be raised over whether the increased appetite for renewable assets has led to valuations becoming too high to justify,” he notes, though he remains bullish in the long-term.

“There is clearly an exponential growth opportunity in renewables over the next decade. We believe that this broad opportunity will enable a lot of companies to succeed. We expect to see investors shift focus to utilities and other traditional energy companies investing in renewables — given the more attractive risk-reward.”  

The carbon mitigation argument is less straightforward when it comes to deforestation and how this should be curtailed. Fundamentally, carbon values have traditionally not figured in timber markets or influenced financial motivations to cut down trees. This is starting to change.

Eric Cooperström, managing director of impact investing and natural climate solutions at Manulife Investment Management, explains that carbon credits can influence timber pricing while also offering opportunities for investors.

“The investment case is really a logical evolution of the timberland investment sector where, as fiduciaries, we are charged with generating as much value from the assets as possible for our clients,” he says.

“Carbon value becomes another component of total returns for investors and one that can increase the value of standing forests beyond deforestation alternatives or incentivise reforestation or afforestation activities on bare or degraded land.”

The harvest can still occur, but only after the trees have accumulated more carbon than under the business-as-usual management regime, Cooperström explains.

Schemes should adopt ‘unrestricted view’

There are also considerations around how pensions schemes access these themes from a logistical perspective.

Julius Pursaill, strategist at Cushon and member of the pensions expert panel for the Impact Investing Institute, says it is important for pension funds to adopt an unrestricted view.

“The suite of available solutions across these four areas (and beyond) is significantly reduced if pensions are restricted to either passive solutions or to listed markets, or to both,” he notes.

“Both active listed equity and active listed bond managers see thematic investment as an opportunity to both deliver better risk-adjusted returns and to protect their revenues from ongoing erosion by passive managers.”

Passive may be a clear choice for some pension funds, not least because of the cost savings, but Pursaill points out that the price premium of active management may be justified with a goal such as carbon mitigation.

“Specialist indices that offer more concentrated exposure to the decarbonisation theme are increasingly available, but at higher cost and with less diversification than a broader based index,” he says.

“Private markets offer the broadest opportunity set for pension funds to both mitigate climate risks and exploit opportunities, but at the highest cost.”

The advantage to active management goes beyond research and stock picking, with Gopinathan pointing to the benefits of proactive engagement with investees on their carbon emissions.

“[Railpen] has a dedicated climate work stream, which is responsible for designing and implementing its net-zero commitment and engagement plan and Task Force on Climate-related Financial Disclosures reporting,” he says.

“The availability of data, tools and technologies […] and engagement across investors, regulators and policymakers, provide pension funds and asset owners with the tools, frameworks, support and investments to play their part in reducing climate risk and taking advantage of climate-related opportunities.”