With Australian and global regulators calling on funds to incorporate climate risk into their overall risk framework, funds are focused on ensuring the companies they invest in do not drive up the net emissions of their overall portfolio.

But assessing whether companies will be resilient in a warmer, lower-carbon world is no simple task and requires a holistic approach that takes account of the risks across the entire value chain, says Jaime Ramos Martin (main picture), portfolio manager of the global equity team at Aviva Investors, who is responsible for managing the firm’s global climate transition strategy and global equity stewardship strategy.

While investors are actively reducing or ceasing investment in fossil fuels­­ and directing funds towards solutions such as renewable energy and other technologies to help mitigate climate change, this doesn’t go far enough, Ramos Martin says.

It is also important to direct investment towards the likely winners in a warmer, lower-carbon world: transition-orientated companies that are aware of the risks and adapting their business models.

“Climate change will affect every single company in the world, and carbon emission unfortunately is present in every economic activity,” Ramos Martin says. “I cannot think of any commerce that has no carbon footprint. Therefore, we need to find a way to incorporate that risk and opportunity if you are ahead of others in changing your business model.”

Stepping in where financial markets are failing

Experts have pointed to the inability of financial markets to efficiently price the risk of climate change. Jillian Reid, Senior Responsible Investment Specialist at Mercer, says the lack of consistency in the approach companies take to pricing climate risk leaves plenty of room for investors to play a role.

“Our many conversations with the fund managers Mercer rates, as they prepare for the transition to a low or zero carbon scenario, suggests the majority of managers are incorporating climate risk into their analysis in some way,” says Reid. “However, there isn’t a single view on transition timing or physical damages impacts, and these differences present investor risks and opportunities.”

Mercer’s climate transition framework and Analytics for Climate Transition, launched in November 2020, focusses on a portfolio’s transition capacity, encouraging clients and appointed fund managers to not just look back to a company’s historical emissions, but to also look forward at whether companies are building capacity to transition and adapt.

Aviva Investors is directing resources to fundamental company analysis, linking its climate risk approach to its equity investment process and its well-research global opportunity set.

It has built its own transition risk model which identifies decarbonisation risk but also incorporates physical impact risk using qualitative analysis, rating 159 sub-industries into high-, medium- and low-risk groups.

Companies are then analysed and given a CDP score and weighting based on their progress towards environmental stewardship.

“It is a holistic approach, literally incorporating all that we can in terms of what climate change means for all sectors,” Ramos Martin says. “This is applicable to other asset classes also; we will apply the same approach to credit and real assets as well.”

Australian funds taking the lead

John Pearce (pictured, inset), Chief Investment Officer at UniSuper, says investors face obstacles investing in renewables as public markets are not providing depth and breadth of opportunities, and private market valuations look stretched.

But Australian funds are “reasonably competitive” when it comes to climate risk reporting and disclosures, he says. Many are reporting in accordance with the Taskforce on Climate-related Financial Disclosures (TCFD) and have developed–or are in the process of developing–Investment Climate Action Plans.

“Our 2030 and 2050 climate targets are deliberately aligned with many other Australian funds,” Pearce says. “UniSuper has also set a short term target of 100% of our portfolio companies to set Paris-aligned operational emissions targets by the end of 2021.”

UniSuper is also prioritising engagement with high emitting companies to influence both real operational emissions reductions and physical risks, future investment commitments and decarbonisation targets.

Engaging with companies to drive change

Driving action on climate change requires a nuanced and pragmatic approach, and Aviva Investors adopts multiple strategies to push companies towards better environmental stewardship.

This includes asking companies to increase their disclosure by requesting they complete the global disclosure questionnaire put out by not-for-profit charity CDP.

Around half of companies currently do not respond to this request for information, Ramos Martin says. Aviva Investors also requests companies align with the recommendations put out by the TCFD, and set targets using the Science-Based Targets initiative. This helps ensure robust steps are being taken.

“The date 2050 is so far away it can be lost in time,” Ramos Martin says. “We ask for that commitment to Science-Based Targets, and we want to see that roadmap. It’s not just about 2050. We want to see targets for every year.

Aviva Investors’ opportunity set includes carmaker VW. While still operating under the cloud of the ‘Dieselgate’ scandal, Aviva Investors believes VW has the strongest commitment to electrical vehicles among Original Equipment Manufacturers.

VW is also well-placed to meet strict EU emissions regulations targets for 2021 and 2030, Aviva Investors says in its investment materials.

In its engagement with Aviva Investors, VW noted its ESG scores were coloured by weak governance which was adding significance costs to borrowing. Following this engagement , the company adopted targets in line with the Science Based Targets Initiative call to action criteria. Aviva Investors also outlined recommendations to improve governance including significantly increasing independence of its supervisory board.

Flow-on effect

Ramos Martin gives the example of US technology giant Apple which, while not a stock that Aviva Investors owns, demonstrates the flow-on effect of strong action. Apple’s ambitious climate targets are putting pressure on Sony–which provides the cameras used in iPhones–to use renewable energy. Sony, in turn, last year warned the Japanese government it may have to shift manufacturing out of the country unless rules hampering the expansion of green energy are changed.

“The good thing about Science-Based Targets is you are forced to take Scope 3 emissions into account and have a plan for those,” Ramos Martin says. “That means that suddenly you need to ask your whole supply chain to incorporate climate change. The ripple effect is enormous.”

Scope 3 emissions are all indirect emissions occurring in a company’s value chain outside purchased electricity, heat and steam. They are often neglected, Ramos Martin says, despite being greater than the more direct Scope 1 and Scope 2 emissions in some sectors.

Funds that ignore Scope 3 emissions do so at their peril, Ramos Martin says. Companies that appear to be tackling climate change might be less resilient than they appear, and funds could find themselves holding the wrong stocks, he says.

Aviva Investors in February announced its Climate Engagement Escalation programme focusses on its investments in 30 of the biggest carbon emitters in the world from the oil and gas, metals and mining and utilities. Aviva Investors requires them to deliver net zero ‘Scope 3’ emissions by 2050 and establish robust transition roadmaps. Should any of those companies fail to meet its climate expectations, Aviva Investors is committed to full divestment across its equity and debt exposures.

“The ultimate objective for us to align the economy and companies with the 1.5-degree target of the Paris Agreement by 2050,” Ramos Martin says. “We know that this cannot be about one strategy in particular. It has to be teaming up with industry and other investors and using the whole field to drive change.”

This Infocus article was created in partnership with Aviva Investors.

Ben Hurley is a journalist and editor with more than a decade of experience in the industry. He has written for The Australian Financial Review, Business Review Weekly, The Guardian and a range of specialised and industry publications.
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