It is potentially one of the most important institutional investment papers on climate change. Link to RI news story
And more than that, it is already being implemented successfully, and could pave the way to significant mainstream take up for low carbon portfolios.
The 42-page study, titled: “Hedging Climate Risk” proposes a “simple dynamic investment strategy that allows long-term passive investors – a huge institutional investor clientele comprising pension funds, insurance and re- insurance companies and sovereign wealth funds – to significantly hedge climate risk while minimizing the risk of sacrificing financial returns”.
If one considers that the global indexing market is estimated to be worth some $10 trillion, it doesn’t take long to work out how significant its impact could be in terms of C02 reduction and investment impact.
The report’s authors are Mats Andersson, Chief Executive Officer of SEK276bn (€29.9bn) Swedish state buffer fund Fjärde AP-fonden (AP4), Frédéric Samama, Head of Financial Solutions at Amundi, the French fund manager, and Patrick Bolton, the respected Columbia University Professor (Samama and Boulton are both joint authors along with Joseph Stiglitz of the book: Sovereign Wealth Funds and Long-Term Investing
Mats Andersson at AP4 talks to RI about the report’s genesis:
Hugh Wheelan (HW): What were the origins of the thinking on the low carbon strategy: was it government instigated? How was it implemented?Mats Andersson (MA): It wasn’t government related. Everything starts with yourself. The job I have gives me the opportunity to travel around the world and attend interesting conferences where you hear from very interesting people such as Al Gore on climate change, and speakers like Bill Clinton and Jeffrey Sachs. Then you come back to the office and your daily business and ask when the next board meeting is and next committee, etc. Then, in those board meetings you tell everyone about the very interesting conferences you’ve attended, and that climate change is getting very serious, etc, etc. But then what? I was at a conference organised by the Rockefeller Foundation, Amundi and Columbia University in New York, and the concluding session of the conference was to challenge participants to find two ways to address the climate issue and create something investable. Two ideas were suggested. The first was to create a green infrastructure platform. Around the table were twenty of the largest pension funds and sovereign wealth funds, so there were assets. They started to work on the idea, but gave up because they couldn’t find the right legal structure, right currency…
I was leading another group trying to twist an index to address the issue of carbon. We also gave up because we couldn’t decide whether it should be in Ireland or Luxembourg, in dollars or euros, and how you could get money in/out. We left it at that at the end of the conference. But afterwards I thought let’s try and do it for ourselves at AP4 and come back to the group with our proposal. I took the mission back to my colleagues in the office, spoke to two bright guys and asked them to see if there is a way we can address carbon without giving up returns, or making the return impact as small as possible.
HW: What happened then?
MA: It took them probably six months or so, but they started to play around with the S&P500. They asked Trucost to put together the carbon footprint for the 500 companies, then they took out the worst polluters in every sector, totalling 150 companies. The interesting thing was that the tracking error of the final portfolio was less that 1, at 0.7, and at the same time you lowered the carbon footprint by 50%. So, you more or less got the same beta exposure as if you’d invested in the full 500 companies, but at the same time slashed the carbon footprint by half. You also get a free option that carbon is mispriced, and we believe that there will be a price on carbon.
We also lower the portfolio risk, if, as we believe, carbon pricing is a risk. Then we found out that after 12-18 months this tilt of the S&P500 actually outperformed the base index by 100 basis points. If I look back now over the past two and a half years it’s never been below zero, but it has been 0-120bps+.
HW: What do you think that outperformance is due to?
MA: It’s hard to say. You need to measure this over a longer period than 1-3 years, probably over a ten-year horizon, and I’ll come back to why this is hindering pension funds today. Someone said that if you look after your carbon footprint as a business then maybe you have a similar eye on the company business: I don’t know if that’s true, but it could be.
Encouraged by this we then started to do the same thing with emerging markets based on the MSCI Emerging Markets Index. That has been investing for a period of 12 months or so now. There we’ve lost some 50 basis points, but again it’s early days. I think probably the carbon footprint and analysis is a bit tougher when it comes to emerging markets than in the developed world.HW: What is the overall level of low carbon investment now?
MA: At this point we have about 10% of our global equity portfolio, or $1.5bn, invested in low carbon strategies and our objective is to make this a global approach during 2015, and within three years ‘decarbonise’ the whole equity portfolio. At the same, I also believe that we have done it because you come to a point in life where you need to think seriously about what is going on regarding climate change. You should also ask yourself what if the world goes plus 2 degrees, plus 4 or 6? What will your kids say 20-30 years from now: “Dad, were you aware of this, and what did you do? Did you have the possibility of doing something?” Well actually, the answer is we have some $40bn managed on behalf of other people also facing the climate change issue. That’s a starting point for me. But it has to be done in a proper way, and I think we’ve managed to find a strategy where we don’t give up return. I think that sustainability is not about charity, it’s about enhancing returns. You cannot be long-term successful unless you put sustainability high on the agenda. I think that is a misconception that is out there today.
HW: Has the strategy met with approval by the Swedish government?
MA: Absolutely. We are being evaluated once a year. I think it’s ridiculous to be evaluated in a business like ours every year because we should have a mandate of 20-30 years. I think the politicians and my Principal, the Parliament in Sweden, are fully aware of this. So far, they have approved and are supportive of what we are doing. I have my own board, and they have approved it, and we report in a transparent way, which we strongly believe in: we are, after all,
managing other peoples’ pension money, so we need to be. We are long-term investors, and we are extremely lucky not to have a solvency capital, so we can do this without too many problems.
However, a related point to add is that pension funds tend to be evaluated in risk terms, and that risk is measured in terms of volatility. I object strongly to that: volatility is a permanent loss of capital, and since we don’t have a solvency capital we don’t care about volatility as long as thirty years from now we get the best returns. I think that the academics have partly destroyed this industry because they are measuring our risk in a way in which you end up reducing risk and giving up returns for the next generation of members.
HW: Why is that? Is it because market orthodoxy has become more short-term?
MA: Absolutely. When you say that you need a more robust portfolio, what you are in effect saying is we are going to reduce risk, sell equities and dampen returns because we can’t stand the volatility. Well, why not? I honestly don’t care about volatility as long as I’m getting long-term good returns for my pensioners. Of course, I can understand that if you are running a traditional pension fund with solvency requirements then you cannot stand volatility in the same way we can. But sovereign wealth funds and AP funds can actually stand up and ride out volatility and use it to our advantage.
HW: You are extrapolating what you are doing to be a serious overall portfolio strategy, not just a portion.
MA: Yes. I don’t think you should stop at equities either: it should be done for fixed income, unlisted assets, real estate, etc.HW: Is it a costly strategy to implement?
MA: No. The additional cost for us running the emerging markets mandate with a low carbon twist is a fraction, and I think that if we do low carbon internally we can do it almost as cheaply as passive mandates.
HW: A lot of the pushback on strategies like this is that you have to have ‘faith’ that a price on carbon is going to arrive at some point relatively soon. Where are the indications that that is going to happen?
MA: I think that the world has changed. There is support in a way that I have never seen before in addressing climate change. As we speak, pension funds like our cousin AP2 are excluding some fossil fuel companies. FRR and ERAFP in France are doing the same. The Swedish church has done it, as have some US universities. It’s coming. We think that the starting point is to make it mandatory for pension funds to disclose their carbon footprint. If you ask a pensions manager about the alpha, beta, gamma, delta, risk-adjusted returns, information ratios, etc. you can get those numbers easily…but not for a carbon footprint. I strongly believe that once you start measuring some thing, things will be done. If you measure the carbon footprint you will have to stand by the figure you have and then you will start trying to lower that.
HW: If you look across other asset classes, what do you think the impact of what you are trying to do here could be?
MA: I think that it’s possible for us to lower the carbon footprint compared to the MSCI World by some 50% all over in three years time, and it could be more. I think we are some 25-30% lower that the MSCI today. I think you could apply the same figure and methods for the whole portfolio. It’s the same for real estate for sure. With credits, yes. Government bonds ought to be doable also. We haven’t looked into it yet, but we will.
HW: Those findings might be interesting for governments!
MA: Absolutely. And I think it’s doable.
HW: In the report you mention that no mainstream financial broker analysis has really looked at carbon risk. Why do you think that is?
MA: I think it’s because if you want to address an issue like sustainability and carbon, you need to have a longer horizon than a quarter or one or two years. I think that most investment banks by nature have shorter time views than the mandates pension funds have, so they tend to be more short-sighted. And if you are a hedge fund then you don’t have a time horizon longer than a year, and it’s usually a lot less. And they are paying more commissions than pension funds! I think that will change because I think that pressure from governments and clients will make asset managers address this.HW: How has the investment industry responded so far?
MA: Mostly very positively. There are some people who say there is no upside in doing this. Well, I say there is no downside either. Even if we’re wrong about this we will still get our beta exposure with a tracking error of less than one, and that’s the kind of risk we’re prepared to take. That’s the beauty of this strategy. It’s easy to say, ‘let’s exclude all fossil fuel companies’, but then you have a bet on fossil fuels, which we still need for the coming years. However, I think if you put a carbon price on all companies it’s different.
But, let a hundred flowers bloom!