Mats Andersson, the chief executive of SEK276bn (€29.9bn) Swedish state buffer fund Fjärde AP-fonden (AP4), has put down his thoughts about how institutional investors can hedge climate risk in a paper co-written with asset manager Amundi and a leading US academic.
Andersson, whose fund is into the third year of a ‘decarbonisation’ strategy and who is at the forefront of trying to persuade pension funds to publish their carbon footprints, has put the 42-page study together with Frédéric Samama, Head of Financial Solutions at Amundi in New York and Columbia University Professor Patrick Bolton. It comes after AP4 last month, along with France’s Fonds de réserve pour les retraites (FRR), announced substantial seed financing for a new suite of low carbon indices from MSCI.
Just yesterday (October 20), RI reported that fellow Swedish ‘AP’ fund, Andra AP-fonden (AP2) is divesting 20 fossil fuel energy firms. And AP2 today announced it was analysing its portfolio’s carbon footprint and that it will publish the results in its 2014 annual report.
“Our central underlying premise is that financial markets currently underprice carbon risk. Moreover, our fundamental belief is that eventually, if not in the near future, financial markets will begin to price carbon risk,” Andersson, Samama and Bolton write.
“If one accepts our premise and fundamental belief one is inevitably led to the conclusion that our Low-TE [tracking error] green index is bound to provide superior financial returns to the benchmark index.”The paper 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”.
The strategy goes beyond a “simple divestment” of high carbon footprint or stranded assets stocks.
“This is just the first step. The second step is to optimize the composition of the low carbon portfolio so as to minimize the tracking error with the reference benchmark index.
“We show that tracking error can be almost eliminated even for a low carbon index that has 50% less carbon footprint.” The authors say that the low carbon portfolios so far constructed in this way have “matched or outperformed” their benchmark. It means investors are holding what the writers term a “free option on carbon”.
They explain: “As long as the introduction of significant limits on CO2 emissions is postponed they are essentially able to obtain the same returns as on a benchmark index, but the day when CO2 emissions are priced the low carbon index will outperform the benchmark.”
They continue: “Although we are well-disposed towards the ethical argument for divestment, we shall show that there is no need to invoke this argument to justify an investment strategy that hedges climate risk.”