The ever-growing rollcall of institutions backing the Taskforce on Climate-related Financial Disclosures recommendations is just one indicator that responsible investors will be putting climate scenario analysis high on their list of New Year’s Resolution for 2019.
On top of the PRI’s recent collaboration with 2° Investing Initiative to create a scenario analysis-focused platform for public equities and corporate bond portfolios, and a model from the Institutional Investor Group on Climate Change, there have been banking pilot projects in China, and statements and reports from regulators including the Bank of England, the European Central Bank, California’s insurance regulator and the Dutch Central Bank.
But much of this has been big picture stuff – looking at political alignment and industry- or –nation-wide financial stability, rather than creating tools to help investors make decisions.
Here’s where Alecta is breaking the mould. You wouldn’t have won much at the bookies for guessing that Sweden’s biggest pension fund would be one of the first investors to take the plunge on scenario analysis: they have been integrating climate change, long-termism and the Sustainable Development Goals into their thinking for years now, and CEO Magnus Billing was one of the 20 official members of the EU’s High Level Expert Group on Sustainable Finance (HLEG), leading its efforts on fiduciary duties.
“We were inspired by the Dutch Central Bank’s work [on scenario analysis], and their approach that climate change is a risk like any other – and should be treated as such,” explains Billing. “Climate scenarios are therefore part of our fiduciary duty, so we address them via our risk department, rather than from a traditional ESG angle.”
This prompted a year of work by Alecta, led by Daniel Asplund, its Chief Risk Officer, to create workable climate scenarios that can be used by regulators and portfolio managers alike.
“We looked at different methods of doing this,” says Asplund, adding that there were “problems with both methods and data”.
“We met with all the different vendors to discuss the options – Bloomberg, MSCI, S&P Trucost, South Pole ISS, Carbon Delta and so on. In the end, we decided that, in order to create something that our portfolio managers could most easily understand and apply, we would calculate the whole thing in-house”.
So, using broader emissions data from an unnamed third-party provider, Alecta decided to focus on a 2°C scenario, but also develop a rough 3°C model, too. Taking these as the ambitions, and using reports from the IPCC and the International Energy Agency, as well as the guidelines laid out in the TCFD recommendations, it settled on a relatively simple premise: in order for the world to remain below 2°C warming by 2040, the necessary carbon price that policymakers must introduce will need to be around $140 per tonne. This will mean additional costs for holding companies, issuers and other assets, some of which will be able to be passed down to consumers while others will hit the balance sheet. Ultimately, what does this mean for Alecta’s current portfolio – public equities, bonds and real estate?
On the latter, which makes up around 10% of Alecta’s portfolio via direct and indirect investment, the focus is on energy efficiency. Namely, what the cost implications are of reducing the energy consumption of a property by 3% each year until 2030.
“It’s fairly difficult to make calculations on real estate, especially around indirect holdings, but it’s still important, because it’s an asset class with perfect alignment between value creation and energy efficiency,” explains Billing, referring to the fact that energy efficient properties are generally worth more as a result. “In the short run the costs can be low, because it’s just a matter of retuning the heating system, for example; but as time goes on, you need to do more to keep becoming more efficient, and that can be expensive.”Alecta has included Scope 3 emissions in its climate analysis for the first time in the new exercise, reflecting a growing awareness of the need to account for emissions further along the supply chain. “But there is a 30-40% double-counting effect expected when you include Scope 3 emissions in this kind of analysis,” warns Asplund. “That needs to be considered.”
“Even so, we found that our public equities portfolio carried lower potential carbon costs than the benchmark,” he explains. The benchmarks Alecta uses for its US and European equities are already ESG-tilted, while its domestic equities are measured using a standard benchmark. Public equity makes up some 40% of the portfolio, and Alecta has no private equity.
“Our portfolio has a value assigned to us by the market, but that value is lower when we do our own calculations, with this additional element” – Magnus Billing, CEO
Applied to the credit portfolio, which makes up around half of its holdings (although sovereign bonds are excluded from the analysis, currently), “it doesn’t really have a financial effect”. This is partly because of the shorter durations for the asset class in Alecta’s portfolio, but also because – echoing the argument of the credit ratings agencies in recent years – the risk to credit portfolios lies primarily in default, which is low over the short term when it comes to carbon costs.
“We have the option of refinancing bonds when they mature, and we probably wouldn’t buy new credit that isn’t aligned with 2°C, but even in our current holdings the impact of carbon pricing is minimal compared with equities,” Asplund concludes.
Billing says that the credit methodology needs further work (it is Alecta’s first foray into any climate analysis for fixed-income), but can already be used to engage issuers on how they will deal with carbon price risk in future.
“For all asset classes, we hope the model will form a good basis for our PMs to engage, because our portfolio has a value assigned to us by the market, but that value is lower when we do our own calculations, with this additional element. So our managers can bring that to the issuer and show them our assumptions to start a discussion about how they view the potential impact of carbon pricing on their business models. That’s going to be an extremely interesting next step for us.”
All of this has been packaged into a 50-page report which Asplund presented to Alecta’s board last month. The report lays out qualitative examples of how the climate transition can impact industries (such as automotives, to which Alecta has notable equities exposure, and that has seen disruption from competitors offering new, greener technologies in recent years), as well as a quantitative discounted cash flow model that portfolio managers can integrate into their existing processes.
“That bit’s important,” says Billing. “That PMs are familiar with the model, and can just add it as another part of what they already do.”
Portfolio managers and analysts will also be given a set of “forward-looking data points” on climate and carbon pricing, to help with investment decisions. And their pay-for-performance packages are now linked to climate alignment, because they’re assessed relative to the ESG benchmarks.
Alecta’s board approved the report, which means climate-focused scenario analysis will be part of its official risk and solvency assessment, presented annually to the regulator, who Billing and Asplund hope will engage with the ideas and perhaps develop industry best-practice guidelines for data and methodologies.
“What we’ve done is a starting point – it’s not perfect,” concedes Billing. “But that’s because it’s complicated, and you could sit and have long discussions about every single assumption we’ve made. But nevertheless, we’re taking our first steps and getting on with it.”