In the second of a series of four articles, Joy-Therése Williams and Alicia Seiger of the New York State Common Retirement Fund’s Decarbonization Advisory Panel take a deeper look at the work of the expert panel. The first article is available here.
This article is the second in a series taking a deeper look into the Decarbonization Advisory Panel (DAP) consensus report for the New York State Common Retirement Fund (the Fund), released last month. Our 6-member panel issued foundational beliefs and ambitious recommendations for the Fund that we believe can apply to investors broadly. This article explains the context of the recommendations and what drove us to be bold in our report. Since our charge was broad – identifying and managing climate risk and capitalizing on low-carbon opportunities, we articulated a Key Ambition as the Fund’s North Star and a First Step to guide the pursuit.
The physical impacts of climate change pose obvious and direct risks to most sectors, regions and professions. As business and industries adapt to new realities in a low-carbon economy (e.g., new technologies, policies, shifting consumer demand, etc.), the transition itself will pose risks to businesses unable or unwilling to change. Investors on the wrong side of this change will suffer. New opportunities are also present. Value will be created as adaptation solutions take hold and mitigation efforts continue to ramp-up.
Climate will drive fundamental changes to economic systems and force the need to rethink entire portfolios. With this understanding that climate risk transcends a single sector or asset class, our Key Ambition was to make the entire portfolio consistent with a 2-degree or lower future by 2030. That is, all assets bought or held would contribute (directly or indirectly) to the decarbonization transition or be neutral to it. We called this posture “100% sustainable assets.” Our definition of sustainable assets allows for investments that have a neutral effect on climate mitigation or adaptation, or are not impacted by the physical transition.
Moving to 100% sustainable assets means evaluating the entire portfolio under a coherent view of climate risk. At best, in current practice, portfolios may allocate a small portion of AUM for climate-related investments. While pilots such as these are a good way to start, continuing small allocations means the majority of the portfolio continues to be invested as if nothing has changed. If nothing has changed, the world will see warming temperatures of 3 degrees or more, yet investment decisions are not pricing this risk accordingly.
How an investor defines a 2-degree or lower future is a key input. The panel noted that there are models of multiple pathways to a 2-degree world and the Fund, or any investor, would need to carefully select which pathway(s) they find credible. What was unsaid, but hopefully understood, was that these pathways would be checked and anchored as time passes and strategies adjusted accordingly – more on this in the next article.
To help the Fund achieve the key ambition, we recommended an important First Step: establish a climate solutions allocation. Investible opportunities are available, but large investors such as the NYSCRF face challenges in capitalizing on such opportunities. Often, these investments do not fit neatly into a traditional asset class or they are smaller than is optimal for large investors.They may have other risk issues as well if they include new technology or have no history of similar investments. And often, allocators and consultants considering the opportunities on an incremental basis are less familiar with the underlying technologies, trends and market actors driving value.
A dedicated allocation helps to put investments that actively address climate change on a level playing field. To further support and enhance a climate solutions allocation, the carve out should be managed using compensation structures and benchmarks that better reflect the risk and expected value attributes of the underlying investments.
Piloting new investment strategies through a focused allocation is not a new approach. Allocators have historically managed targets for emerging managers, emerging markets or other opportunistic trends. These programs are often used to introduce new themes into the main portfolio or for investment staff to build capacity. What is new about our recommendation are the methods by which we recommend managing the allocation and the connection we make between the new allocation and the sustainability of the entire portfolio.
Climate change is rendering historical data unreliable. New and innovative investing strategies will be needed to face wholesale shifts in economic sectors and systems. The climate solutions allocation acts as the tip of the spear collecting the most advanced data on climate risk and opportunity that can in turn be applied to decision making processes across the entire portfolio. Currently, investors are overly dependent on historical benchmarks, which work against capitalizing on the transition and fortifying a portfolio to withstand climate shocks. Relying on historical benchmarks is akin to looking in the rearview mirror as you drive an unknown road.
Of course, our bold ambition and critical first step won’t be achieved overnight, but they should be pursued with urgency. The process will be iterative as data sources, tools and strategies evolve. Investors should continually check their chosen low carbon economy pathway(s) as they progress. Looking for specific milestones along the way will indicate if approaches, strategies and investment decisions need to be changed. One of the Panel’s key supporting recommendations provides a framework for this flexibility: Minimum Standards.
Joy-Therése Williams is Senior Advisor, Mantle314 and Decarbonization Advisory Board Chair. Alicia Seiger is Managing Director, Stanford University Sustainable Finance Initiative and a Decarbonization Advisory Panel Member.
Joy Williams is speaking at the RI Europe 2019 conference on June 11/12, London as a moderator on the following panel:
Sustainable infrastructure: new policy foundations and investment plans
• Why is sustainable infra an opportunity?
• Governments and cities step up on long-term, green infra.
• How infra fund managers are evolving their funds to meet the transition and demand.
• Heidi Finskas, Vice President, Corporate Responsibility and Corporate Governance, KLP Kapitalforvaltning
• Harold D-Hauteville, Head of Infrastructure Equity, Europe, DWS