Op-Ed: Julian Poulter: Why the KLP carbon capital switch raises the bar

Investors will have to put faith in their forward judgement rather than in historical models

Can there still be a pension fund trustee left in the world who hasn’t noticed that the carbon risk debate has livened up a little in the past year?
Furthermore, sound advice would be to sift through their CIO’s notes to their boards to see if the there’s anything in there about ‘massive un-mitigated reputational and investment risks’.
This risk just expanded following last week’s announcement by KLP around their carbon exposure reduction plan that raises the bar still further – in a year where carbon risk announcements are appearing like confetti.
KLP has gone beyond simplistic divestment statements by making a decision on coal across asset classes and industry sectors. Further still, at a time when it is easier to pick the losers than the winners in the carbon war, KLP have said that the resultant underweighting capital will be used positively for new low carbon investments. Whilst sophisticated investors know that divestment itself won’t solve climate change, when asset owners start using the newly available capital to switch to assets that compete with high carbon investments we have a whole new ball game.
Whilst the divestment movement will claim another victory, the reality is that asset owners are rapidly extending their understanding of the fine print of portfolio decarbonisation.

Of course the KLP 50% coal exposure level of negative screen is still a fairly blunt instrument – one that certainly reduces that fund’s relative carbon exposure, but it is further evidence that asset owners are accepting that managing carbon risk requires judgement.

As Anne Simpson from CalPERS said on the same subject, ‘investment is judgement in the face of uncertainty’ and what KLP have proved yet again is that leaders are increasingly prepared to use judgement about a forward risk at a time when asset consultants are still fiercely protecting the false precision of their rearward-facing models. The consultants will do well to respond pro-actively and quickly if they don’t want to be rendered irrelevant as their clients take the lead on the carbon issue – surely it is time to make a carbon hedge or exposure reduction strategy standard advice?What the KLP decision further points to is that in the absence of a market carbon price that would allow free market economics to work its magic, coal is a ‘no-brainer’ to reduce long term exposure. And whilst KLP has defended the forward returns of the Oil and Gas sector, they too are coming under close scrutiny given the balance sheet hit once the 2 degree carbon budget is further established.

To see Shell jump on the coal divestment bandwagon is a sure sign that companies, responding to the new era of investor awareness, are starting to mark out their territory of that carbon budget.
Where it will end? As we speak, the world’s largest asset owners are studying this year’s AODP survey and once again wondering whether or not to disclose to their members how early they are on their journey to decarbonisation or, like KLP, wait until lifting the veil on a new strategy.
Regardless of how quickly members and NGO’s can extract disclosure, the work is continuing apace. Those funds that have already rejected (or are planning to) simple divestment from fossil fuels are either looking for plan B or sitting back and waiting for members and civil society to raise the stakes.
However, beyond the narrowing window for fund PR managers to get their announcements out whilst such things are relatively novel, the analysts deep in the bunkers are slicing up the portfolio carbon exposures into ever smaller chunks with an obvious conclusion – carbon requires a risk premium.

You can dress it up how you like and package it into an announcement about divestment, screening, decarbonisation or a hedging strategy by sector or asset class; but it has a price and this price is being reflected in more and more sophisticated portfolio ways.
We can surely only be months away from the first asset owner to announce their own internal price of carbon at a portfolio level without needing to identify any particular sector or asset class.
A portfolio price on carbon is a tool that can be given to managers to use in their assessments, it can be used for analysts to price stocks and bond risk.

It can be used to build new forward balance sheet calculations for exposed companies and to view high carbon capex equations in a new informed light. Unlike the internal prices (used for mainly marketing purposes?) by companies, these prices will be used to make investment decisions. But what level of portfolio carbon price is appropriate? That is another question that asset owners will inevitably begin to debate as they consider the odds of a major price acceleration anytime in the next 15 years and the odds that their fund managers can sell even half of the assets in the ensuing carbon fire sale. That new era will involve a new generation of analysts and CIOs prepared to put faith in their forward judgement rather than in historically based quant models – some have already started.Once we have asset owners actually thinking about the long term and using their judgement to price long-term risks, they could even hold education sessions for policymakers and regulators perhaps? Further still, as the members of the pension funds who are already helping to drive disclosure and risk management realise that their influence in this new found financial democracy actually works, politicians might find themselves in the awkward position of playing catch-up with the private sector rather than being governed by it – now there’s a thought!

Julian Poulter is Chief Executive of the Asset Owners Disclosure Project.