Comment: Mercer’s climate report: groundbreaking, but will pension funds step up?

Major portfolio surgery required to switch allocations to climate sensitive assets.

The Mercer Climate Risk report released last week is groundbreaking, no doubt. The sheer quality of the contributors and the peer reviews puts it on the map as the equivalent of a Stern review of investment at a portfolio level. Its analysis is thorough and creative, its findings startling and its conclusions uncompromising. But its recommendations are where the party starts to swing – for a while at any rate. It is bold for Mercer to have assumed that the two most likely regulatory scenarios involve carbon prices reaching between $110 and $220 a tonne by 2030, levels which halve the profits of many of the world’s highest emitters. However, the recommendations should stand even lower levels of exposure and lower levels of likelihood. It is highly unlikely policymakers will stand by and watch the planet warm up and markets collapse without action. Mercer’s report reflects this. It is exceptionally bold too for the report to announce previous allocation methodologies as being unable to cope with a unique risk like climate change, i.e. long term but high certainty, high impact. Whilst this is no surprise to many, sometimes even the most obvious of conclusions require in-depth analysis and intellectual rigour. The recommendations of the report, if implemented, would be one of the greatest net trading of themed assets in history as asset owners seek to replace 40% of their portfolio with ‘climate sensitive assets’. Whilst their definitions of low carbon assets aren’t as precise as the ground breaking Deutsche Bank report of January 2010, we all understand that optimising returns across all asset classes whilst reducing emissions intensity means only one thing: winners and losers. Here is where the problems start and why so many funds resist greater transparency like that offered by the Asset Owners Disclosure Project. For funds to actually carry this out will require not just major portfolio surgery but the overcoming of some major cultural problems. One of the largest pension industry reviews was conducted last year in Australia and its lead author cited ‘peer pressure’ and ‘herd mentality’ as the two greatest barriers to productive change and better investment practice.Let us be clear, many funds, including recognised leaders such as Calpers/Calstrs, Norwegian Government Pension Fund, British Telecom, The UK Environment Agency, VicSuper and others, have started this re-allocation already, but would like to go further and faster. Like them, the reason most pension won’t spring fully into action is because the potential changeover period of asset swapping will cost money. The change could occur smoothly and the return sacrifice measure only a few basis points, but nonetheless there will be a price. This is likely to lead to an ‘after you’ queue in the market. The only chance of avoiding this intransigence is if large funds decide to take even more of a bold lead than they have already and drive the game by example. Cheque books at the ready for a Le Mans style re-allocation grid start? I doubt it, but a slow rolling evolution is a possibility. The low carbon change will need to touch every aspect of a fund’s operation and strategy include a restructuring of incentives if it is to work. Asset owners themselves will need to drive fund managers into cultural change. One might need to wear a hard hat and go long in stocks of listed change management consultancies for that, as it could be a bumpy ride. Asset owners should be brave, however. Even the G20 in 2008 suggested their response to climate change would be critical to creating sustainable markets. How brave the funds will be though ultimately depends on the momentum that the Mercer report can sustain. We hope it is held up as the new bible for asset allocation like the Stern Report was for justifying policy, but that it has quicker results. Everybody needs to do their part, but the asset owners involved in the report need to bark loudly about it. Change has a habit, just like financial markets, of being self-fulfilling. Having won the intellectual battle about climate change and risk adjusted returns, pension fund CEO’s and Chairs need to call their staff, peers, managers and investee companies to order and make it a clear message that this should happen, and quickly.
Link to Mercer Climate Risk Report