Today’s CIO Weekly Perspectives comes from guest contributor Jonathan Bailey.
Earlier this month, the United Nations-supported Principles for Responsible Investment (PRI) announced its Leaders’ Group for 2020.
The Leaders’ Group “showcases signatories at the cutting edge of responsible investment, and highlights trends in what they are doing.” This year’s theme is climate reporting, and, for the first time, investment managers were selected for a list that formerly included asset owners only. That makes us especially pleased to have made the cut alongside 19 of our peers, out of a total of more than 2,000 who are signed up to the PRI.
So why do we think climate risk is important for investors, and what have we been doing to measure and manage it?
New Winners and Losers
At Neuberger Berman, we believe climate change is real and will affect businesses in two major ways:
First, there is the physical impact. Extreme weather events, wildfires, floods and higher sea levels are likely to disrupt some supply chains and threaten the viability of some capital assets.
Second, there is transition risk. Efforts to slow climate change through carbon taxes, regulation, green fiscal spending, energy transitions and changing purchasing behavior are likely to create new winners and losers in business, and new risks and opportunities in investment.
We’ve been working these considerations into investment decisions for a long time, but our most recent advance has been the development of a “Climate Value-at-Risk” model, or CVaR.
Comprehensive and Granular
Certain businesses are obviously exposed to climate change, such as airlines and wind turbine manufacturers, but what about, say, a cruise line?
The link may not be so obvious, but these companies invest in long-lasting capital assets that spend a lot of their time sailing in Atlantic and Caribbean waters that could see stronger and more frequent hurricanes. A comprehensive and granular model of Climate Value-at-Risk can help analyze these situations.
Our model assesses physical and transition risk.
The insurance industry has been modeling physical risk for decades, and our colleagues in Insurance-Linked Strategies advised us on the third-party modelers best placed to help us apply this analysis at the required scale.
Transition risk is more complex. The inputs include the temperature change that we think the world’s governments will allow (the 2015 Paris Agreement aims to keep the global temperature within 2°C of pre-industrial levels this century), but also a range of inputs quantifying the current carbon footprint and future adaptability of every company in our investment universe, based on our reasonable assumptions as experienced portfolio managers.
Bring the two sides of the model together, and the output is an estimate of the present value of the change in enterprise value of each company, due to climate-related factors, over 15 years.
Our analysis reveals some broad dynamics.
While some companies are less exposed than others, we believe there is little upside from physical risks. Few companies benefit from more extreme weather, and the higher the input for allowable temperature rise, the worse the potential impact becomes.
Transition presents a wide range of potential outcomes, however, from extreme downside (for airlines or oil majors) to extreme upside (for turbine or solar energy manufacturers). Here, the higher we push the input for allowable temperature rise, the less extreme the upside and downside outcomes are, because everyone gets more time to adapt their business away from the status quo.
Finally, this is a model with complex interactions. Raise the allowable temperature input, and the present value of a solar company will decline despite a likely acceleration of climate change; and while you could still generate revenue by building gas-guzzling cars, you may have to pay to relocate your factories away from floodplains.
At the end of 2019, we calculated the estimated CVaR for all the public equity securities held by Neuberger Berman, given the Paris Agreement’s 2°C limit. The result was -5.1% at risk over the next 15 years, at present value. For the MSCI All Country World Index, the result was -6.1%.¹
The usefulness of this analysis soon became evident within Neuberger Berman, following a fairly radical decision made by our colleagues in Emerging Markets Debt.
Neither emerging markets nor fixed income are generally thought of as hotbeds of Environmental, Social and Governance (ESG) innovation. But in this context, questions that can sometimes feel rather abstract—"What is your upper tolerance for carbon footprint, as a quantitative aggregate across hundreds of stocks?”—get very real. Emerging markets debt investors don’t just buy and sell securities in businesses with polluting legacy assets. They often hand over new money to invest in projects such as new thermal coal power plants or coal mines, in economies with fast-growing power demands.
When we analyzed this, weighing the probable transition away from thermal coal against the undeniable needs of growing economies, we concluded that thermal coal industries are unviable over the long term. Lending to develop new assets seemed almost like burning clients’ money—and a decision was made to prohibit certain new investments in the sector.
This led to several months of detailed discussions with the rest of our portfolio managers, in which the findings of the Emerging Markets Debt team, but also our CVaR analysis of the thermal coal industry, played a persuasive role. The result was a policy applied to essentially all of our U.S. registered mutual funds, closed-ended funds and international UCITS prohibiting new investments in companies that derive more than 25% of their revenues from thermal coal mining or are expanding new thermal coal power generation.
In the Vanguard
This story shows that for us, coming to grips with climate risk is about positive action, not mere portfolio analytics or security evaluation. Moreover, it’s about action that benefits society, the wider market and our peer group, in addition to Neuberger Berman and our clients.
That’s why CVaR analysis is an increasingly important part of our corporate engagement. Some forward-thinking multinationals already submit their own businesses to very similar analyses, but for the long tail of companies with fewer resources, our data can reveal hidden costs and risks, even potential opportunities—and be a spur to action.
It’s also why we are one of five asset managers, and the only one from the U.S., to sign up as a Research Funding Partner with the Transition Pathway Initiative (TPI). The TPI provides free-to-use, independent research to help investors assess the alignment of their portfolios with the Paris Agreement goals and to promote emissions reductions.
Many of our clients are trying to understand their own exposure to climate risk. A number of Australian superfunds, U.K. pension pools and U.S. insurance companies have told us that capabilities like our CVaR analytics remain rare in our industry. We want to change that. Through our partnership with the TPI and our 12-month stint as PRI Leaders on climate reporting, we aim to raise awareness of the importance and effectiveness of this kind of analysis among corporate management and our peers.
It’s great to be in the vanguard, but our hope is for this to become an asset management industry standard.
In Case You Missed It
- U.S. Consumer Price Index: +0.2% in September month-over-month and +1.4% year-over-year (core CPI increased 0.2% month-over-month and 1.7% year-over-year)
- U.S. Producer Price Index: +0.4% in September month-over-month and +0.4% year-over-year
- China Consumer Price Index: +1.7% in September year-over-year
- U.S. Initial Jobless Claims: +898,000 for the week ending October 10
- U.S. Retail Sales: 1.9% in September
What to Watch For
- Monday, October 19:
- China 3Q 2020 GDP
- NAHB Housing Market Index
- Tuesday, October 20:
- U.S. Housing Starts and Building Permits
- Thursday, October 22:
- U.S. Initial Jobless Claims
- U.S. Existing Home Sales
- Japan Purchasing Managers’ Index
- Friday, October 23:
- U.S. Purchasing Managers’ Index
- Eurozone Purchasing Managers’ Index
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