Investors Shift Portfolios Amid New Frameworks & Policy on Climate Risk 

Supported by Impax Asset Management


Lawmakers, regulatory and other policymakers around the world are increasingly taking steps that are intended to speed the adoption of sustainable investing and the transition to a low-carbon economy. The changes have been a long time coming, and many are moving at the slow pace typical of most major policy adjustments. But experts are encouraged by the shifts, which they say have the potential to spark dramatic positive improvements. Asset owners and managers are starting to embrace the changes as well.

“A movement is building, with more and more capital market leaders calling for action from our financial regulators by the day,” CERES president and CEO Mindy Lubber says in a recent Barron’s op-ed. “It’s time our financial regulatory agencies listen to this increasing number of calls for action, learn from them and then act.”

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One of the pioneering jurisdictions when it comes to policy frameworks has been the European Union, and one of its leading efforts is the EU Taxonomy framework, which is currently in the process of being implemented. The EU Taxonomy is a classification system that allows companies to define which of their activities are environmentally sustainable while also requiring greater disclosure by corporations.

All EU companies must use the taxonomy “to disclose how and to what extent their activities are associated with environmentally sustainable economic activities,” says Chris Dodwell, head of policy and advocacy at Impax Asset Management. It also means “financial market participants which are offering environmentally sustainable products [must] disclose how they support activities aligned with the taxonomy.”

Among the goals of the taxonomy is to help investors better understand what companies meet the criteria for sustainability, encourage the use of ESG factors in investment decisions, and shift more investor capital into green products.

Its provisions include a requirement that, by the end of next year, fund managers that market their products as green or sustainable must meet more stringent disclosure standards outlined in the taxonomy.

The requirement for disclosure is crucial and much-needed, experts say. “We are always encouraging companies to disclose more and be more transparent,” said Adam Hynes, portfolio manager at APG Asset Management, speaking at a recent CleantechIQ online forum. The Taxonomy “ will have significant implications for disclosure.”

It also is poised to have an impact well beyond the borders of the European Union. “The adoption of the taxonomy is likely to lead to voluntary efforts by asset owners and asset managers to increase their exposure to Taxonomy aligned investments both in Europe and further afield,” Dodwell says.

Indeed, even funds with no EU presence could face pressure from ESG-focused investors in the EU or elsewhere to “disclose the percentage of investments that are aligned with the EU Taxonomy and ultimately may face pressure to allocate capital towards such investment activities,” Kirkland & Ellis partners Alexandra Farmer and Sarah Thompson say in a recent memo about the Taxonomy.

They argue that investment products in jurisdictions that lack clear guidelines around sustainability “may benefit from utilizing EU Taxonomy terminology to provide some clarity to investment professionals and protection against ‘greenwashing’ claims.”

On a more practical basis, Dodwell notes that EU public expenditures “will increasingly be directed towards taxonomy aligned activities.” He says it’s “likely” that officials will use the Taxonomy to determine where to spend hundreds of billions of euros of Covid-19 recovery money.

Overall, the taxonomy is a “comprehensive framework that bridges the gap between international sustainability goals, such as the Paris climate agreement, and investment practice,” says Will Martindale, director of policy and research at Principles for Responsible Investment, or PRI.

While the EU moves ahead on such sustainability frameworks, the U.S. has largely lagged behind, due in no small part to nearly four years of the Trump administration. But even here there are signs of movement and progress.

CFTC Report

Sept. 9, for example, saw the release of a report commissioned by the Commodity Futures Trading Commission about financial risks related to climate change. The report, “Managing Climate Risk in the Financial System,” was written by a subcommittee whose members include experts from companies ranging from Vanguard and Morgan Stanley to Caergill and BP.

The report concludes that climate change represents an existential threat to U.S. financial markets and calls on the CFTC, the Federal Reserve, the Securities and Exchange Commission and other financial regulators to take quick steps to intervene. Among its recommendations: financial firms should be required to address climate-related financial risks through their risk management frameworks, and financial regulators should support greater climate risk disclosure.

“We believe that this is a positive step forward for US policymakers,” Martindale says of the report. He adds that the PRI is “pleased to see a group affiliated with a US regulator put forward policy recommendations to address the risks climate change poses to financial markets.”

Impax “supports the conclusions reached in the report, which frames the magnitude of the challenge and sets a proper tone for the responsibilities of financial regulators and market participants,” Dodwell says. “While it is too early to make a judgement on its potential impact, the report provides a foundation for further regulatory action and points out that regulators already have the authority they need to take action on many of its recommendations.”

TCFD Recommendations

One of the leading voices when it comes to policies and related frameworks has been the Task Force on Climate-related Financial Disclosures or TCFD , which in 2017 issued a recommended list of information that companies should disclose in order to help investors, banks and underwriters better understand how the companies oversee and manage climate-related risks and opportunities, and what risks they face.

The recommendations have found significant traction, and Dodwell thinks they will gain even more momentum in coming months, thanks in part to the “ growing acceptance [of the TCFD recommendations] as the global standard for corporate reporting on climate risk.” He notes that as of the last status report in June 2019, there were 1,200 signatories; many more companies and organizations have announced their commitment to the recommendations since then.

Among those is the $90 billion Alberta Investment Management Corp., which released its first TCFD report last year and also formed an interdepartmental working group to develop a holistic approach to TCFD, the firm’s v.p. for responsible investment, Alison Schneider, said at a CleantechIQ forum this month.

Schneider also sits on a steering committee of the CSA Group, a Canadian standards organization focused on developing a ‘made in Canada’ transition taxonomy, as recommended by Canada’s Expert Panel on Sustainable Finance . It is still a work in progress and “not ready for prime time,” Schneider says. Still, the group has made real progress, and it’s further proof of the growing acceptance of taxonomies. She adds that there is an effort underway within the CSA to create a global taxonomy as well.

Among other major moves involving the TCFD recently: Canada is demanding that companies report climate risks if they want to receive Covid-19 bailout funds, while earlier this month New Zealand enacted legislation that will require companies to make TCFD disclosures. The UK also plans to make TCFD a centerpiece of the COP 26 talks next year, Dodwell notes, “and is likely to support a concerted push for international adoption of TCFD recommendations.”

The UK government itself is embracing the TCFD recommendations. In late August, the country’s Department for Work and Pensions unveiled a proposal that would require the vast majority of UK pension funds to follow the TCFD recommendations, including assessing and reporting on the climate-related risks that their investment portfolios face. The mandate would eventually apply to some 80% of UK pensions. Those pensions would also be required to conduct scenario analyses as to how their holdings will be impacted by various degrees of global warming.

IIGCC’s Net Zero Investment Framework

Another brand-new framework is coming from the Institutional Investors Group on Climate Change or IIGCC, which in August released a draft investor guide called the Net Zero Investment Framework. It’s intended to give investors a “practical blueprint” to better align with the Paris Agreement goals

The IIGCC is now seeking input on the draft framework, which it says “provides a comprehensive set of recommended actions, metrics, and methodologies to enable both asset owners and managers to become ‘net zero investors.’” The framework covers listed equities, corporate fixed income, sovereign bonds and real estate, and will be expanded to cover other asset classes in the future, the group says.

In addition to soliciting input on the draft, the IIGCC says five investors – APG, Brunel, the Church of England Pensions Board, PKA, and Phoenix Group – are testing the framework “by modeling its impact across the performance of their portfolios.” A final version of the framework is slated for release later this year.

Investors are also testing out the EU Taxonomy. More than 40 asset managers and pensions have implemented the taxonomy in their own portfolios, seeking to learn and share how best to measure investments that are eligible for the taxonomy and potential gaps in the data-collecting process and other issues. Participants in the exercise, which was organized by PRI, included BlackRock, Impax, Morgan Stanley Investment Management, Neuberger Berman, Wells Fargo Asset Management and Denmark’s AP Pension, among many others.

PRI has published the results of each investor’s work on its website, along with its own conclusions based on those case studies. The nonprofit’s recommendations to EU policymakers include providing more guidance around what regulators expect in terms of disclosures, and working to harmonize the taxonomy with international standards.

The movement toward more regulatory action around sustainable investing will surely gain even more momentum if Donald Trump leaves the White House in January. As the New York Times notes, Federal Reserve governor Lael Brainard — who is said to be a contender for Treasury secretary if Joe Biden becomes president has called on financial regulators to act on climate change as a significant risk to the financial system.

It’s clear that support is building for more frameworks and regulations around sustainability and ESG investing, sparked in no small part by efforts like the EU Taxonomy. “Countries outside the EU are undoubtedly looking at European models to see how they might integrate those practices in their local markets,” Martindale says, citing a long list of countries including China, South Africa, Japan and Malaysia

Indeed, it seems certain that taxonomies like those being implemented by the EU are the wave of the future. “The PRI considers taxonomies a generational shift in how we think about sustainability issues,” Martindale says. “Taxonomies are here to stay.

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