Blood & Gore: Invest for Climate Change, or Pay the Price Later

(October 30, 2013) – Pension funds must amend their investment habits to incorporate climate change, or risk losing millions in dwindling energy company values and damaged real assets, according to environmental lobbyists.

Former US Vice-President Al Gore told investors they have been too slow to appreciate the implications of carbon-intensive assets in their portfolios.

“They have largely ignored the conclusions of the Copenhagen Accord and the IEA’s subsequent carbon budget. The global economy must continue to rapidly evolve to reflect the realities of climate change,” he said. “Investors must now acknowledge that corresponding changes are needed on their part as well.”

Generation Investment Management–a foundation he established in 2004 to drive forward the mission of strengthening the field of sustainable capitalism.

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David Blood, senior partner at the firm, added that climate change could no longer be considered a peripheral issue for investors, given they were now clamouring for superior investment returns.

Speaking about the launch of his company’s white paper on the issue, Blood said: “The competitive landscape for fossil fuel‐intensive companies is losing its attractiveness at an accelerated rate. The ‘economic moat’ of carbon‐intensive assets will continue to deteriorate as developments on both the supply and demand side of the industry force significant pressure on margins.

“Investors should consider the recommended actions outlined in this paper ahead of events that would result in a fire sale of carbon‐intensive assets.”

Also banging the drum for climate change-investing this week is Share Action, a campaigning group, formerly known as Fair Pensions, which has also published a report into climate change and its impact on institutional investors: “The Green Light Report”.

In it, the group has claimed pension funds are sleepwalking into losing substantial amounts of money through not preparing for the effects of regulatory changes to carbon emission allowances and the effects of climate change on physical assets.

There are key types of climate risk which are common across the entire pension industry, the report said. These are the regulatory risk for carbon intensive investments—that policy measures locally, nationally, and globally put a material price on carbon emissions or restrict the burning of carbon—the physical risks to assets hit by extreme weather events, rising sea levels, or water stress caused by climate change, and the risk of opportunity loss from not investing in climate-alert companies.

“In addition to affecting schemes’ investments, these risks may also – in the case of defined benefit (DB) schemes – influence the strength of employer covenants,” the report added.

Leading the Way

Some UK pension funds are already integrating climate change policies into their portfolios: The Environment Agency, BT, and USS were all cited as pension funds that had embraced the climate change challenge.

The Environment Agency Pension Fund, for example, places looks for their most carbon intensive equity holdings per £ of revenue, which then leads to decisions to sell stocks where the carbon risk appears to be financially unrewarded, the report said.

The fund has also begun to analyse the environmental performance of the companies which issue its bonds, and already has between 12% and 13% of its portfolio allocated to the green economy.

Upping its allocation to sustainable property, infrastructure, and farmland/forestry also has the attraction of acting as a hedge against both inflation and climate change.

“The fund states that some of its best performing managers since inception are those who have integrated ESG issues including climate risk at a systemic level,” the report said.

USS, meanwhile, has had a sustainability manager on its property team since 2010, who specifically focuses on ensuring that the fund addresses environmental and social issues associated with the fund’s property portfolio.

The move was driven by “a belief that a sustainable approach to property will increase the value of its investments and lead to higher returns”, the report said.

And BT published a sustainability policy in 2012, and is actively exploring ways to efficiently allocate capital to investments that could outperform as a result of policy moves towards a low carbon economy.

In 2011, the fund also invested £100 million in a carbon-tilted version of the FTSE All-Share Index where carbon intensive companies are underweighted.

Share Action has urged all pension funds to generate a climate policy and develop clear goals with simple ways to measure how their risk assessments and policies translate into action, such as setting targets to reduce portfolio carbon risk, reducing exposure to high-carbon, or investing in low carbon opportunities.

The Share Action report can be read here.

(October 29, 2013) — After several false starts, the creation of a capital market where longevity risk can be traded may be about to happen—and other options might be coming online too.

Until now, all swaps that have been carried out by investors hedging this risk have included a reinsurer, but Allianz Global Investors thinks this may be about to change.

“It is hard for a normal investor to invest, as longevity swaps are not standardized, the market isn’t liquid yet and documentation isn’t in place,” Bernhard Brunner of risklab, a subsidiary of Allianz Global Investors, wrote in a recent paper issued by the financial institution. “But the first steps are being taken towards the creation of a liquid capital market.”

Brunner highlighted the 2010 creation of the Life and Longevity Markets Association by several banks and insurers in a bid to speed up transactions via methods such as standardizing documentation.

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In anticipation of a properly functioning longevity market, Allianz Global Investors set out a range of possibilities for investors.

“If more liquidity is introduced into the market, other longevity hedging solutions are likely to emerge in popularity alongside longevity swaps, such as q-forwards and s-forwards, which are currently more theoretical instruments. A q-forward is essentially a mini swap that uses a one-year death probability rate.”

However, the company said investors themselves might be interested in taking the other side of the bet through longevity bonds.

It detailed “principal at risk” longevity bonds, which are hedges against catastrophic mortality risk and “coupon-based” longevity bonds, which link payments to the survival rate of a cohort.

In Brunner’s opinion, longevity swaps hold the advantage over coupon-based bonds. “Bonds involve huge upfront payments, plus they have the issue of how dividend payments are specified,” he wrote. “They are very capital intensive and have basis risk. Swaps, meanwhile, aren’t as capital intensive, don’t drain much capital, and the floating rate can be linked to different ages and cohorts of interest.”

Principal at risk longevity bonds could appeal to investors familiar with Insurance-Linked Securities (ILS), such as catastrophe bonds. The challenge, Allianz Global Investors said, would be to design payments that are both beneficial to the hedgers and appealing to ILS investors.

“By issuing standardized longevity bonds that are index-based on the country’s own population, governments would make prices publicly available,” Brunner said. “These would then be used as reference points for other transactions and assist the growth of a longevity derivatives market, solving the problem of transparency that is also holding back the market in current over-the-counter deals.”

The amount by which longevity shocks can blow a pension fund off course has been outlined by consulting firm Redington.

“Even for schemes with an achievable set of investment objectives and deficit recovery contribution schedule, the magnitude of the moves in longevity assumptions experienced over the last decade can substantially damage the chances of the scheme meeting its investment objectives, “ said Wenyu Bai, a member of the ALM team at Redington.

“Moving from a popular mortality assumption back in 2006 to the most frequently used assumption in 2013, a typical UK pension scheme could see their liability present value increased by 7.2%, and interest rate and inflation hedge ratio reduced by 9%. This means that the scheme will have to increase their required return on assets by 88 basis points, or increase their annual deficit reduction contribution by £6.9 million.”

All investors need now, is to engage governments and regulators.

To read the full Allianz Global Investors paper, click here. For the Redington research, click here.

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