NZ Super has developed a framework to help the investment team think about pricing climate change and adjust its valuation methodologies.
Today, few institutional investors fail to consider climate change risks to the companies they invest in. But being cognisant of these risks and pricing them are two different things.
The New Zealand Super Fund (NZ Super) developed a framework to assist integrating these risks into its investment valuation processes, when it developed its Climate Change Investment Strategy a few years ago.
“It is our inhouse view that the true risk posed by climate change to investment returns is still not well understood, nor fully priced by the market,” Jessica Gilbert, Portfolio Manager for Direct Investments at NZ Super, says in an interview with [i3] Insights.
“NZ Super has a substantial direct investments program – where we take active equity positions in both listed and unlisted assets – and we wanted to address the question of how to price climate risk from the bottom up.
“Our Climate Change Strategy means we now look to price in underlying climate risks, or potential opportunities, when evaluating potential or existing direct investments.
“By and large, much of the analysis that exists globally assessing the impact of investment climate change risk focuses on the macro, portfolio or sector impacts, adopting a top down rather than a bottom up approach.
“From this research we have a pretty good understanding of the possible industry-level effects from climate change. Assessing risk at the asset level, however, is something the investment community is still working through and it comes with its own set of challenges.
“So, we developed a Climate Change Valuation Framework. It assists our investment professionals with integrating climate change considerations into valuations of active equity positions.
Very quickly we realised we couldn’t produce a prescriptive 'how to' framework due to the complexity of climate change – given uncertainty around climate scenarios and how they’ll play out. Plus, the fact that the impacts will vary by geography and sectors, and also by the companies within this
“It was an interesting piece of work as it wasn’t something that had really been done before.
“Very quickly we realised we couldn’t produce a prescriptive ‘how to’ framework due to the complexity of climate change – given uncertainty around climate scenarios and how they’ll play out. Plus, the fact that the impacts will vary by geography and sectors, and also by the companies within this,” she says.
The framework that NZ Super came up with focuses on assisting non-climate change experts to think about how to identify and then price climate-related risks. It was designed with some simple principles in mind like ‘being a practical and pragmatic framework’ and ‘not replacing investment professional judgement’.
The framework consists of several steps that guide its investment professionals through this process:
- Identification of the key value drivers of the asset
- Assessing how those value drivers could be impacted by climate change in terms of physical and transition factors
- Filtering impacts down to those that will potentially have a material impact on investment performance, and, by extension, asset valuation
- Integrating the expected impact into the valuation – the various options available
- Actively monitoring and influencing investments with regard to climate change once they are in the portfolio.
“What we found is that the first three steps are relatively straight forward, because there is plenty of climate-related research to draw from with regard to what the broad impacts might be,” Gilbert says.
“However, moving beyond just a broad understanding of what the climate change exposures might be, and to the point where we are confident we understand them enough to start adjusting the drivers of our valuations is easier said than done.
“Due to uncertainty around the trajectory of climate change, the challenges with finding relevant data and being able to quantify adjustments, it’s often difficult to take this next step, particularly for base case valuations,” she says.
“Your base case is your best guess as to what the future state of the world looks like for your asset. With the uncertainty that comes with climate change, how do you get high enough conviction to adjust your base case and make buy/sell/hold decisions on this basis?”
“Our experience has been that some asset valuations are easier to adjust than others, particularly those for which key value drivers are likely to be impacted by rising carbon prices.
“This does require having a central ‘house view’ on a climate change scenario, or set of scenarios that outline what the key associated impacts would be under each of them. Fortunately, there is good research on this globally which we are able to lean on. It is also easier to estimate the first order impacts that a company may face, as opposed to second or third order ‘flow on’ impacts.
“For assets that are harder to adjust base case valuations for, there is still a lot of value in applying the valuation framework. It helps us understand the climate-exposures of our assets, and enables sensitising of our valuations to understand the range of outcomes under different climate scenarios.
“It also gives us a solid starting point to actively engage with our investee companies on how climate change could impact on them, getting them thinking about mitigation/positioning activities, and how best to track developments in this area.
Work on the Climate Change Valuation Framework continues at NZ Super, with investment professionals working with others in the global investment field to keep refining and developing their approach.
“This is very much a work in progress for us. As information improves, we expect we will be able to better price climate-related risk at the asset level” says Gilbert.
Dealing with Portfolio Skews
New Zealand Super launched its Climate Change Investment Strategy in 2017, but it had spent several years developing it prior to that. The fund established four work streams; these include Analyse, Engage, Reduce, and Search to consider all aspects of the issue and forms the fund’s Climate Change Investment Strategy.
The framework to help think about the impact of climate change on valuations was part of the Analyse work stream as outlined above.
Arti Pasad, Senior Responsible Investment Specialist at NZ Super, has been part of the Reduce work stream and helped the Asset Allocation team formulate how the fund could reduce its exposure to carbon emissions and carbon reserves, particularly in its equity holdings.
The strategy aims to make the portfolio more resilient to climate change risk and seeks to reduce the carbon emission intensity of the fund by 20 per cent, while reducing the carbon reserves in the portfolio by 40 per cent.
“Our Climate Change Investment Strategy sits across the whole of the portfolio and is owned by the Board,” Prasad tells [i3] Insights.
“We involved Mercer as part of that work early on in helping us get through the journey and having a third party to come and tell us that the portfolio is at risk of climate change was quite useful. Mercer gave us guidance and insights on which types of investments are at most risk and over which scenarios.
“Our work around climate change and progressing the various work streams got built into our KPIs, which is a key lesson. In order for ESG and climate change strategies to drive portfolio decisions, they need to be board-owned, they need to have a good governance structure and ownership around them – and they need to be well embedded within the organisation,” she says.
As a result of the Reduce workstream, we made some substantial reductions in our equities portfolio and whatever we’ve taken out, we have rebalanced, re-weighting sectors with similar risk profiles
The strategy has resulted in placing restrictions on the type of companies the fund can invest in, particularly in its passive equity exposures, and this means the fund had to think carefully about how to deal with the skews introduced into the portfolio.
“As a result of the Reduce workstream, we made some substantial reductions in our equities portfolio and whatever we’ve taken out, we have rebalanced, re-weighting sectors with similar risk profiles,” Prasad says.
“We are addressing climate change risks as an investment risk issue. We felt it was important not to measure short term portfolio performance, but to take a long term view. We feel that if we don’t properly consider climate change, then it will have a dire impact on our portfolio, from a financial perspective, in the immediate future,” she says.
“As part of the Reduce stream, we identified the high emitters and we have a ‘carbon reduction list’, as we call it, of companies, that get removed from the passive portfolio.
“But for some of the active equity side of the portfolio, our external managers don’t follow the list of exclusions, instead they follow the targets we have set in emission reductions,” Prasad says.
“The key reason for this is to enable our factor managers to meet certain factor requirements and accommodate all the complexities they have as part of their mandate and still have a climate resilient portfolio,” she says.