Pension investors who are on the train, or still trying get out of its way - and want to deliver sustainable, long-term returns to their members - must now act to:
- align their portfolios with the “well below” 2°C target to reduce the downside risks in the transition to a low-carbon economy;
- avoid systemic risks by ensuring that climate change is successfully limited to “well below” 2°C above pre-industrial levels; and
- develop new asset allocation strategies to ensure that the upside of a clean energy transition is captured.
Of these three challenges, the most pressing one is portfolio alignment with the well-below 2°C target. For a diversified portfolio, this means reweighting investment allocation to capture the gains of new low-carbon economy ‘winners’ while minimising the losses of old, high-carbon ‘losers.’ And there is now no doubt that there will be winners and losers. As energy consultants at Wood Mackenzie recently pointed out, the clean energy transition “is clearly existential because you are talking about what happens to producers of hydrocarbons in a world where demand for hydrocarbons is slowing.” Carbon risk is real and must become a factor in pension portfolio risk management. Leading pension investors are already acting to address economy-wide transition risks.
Increasing transparency as the energy transition train speeds up
The transition of energy systems has implications that will filter into all sectors of the economy. ET Low Carbon and Fossil Free Indexes help long-term pension investors to manage this systemic risk by re-weighting investment across all sectors away from high-carbon companies to the most carbon efficient large companies. By linking a low-carbon index series to public rankings of the world’s largest listed companies, the indexes send a message in investor expectations on rapid decarbonisation across the economy. Companies like Exxon who ignore the call for decarbonisation and wind-down will see the cost of capital increase.
More transparent indexes aligned with economy-wide decarbonisation targets support long-term investors to channel capital into sustainable, stable growth. The message from Marrakech was clear: the smoother the transition away from fossil fuels and the transformation of other high carbon sectors, the better. This means that pension funds taking action sooner, rather than later, is required to protect portfolios from systemic risk, and to benefit from the upside of decarbonisation.