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Hedging climate change risk

by Frédéric Samama

Hedging climate change risk

Investors and financial markets cannot continue to ignore climate change. The effects of rising temperatures, the increasingly extreme weather events climate change generates, and the climate change mitigation policy responses it could provoke may have dramatic consequences for the economy and thus investment returns. Financial innovation should be explored so the power of financial markets can be used to address one of the most challenging global threats faced by humankind.

Governments have focused mostly on introducing policies to control or tax greenhouse gas emissions and build broad international agreements for the global implementation of such policies.

Index decarbonisation can boost support for such policies among a large section of the investor community. As more and more funds are allocated to decarbonised indexes, stronger market incentives will materialise, inducing the world’s largest corporations – the publicly traded companies – to invest in reducing greenhouse gas emissions.

Encouraging climate risk hedging can have real effects on reducing greenhouse gas emissions even before climate change mitigation policies are introduced. The mere expectation that such policies will be introduced will affect the stock prices of the highest greenhouse gas emitters and reward those investors who have hedged climate risk by holding a decarbonised index. Anticipation that climate change mitigation policies will be introduced will create immediate incentives to initiate a transition to renewable energy.

Mandatory disclosure

A simple, costless policy in support of climate risk hedging that governments can immediately adopt is to mandate disclosure of the carbon footprint of their state-owned investment arms (public pension funds and sovereign wealth funds). Such a disclosure policy would have several benefits.

As climate change is a financial risk, disclosure provides investors (and citizens) with relevant information on the nature of the risks to which they are exposed.

Some pension funds have already taken this step by disclosing their portfolios’ carbon footprint – in particular, Erafp, the public service additional pension scheme, and Fonds de Réserve pour les Retraites in France; KPA Pension, the Church of Sweden and the AP national pension funds in Sweden; APG in the Netherlands; and the Government Employees Pension Fund in South Africa.

Given that citizens and pensioners will ultimately bear the costs of climate change mitigation, disclosure of their carbon exposure through their pension or sovereign funds helps internalise the externalities of climate change. Investment by a public pension fund in polluting companies generates a cost borne by its government and trustees, lowering overall returns on investment. China Investment Corporation, China’s sovereign wealth fund, has already made statements in this direction.

Disclosure of the carbon footprint of a sovereign fund’s portfolio can be a way for sovereign funds of oil- and gas-exporting countries to bolster risk diversification and hedging of commodity and carbon risk through their portfolio holdings.

Diversifying investments

The basic concept underlying a sovereign fund is to diversify the nature of the country’s assets by extracting the oil and gas under the ground, thereby ‘transforming’ these assets into ‘above-ground’ diversifiable financial assets.

A more direct way to support investment in low-carbon, low-tracking error indexes is to push public asset owners and their managers to make such investments. Governments could thus accelerate the mainstream adoption of such investment policies.

In this respect, it is worth mentioning the precedent of the policy of Prime Minister Shinzo Abe’s administration in Japan to support the development of the JPX-Nikkei Index 400 – comprising companies providing high returns on equity and with high standards of corporate governance. The Abe administration sees this index as an integral part of its ‘third arrow’ plan to reform Japan’s companies.

Japan’s Government Investment Fund, by far the largest Japanese public investor with more than $1.2tn of assets under management, has adopted the new index. This shows how combining a newly designed index with a policy-making objective and the adoption of that index by a public asset owner can be a catalyst for change.

Financial innovation

Climate change has mostly and appropriately been the bailiwick of scientists, climatologists, governments, and environmental activists. There has been relatively little engagement by finance with this important issue.

Robert J. Shiller, in his 2012 book Finance and the Good Society, advances a refreshing perspective on financial economics. Finance is not about ‘making money’ per se – it is a ‘functional’ science in that it exists to support other goals, namely those of society. The better aligned society’s financial institutions are with its goals and ideals, the stronger and more successful the society will be.

It is in this spirit that Amundi has pursued its research into how investors can protect their savings from the risks associated with greenhouse gas emissions and their long-term impact on climate change.

Our basic working assumption is that to foster financial markets' engagement with climate change, it is advisable to appeal to investors’ rationality and self-interest. Our argument is simply that even if some investors are climate change sceptics, the uncertainty surrounding climate change cannot be used to dismiss it and related mitigation policies as a zero probability risk.

Any rational investor with a long-term perspective should be concerned about the absence of a market for carbon and the potential market failures that could result from this incompleteness. A dynamic decarbonised index investment strategy seeks to fill this void, offering an attractive hedging tool even for climate change sceptics.

The decarbonisation approach we have described for equity indices can also be applied to corporate debt indices. Although the focus in fixed-income markets has been on green bonds, corporate debt indices – decarbonised along the same lines as equity indices (screening and exclusion based on carbon intensity and fossil fuel reserves while maintaining sector neutrality) – could be a good complement to green bonds.

Frédéric Samama is Deputy Global Head of Institutional & Sovereign Clients at Amundi Asset Management.