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ESG is now embedded in the investment strategies of many global asset managers and international targets for emissions reaching net zero by 2050 are widespread. Asset managers can and do use these targets to measure progress, when set against variables such as carbon pricing, net-zero transition, diversity and inclusion and social responsibility.
However, those in the industry believe there are many risks that could counter progress towards a more ESG-friendly world. One of those that is around duration risk.
So, what is the industry doing to investigate and identify this area?
Of the risks that could be included into the duration category, one of the most immediate, and possibly short-term risks is around climate change.
Navjit Sagoo, Science Engagement Officer at consultancy Climate X, said that the insurance investors clients it advises have moved from transition, through to the prospect of climate change, to now managing actual physical risk.
She said global warming and changes to the climate were already formidable challenges for investors. “Climate hazards, in particular, are proving formidable as they impact asset valuations, operations, supply chains, and market responses, translating into tangible, quantifiable losses,” she said.
"For our real estate portfolios, infrastructure assets, the transition and physical risk is very apparent, particularly on physical risk.”
Sagoo said that some markets were becoming uninsurable partly due to these factors. “As a result, we anticipate that by 2025, market dynamics will shift further, leading to a concerted focus on physical risk.”
This is part of a pattern across different sectors of climate risk no longer being seen as a future concept. “It's already happening today, and we are already analysing our portfolio based on current, present risk from transition and physical climate risk,” said Shuen Chan, Head of Responsible Investment and Sustainability at Legal and General Investment Management (LGIM) Real Assets.
“So, for our real estate portfolios, infrastructure assets, the transition and physical risk is very apparent, particularly on physical risk.”
Chan said a lack of prescriptive, standard methodology had led LGIM to work with a number of climate model specialists. She pointed out that while the world’s financial regulators were bringing out targets, LGIM had taken a view that it needed more information.
“We own these assets on behalf of our clients, the L&G group being one of them, so it’s important that we have the information so that we can develop the right adaptation plans depending on the future risk or probability of risk that we see from the analysis,” she said.
Sagoo said LGIM was not alone in seeking its own climate assessments. “Although insurers have a successful and proven model for natural catastrophe modelling, the regulatory impetus and shifting realities of climate change have led some pioneering insurance firms to seek out climate physical risk data as a complement to their existing models," she said.
“When you start making improvements, [to] housing or commercial property or clean energy it turns from a risk to an opportunity."
“Insurers have had to withdraw coverage in some locations, which has significantly impacted asset values and drawn attention from regulators and banks.”
Others said there was still too much reliance on developed markets for complete and verifiable data sets and that this could be losing them valued insights. “There is increased recognition that to solve the climate crisis there will be a greater need to finance solutions in emerging market economies which, on the whole, are more likely to be affected by climate change," said Chris Pritchard, Partner at Barnett Waddingham.
Pritchard added that if investors had suitable risk budgets and could engage with underlying entities to improve data points on ESG risks then emerging markets could present huge opportunities for investment.
“When you start making improvements, [to] housing or commercial property or clean energy it turns from a risk to an opportunity,” said John Alker, Head of Sustainability at LGIM Real Assets on where these opportunities might lie.
He explained that asset managers in the ESG space had been given tools that allowed them to manage risk and create opportunities; the Task Force on Climate-related Financial Disclosures (TCFD), the Taskforce on Nature-related Financial Disclosures (TNFD) and the Sustainability Accounting Standards Board (SASB).
Anand Rajagopal, Head of ESG and Sustainability Research, Global Investment Research at Phoenix Asset Management said the nature of these target-led initiatives had helped to make energy transition one of the most appealing sectors for investors.
He said Phoenix were focusing on productive investments, such as water utilities, early-stage venture capital and private equity leading to productive capacity building, as noted through the Mansion House Compact and the Investment Delivery Forum efforts.
The main pivot for many ESG-themed investing is, and was, around decarbonisation, but this was now changing and with it the perceived risk was changing as well.
Historically, risk has been achieved through disinvestment but that can cause shorter term performance issues by disinvesting out of specific sectors. It also doesn’t recognise that some companies in highly intensive sectors will be able to transform well and drive the change needed in society.
“There are issues with companies operating in hard-to-abate sectors that need to be managed in conjunction with the risk exposure of the portfolio."
Rajagopal said Phoenix, as a member of the UN Net Zero Asset Owner Alliance, was working towards a net zero target 2050 and had created interim milestones for “portfolio-level decarbonisation”. This included a reduction in portfolio emissions intensity, by 2025 and 2030, against a 2019 baseline.
“There are issues with companies operating in high intensity and hard-to-abate sectors that need to be managed in conjunction with the risk exposure of the portfolio,” he said.
Furthermore, transition investments, in particular, could have high emissions intensity at origination, but these are the issuers and areas that would need such funding to bring about the necessary change. “So, they need investors to help them transition to a lower-emissions intensity or lower-carbon state and, indeed, present institutional investors, such as us with accretive investment opportunities,” Rajagopal said. “In addition, enabling activities often have high intensities but facilitate decarbonisation elsewhere, such as electric vehicle battery manufacturing plants.”
Rajagopal said stakeholder discussions focused on the UK Transition Finance Market Review has helped focus on direct actions and indirect consequences resulting from portfolio changes.
“The former includes specific investments from companies to reduce their emissions like a real estate company improving its energy performance certificate with insulation/double glazing, while the latter includes cleaner energy owing to ongoing decarbonisation of the national grid,” he said.
On top of this, Pritchard said there were nuances associated with decarbonisation that were throwing up other issues. “For example, an emissions reduction target set against scope 1 & 2 emissions of The Greenhouse Gas Protocol will favour disinvestment from utilities.
“But once you allow for scope 3 emission then sectors like real estate and financials start to look more emissions intensive,” he said. “Away from climate change, certain sectors can be more materially exposed than others to specific ESG risks.”
Beyond decarbonisation there were other sticking points emerging, said Pritchard. “We find that modern slavery is flagged as a higher risk in services, manufacturing, construction and agricultural sectors.”
Pritchard said a number of investors were using forward looking measures to reflect on how ESG compliant a company was. He pointed to the example of the goals of the Paris Agreement. “For example, Implied Temperature Rise (ITR) and Science Based Targets initiative (SBTi) measures]. Coverage of such measures is lower for credit than for equity but is improving.”
“These are specific risks assessed during our pre-investment deal-level due diligence and noted within our investment memoranda."
Sagoo added that many of our asset management clients were looking at their exposure to social housing. “Given the vulnerability of these buildings, locations, and their occupants to the effects of physical risk, including insurability considerations.”
Sagoo said the majority of clients were considering holding periods of five to 10 years for their ESG investments, but that some of the more mature clients were looking further into the future, considering periods of 20 to 30 years.
Rajagopal said he saw duration risk as a consequence of transition: “An example might be the timeframe and extent to which a gas distribution network operator will have the capacity to upgrade its existing infrastructure to distribute green gases/transition fuels, for example hydrogen.
“These are specific risks assessed during our pre-investment deal-level due diligence and noted within our investment memoranda.
“In some cases, investments will have a specific use of proceeds with targets, or incentives/penalties depending on the structure, enabling [Phoenix] to gain comfort with the pace and relevance of investment, delivery of KPIs, and decarbonisation trajectory etc.”
Some investors are favouring shorter duration credit allocations to combat duration risk, which could be at a sector level or based on individual companies that are assessed to be transitioning to a low carbon economy slower than the investor believed is acceptable.
While there is increasing demand for private credit among banks and asset managers, Sagoo said very few insurers, when assessing their collateral pools and mapping assets, understood the physical risk vulnerabilities therein.
However, pricing, including the illiquidity premium in the case of private credit, should compensate – as much as possible – for all types of risks on an individual deal basis where risks are known/understood but could also be unknown in nature.”
“Even if this is not explicitly visible, ESG risks, including physical and transition climate risks are typically incorporated into credit ratings and, therefore, will influence pricing levels required and investment risk appetite for execution," said Rajagopal.
"We are investing in the real-world economy, there will be strategies that may seem, on the face of it, quite carbon intensive."
“As part of deal level pre-investment due diligence, we look for risk mitigation, or a commensurate premium for in-tolerance risks. Again, this is calibrated within the context of our overall investment portfolio.”
Evolving credit solutions such as debt-for-nature swaps are emerging as a longer-term form of ESG-themed credit,
Chen said this type of debt – a financial agreement where a portion of a developing country's foreign debt is forgiven in exchange for investments in environmental conservation – was an exciting development.
New products aside ESG, even within known sectors, still comes with many challenges, not least of all appetite for the changes it claims to represent and also investor appetite for some of the longer-term transitions that need to occur.
“We can't just come up with strategies if there's no demand,” said Chan. “We are investing in the real-world economy, there will be strategies that may seem, on the face of it, quite carbon intensive but may be part of supporting the transition of the whole real-world economy.”
"Pricing nature-related risks poses a significant challenge, and understanding the impact on insurance remains difficult at this stage.”
Pricing risk and seeking opportunities still remains a new concept. Nature-related risks are another theme, where pricing was proving an issue.
“The conversation around how to price risk, whether through changes in property valuation or increased insurance premiums, is relatively new, even among the more mature clients,” said Sagoo. “The assessment of nature-related risks is still in its early stages, with clients only beginning this process. Pricing nature-related risks poses a significant challenge, and understanding the impact on insurance remains difficult at this stage.”
Whatever happens, it's likely to be an issue that insurers are dealing with for a long time to come.
