Approaching Responsible Investing

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Robert Brown, FSA, ACAS, FCIA, HONFIA, co-editor for this issue of The Actuary, was interested in what impact climate change might have on institutional investors. He talked with Barbara Zvan-Watson, FSA, CERA, FCIA, who is the chief risk and strategy officer, Strategy and Risk, at Ontario Teachers’ Pension Plan (OTPP). OTPP has assets totaling $189.5 billion. The plan has 323,000 active and retired members.

Brown: Tell us about reputational risk at OTPP.

Zvan-Watson: Our reputation and our brand are fundamental to our license to operate and our ability to invest. These have been built over years of effort, and they form the foundations for the trust that exists between our members and us, giving us the flexibility and the independence to exercise our judgment in what investments we choose to make.

Ultimately, much of what we do is geared toward maintaining our ability to make the best investment decisions for our members, to guarantee their pensions over the long term. That requires us to be both agile and prudent in our investing.

This is a journey, and while we have always considered material environmental, social and governance (ESG) factors, over the years we have worked to evolve our organizational culture to incorporate a systematic approach to our investment process. As our approach developed, so did our confidence in providing transparency on our activities to stakeholders.

We conducted a first “education” session for members in 2011, and since then we have continued to build their knowledge of ESG factors and of our approach to responsible investing. We have published thought pieces on our website that discuss our research and analysis on climate risk, carbon footprinting, cybersecurity and other topical ESG issues.

Internally, we have worked hard to put in place systematic processes across the plan to integrate ESG risks and opportunities through building awareness and knowledge, and taking actions. This approach helps ensure that portfolio managers are thinking about these when making investment decisions.

Climate change poses numerous challenges to investing, including those pertaining to reputational risk. Climate change is a subject of great nuance and substantive rhetoric, and investors are increasingly brought to task to show what they are doing about it. Our members hear from many that the solution lies in divestment of fossil fuels; investing in fossil fuel companies is tantamount to contributing to the causes of climate change. In our view, mitigating climate change is a lot more complicated than that and will require fundamental changes in our economic and social structures.

Reputational risk also extends to our investment partners. We want to be an attractive partner. We know that if we do not manage material/critical ESG risks well, we will be unable to gain the confidence of partners, like governments, who have entrusted us with critical infrastructure. For example, without our reputation as responsible investors, it is unlikely that the Chilean government would have allowed us to manage nearly a third of the country’s water distribution.

Brown: Let’s look at ESG more broadly. What impact has climate change had on your thinking and how it fits in there?

Zvan-Watson: Climate change is not a single risk, nor is it only environmental risk. Rather it is a set of ESG risks that are in turn a subset of the broader universe of ESG risks.

We see responsible investing as a process or approach. We do not see it as a noun, but rather as a verb. It’s how we make investment decisions, and how we manage our investments to ensure that we continue to earn the investment returns we need to meet pension payments over the years. It is called responsible investing because it explicitly considers ESG risks as part of the process.

Climate change is a broad set of risks that can affect different companies in different ways. While we may not know the nature and timing of the impact, we do know that it will reach broadly across sectors and geographies, and that it will be difficult to hedge the plan against those risks. So they need to be managed, at the company level as well as at the portfolio level.

Brown: What are the climate change risks?

Zvan-Watson: Typically, we categorize climate change risks into buckets. Obviously, there are the physical risks of climate change, and those are both “E” and “S” risks. Physical risks might be—in the “E” part, extreme weather, droughts, ocean acidification—all the things that happen to the physical environment due to climate change. The “S” part of that physical risk is really about impacts on employees, customers, communities and the like. Here we are talking about phenomena like migration or social unrest, disease, availability of clean water, and health and safety.

For instance, one of the potential risks of a warming climate is that certain disease sectors do not die off. In Canada, mosquitoes die off at the end of every year because it gets cold here. Well, what if they didn’t? So now you have constant exposure to viruses that are not dying off, and they have the ability to strengthen.

Then there is transition risk, relating to actions that we as a society take in order to deal with climate change. These can include regulatory risk, carbon taxes, carbon caps and restrictions on water use. It can also include disruptive technologies. If you are a car company and you do not have an electric vehicle and everyone else does, you risk being disrupted because technology has moved to electric. Other technology risks include the movement to renewables in general. If you are coal-fired and the world is moving to renewables, you have stranded assets. Other risks come in the shape of general changes in consumer behavior. If consumers decide that climate change is something they are actively taking action against, maybe they reduce their meat consumption, or maybe they reduce their air travel, and suddenly demand for certain products changes.

Brown: How have climate change considerations impacted your responsible investing approach?

Zvan-Watson: Climate change has been described by Mark Carney, governor of the Bank of England and chair of the financial stability board, as a systemic risk—meaning you can’t get rid of it by diversifying companies or by ignoring certain sectors of the economy. So if we think about climate risk as a systemic risk, it changes how we operate and how we manage it because now it becomes a total fund issue.

Among other factors, broad global reactions to climate change have been catalysts to structural change, prompting an approach that is more total fund-wide rather than being managed company by company.

Other catalysts for change include recommendations from the Task Force on Climate-related Financial Disclosures (TCFD) that asset owners should also disclose their exposure to climate change, in addition to corporate disclosures. It means that the board of an asset owner, our board, must consider even more than before how they provide oversight over climate change risk at the portfolio level. I think the world has evolved to understand that climate change risk is a much broader risk that needs a different type of management.

At OTPP, we look at it from the perspective of the impacts of climate change across the plan. To do that, we launched a scenario analysis to understand the potential structural changes that can happen in the economy as a result of climate change. We then applied what we learned across the plan to understand the implications across different asset classes and across different sectors. So we have taken a much broader, a much more total fund approach to climate change considerations. This is expected to inform how we construct our portfolio, how we find and evaluate investment opportunities, and how we assess companies’ preparedness for climate change.

Brown: Has climate change caused the plan to take a long-term view of risks?

Zvan-Watson: The short answer is no because we have always had a long-term orientation around plan sustainability. An early warning system is in place to seize opportunities and position the plan for the future.

At the same time, long-term orientation means that you may take actions today that will pay off in the long term because it is more cost-effective to do so today. This is why, for example, our engagement with companies includes asking about emissions reductions.

As a long-term investor, we endeavor always to understand what business models have the most attractive growth prospects. With this lens, coal-producing companies or businesses that rely directly on coal are not attractive investments, but new power technologies such as micro grids and battery storage are attractive even though they are not dominant in the market.

What has become clear over time is that, even though climate change is a long-term risk, it can get priced in the short term quite quickly and rapidly. We saw that clearly with the coal companies. Coal has not been eliminated from the economy, but the re-pricing of coal that happened a couple of years ago really drove home the fact that it doesn’t have to be happening immediately. If the market thinks it is going to happen eventually, it then prices that in.

Climate change has also impacted our thinking around infrastructure investments and the type of investments we look for. At OTPP, when we think of long-lived infrastructure or agricultural assets, we are thinking about positioning the portfolio for the future. That is why we invest in smart meters, which represent an important step toward a low-carbon economy. We invest in micro grids because distributed energy systems are where we think power generation is headed. Our investment in rope-grown mussel farming is supported by the fact that it is a highly sustainable form of meat protein production. It bears emphasizing that we’ve always had an orientation to the long term, and that has never changed.

Brown: How do Canadian investors grapple with the fact that Canada is a resource-based economy, while managing climate change risks seems diametrically counter to that?

Zvan-Watson: We have had to be thoughtful, balanced and pragmatic in our approach to this question. While natural gas and renewables are replacing coal-fired generation in developed (and increasing in developing) nations, there is no ready substitute for oil, which based on current technology, will continue to be needed for steel-making as well as air and sea transportation. Regularly updated models from the International Energy Association (IEA) estimate that coal, oil and natural gas continue to be a part of global energy under what we know now to be an optimistic, two-degree scenario. We have a less progressive view of coal given its impacts on air quality.

We use our influence to encourage Canadian oil companies to lead the way in making Canadian Exploration and Production (E&P) operations among the least resource-intensive, environmentally and socially impactful operations. They need to be competitive on a cost-, resource- and emissions-basis with conventional oil and gas, or risk being priced-out (stranded).

At the same time, we want to encourage policymakers and the industry to think long term and strategically about how Canada will be positioned for the Low Carbon Economy (LCE). Over the long term, the industry has to be thinking about where it’s investing and about whether payback on capital expenditures (capex) is adequate and, if it is not, it needs to be considering the viability of those investments.

Ultimately, the changes required to avoid more severe climate change impacts go way beyond the extractives sector. These structural and societal changes will create winners and losers, and as a pension plan we need to be cognizant of these and manage these risks.

Brown: Where do renewables fit into the investment equation? What is the new investment opportunity set?

Zvan-Watson: OTPP has long been in renewables. We invested in BluEarth renewables in 2009. We partnered with the federal Public Sector Pensions (PSP) to create Cubico Sustainable Investments in 2015. Both of these investments seek to build a portfolio of wind, solar, hydro and other renewable energy assets.

We also have investments in clean technology, such as micro grids and smart meters, two tools in the LCE transition. Recent investments in energy storage, smart meters, micro grids and renewable generation highlight our activity in this space. Going forward, we plan to expand these efforts to include other climate-smart sectors, including other forms of energy efficiency, mobility and charging, waste-to-value and alternative fuels. There are attractive opportunities in food and agriculture amid growing demand for sustainably produced, healthy, natural food and proteins. Climate change adaptation opportunities are also arising, including technology to make buildings more energy efficient. Desalination of seawater has a very forward-looking thesis.

Climate change and actions that we take to mitigate climate change make investments like these attractive, but it does not make them free of ESG risks. Just because something is renewable, for example, does not mean we are willing to accept a lower return, and we are not going to accept a higher level of risk. If an investment relies heavily on subsidies or is in a jurisdiction that we find to be unfavorable for a long-term investment, that will weigh on our decision-making process. Where there are subsidies involved, we review the investment to make sure that the asset is still attractive without the subsidies.

It bears underscoring again that the opportunities that come from climate change will go well beyond renewables, and that is how we need to be thinking. What are the areas of opportunity that have not yet really been explored?

Extensive investments in infrastructure in both developed and developing countries are required to ensure climate change mitigation, and this is expected to result in increased deal flow, critical in a highly competitive investment market.

While climate change poses an unprecedented risk to the world, it also brings a wealth of opportunities. If one thinks about how energy or other technological transitions have occurred over history, the successful disruptions have been technologies that offered superior benefit-cost trade-offs for consumers. As investors, supporting the technological developments for a low-carbon economy transition is a very exciting and profitable prospect.

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