Approach to responsible investment

The key climate-related risks in the team’s portfolios include physical, transitional, reputational and regulatory risks.

Physical risks are expected to arise from longer-term shifts in climate patterns which may have financial implications for companies the team invests in. For example, an increase in adverse weather events, such as flooding or extreme heat, may result in operational downtime, supply disruption or increased capex.

Transitional risks to a lower-carbon economy may entail companies dealing with material changes to how they are able to develop, produce and sell products and services. This may lead to potential earnings risk, stranded assets, restricted markets, or carbon border tariffs.

Reputational risks arise from expectations and perceptions of a company’s contribution to the shift towards a lower-carbon economy. Those companies tied to fossil fuels, higher emissions and failure to transition may be at increased risk of losing their social licence to operate. 

Regulatory risks will continue to evolve, with new legislation likely to encourage or mandate companies to reduce carbon emissions. The move towards net zero will not come without cost for small and mid cap companies, especially for higher emitters which are likely to have increased administrative and operational expenses.

The team expects these risks to emerge over the medium- (3–7 years) to long-term (7+ years) investment horizon. 

The team’s comprehensive research process assesses every potential investment on a range of six factors, one of which is sustainability. Climate change and carbon risk are considered as part of the sustainability rating.

In-depth, ongoing company engagement is the primary tool the team uses to identify climate related risks in the portfolios. This is augmented by third party research and the in-house Responsible Investment function’s expertise. The team works closely with companies to understand and manage the risks associated with climate change and the transition to a low carbon economy.

The team does not use quantitative carbon-related metrics in valuations or risk models. Rather, the team takes a qualitative, case-by-case approach with regards to understanding and managing climate related risks to companies and the portfolio. 

Climate change risk is evaluated by the team when considering the sustainability of a company’s activities. Although climate change may not be an important short-term issue for some stocks, it is likely to be an important long-term issue for stocks with sensitive exposure to trends in climate change. For example, industries related to fossil fuel production, such as the coal, oil and gas industries, will likely face multiple challenges during the transition to a low carbon economy.

The team engages heavily with senior management and boards to identify potential or existing risks. The team expects senior company management to understand ESG risks and manage them successfully. When this isn’t the case, the team works closely with management to resolve any ESG risks to the satisfaction of the investment team.

Where the team cannot gain confidence in management’s understanding and management of ESG risks, this will be reflected in the team’s proxy voting decisions and will ultimately feed through to stock positioning in the portfolio via the team’s investment process. 

The team has committed to short, medium and long term targets for selected companies in the portfolio, based on analysis performed in line with the Institutional Investors Group on Climate Change (IIGCC) Net Zero Investment Framework Implementation Guide. The targets are as follows:

Short term: The selected companies are to develop a decarbonisation strategy and set a net zero target accompanied by targets that align with net zero emissions by 2050 or sooner.

Medium term: The selected companies are to have a decarbonisation strategy in place with emission reductions achieved in line with targets set by company.

Long term: The selected companies are to achieve net zero by 2050.

More specific targets have not been set at this time, as mandating targets of this type is inconsistent with the team’s broader investment philosophy and process. Rather, the team collaborates with the selected companies on the issue of climate change, related risks, and the transition towards net zero. Pleasingly, a rapidly increasing number of companies in the small and mid cap companies’ space are positioning themselves to provide the solutions needed to reduce emissions, manage climate-related risks and successfully transition to a low carbon economy.