Hetal Patel, head of climate investment risk at Phoenix Group, discusses the various tools available to insurers for delivering on their net-zero pledges, as well as the associated challenges.
If an insurer has pledged to be net-zero by 2050 and has gone through the hurdle of setting interim targets, what happens in practice after that to achieve that goal and those targets?
The industry went through a cycle where it felt that setting net-zero pledges and targets] was almost became a license to operate. So people did that, but there wasn't necessarily the required level of detail analysis in the industry as a whole around how that was going to be delivered.
And now each company is at various stages of that journey, but we are now well into the phase of taking action to deliver into these commitments crystallising what it means for the frontline business and understanding what the potential trade-offs are.
For insurers, a distinction needs to be made between shareholder assets, where the insurer holds the investment risk, and policyholders' assets, where the investment risk largely lie with the policyholder. Coverage of net-zero pledges vary across the industry and sometimes focus just on the shareholder book.
For policyholder books, which tend to be more equity heavy, typically your starting point for decarbonisation is to do something with the index. Replacing a traditional broad market index with a customised decarbonising index, whether it be one of those EU benchmarks, or Paris-aligned benchmarks, or other.
For the shareholder book which often is predominantly a liability matching portfolio, your tools are slightly different. There isn't an index, so you work with the asset managers who are looking after the investment to overlay decarbonisation requirements into the mandate: these are our objectives, these are the metrics that we are considering, and we want these metrics to follow this sort of trajectory. And so, when certain bonds roll off or when there are asset allocation decisions being implemented, these factors will be taken into account by the asset managers as part of the guidelines.
That's why there isn't one simple answer to your question: it depends on which angle you look at it. For example, from an asset class perspective, if we look at real estate, it becomes an asset-by-asset, specific schedule of actions. And your considerations will be around how much of the capital expenditure can go into energy efficiency initiatives. What goals do we have in engaging with tenants to switch to more renewables energy sources?
So, the approach for delivering those goals is different for different asset classes, different books of business, and I'm sure it will be different across different insurers. Look at the simple decision of which data provider you may be using. Between the different data providers there's a huge amount of variation, and that alone will impact your assumptions and approach.
Going back to using the indices as a lever, one consideration there is that you may be 'artificially' decarbonising your portfolio, removing polluting companies and keeping the best in class, but that achieves little in the real economy?
That is what some call 'paper decarbonisation' versus 'real world change'. And there is a question mark over whether using indices is paper decarbonisaiton, because you end up moving away from energy and utilities and more into tech, healthcare and other lower-intensity sectors.
And that is why the headline story for the financial sector as a whole is increase engagement with borrowers and investees. But engagement doesn't yield results overnight, it takes time. You can't engage with your entire portfolio if you have tens of thousands of investment counterparties; you need to be targeted and identify the biggest emitter in your portfolio. This is a very important part of the puzzle, but again one that takes time. In the meantime, you still have to focus on your short- to medium-term targets. And here indices can be useful as a means of supporting near term decarbonisation but also steering portfolios away from names that are vulnerable to transition risk.
Using decarbonising indices, you install some bias in your portfolio away from carbon intensive names, if this happens on a large industry-wide scale, capital is channelled in a way that will result in an improved cost of capital for transition leaders versus laggards, and that is a 'real world' impact.
But you need to use all the tools and solutions to achieve the overall goals of decarbonisation, sound risk management and effecting real world change.
Is the fact that most indices are based on backward-looking data an issue?
That is something that is changing. Some of the indices, like the EU ones, which have been baked into regulation, were designed at a time when the whole concept of decarbonisation was still in its infancy. Today, indices have continued to evolve and incorporate forward-looking measures so that you are not only overweighting exposure to names that have a low carbon footprint today but those that are transition leaders and will be the companies that decarbonise faster.
Asset owners often work with index providers to consider customised indices which draw from the best of these features. But this can brings a real resource and governance challenge as officers of an organisation and its Investment Committee will need have to really trust that a bespoke answer is going to deliver a better outcome than an off the shelf solution that has come out of regulation.
Ultimately, investors are trying to internalise the externalities of climate risk, but it feels sometimes that the focus is more on internalising the externalities at the company level, rather than at the portfolio level – companies shouldn't be the only ones to bear the cost of carbon, it should also be borne by investors... would that be a fair assessment?
What you are trying to do is to put a fair risk factor on climate, and then the challenges will be how to measure that risk factor and how to bias your portfolio to say you've correctly priced for it. There are no perfect measures, or at least there is no consensus on that. Certainly, by setting decarbonisation targets everyone is trying to take action in some form or another, but only time will tell which approaches and measures have performed better.
But the key is that, today, you're trying to price for something you believe isn't being correctly priced in the market. However, we think ultimately there will come a point where the market will start pricing correctly for this sort of risk and that's when a 'low carbon portfolio' will start to resemble a 'broad market portfolio'.
That touches on one of the challenges of decarbonisation: how not to reduce your investment universe?
It is a question of timeline, really. When we look at sustainability or climate goals, we are talking about 2025 – which is not far but only two years from now. Further, you have short term return expectations. Are we delivering the best outcome for policyholders in the short term by having all these sustainability requirements?
There is a general consensus that, in the long run, integrating sustainability should a better outcome. But last year has shown with the energy crisis that there could be short periods where a decarbonised portfolio performs worse than an oil-heavy portfolio.
That is a real challenge, especially when you have a very diverse customer base like insurers do. Some customers are going to be with us for 20 years, and some for much shorter timeframes. The customers who are there for 20 years may well see the benefit of a decarbonised portfolio, but in the short term, if you have an energy crisis, what does this mean for the person whose policy is maturing in 12 months? There is no obvious answer, but there are internal challenges which have to be worked through and we have to demonstrate decisions on decarbonisation are in the fiduciary interests of our customers.
Insures should have clarity on the theory for change. Is decarbonisation being pursued to reduce risk to the portfolio or to improve return? Or is there an objective to 'do good' for the world?
They should then evidence why this is in the interests of their customers.
If I may play Devil's advocate on this question of short-term versus long-term: when equity or bond markets are not performing, a chief investment officer at an insurer would say 'we invest through cycles'... why should it be any different here?
That is fair. But here again we need to differentiate the shareholder book from the policyholder book. While the shareholder assets will absolutely be invested through cycles, on the policyholder side, especially now with consumer duty, you've got to make sure that you're thinking about good outcomes that are appropriate for all your customers, some who may well have a shorter maturing period.
Taking a step back, you said there was a different way of pricing and measuring climate risk, can you take us through those?
The most basic measure is carbon emissions. You can evaluate a portfolio's absolute emissions by taking the fair share of emissions of the investee counterparties. The higher the emissions the more vulnerable it is to transition risk. Investors also look at the portfolio's carbon intensity where the emissions are normalised by portfolio value or company sales. This enables comparison of portfolios of different sizes. These are considered backward-looking measures as they inform about the current carbon profile.
You can have forward-looking measures where you look at your portfolio alignment with things like a net-zero world, or a carbon budget consistency with a 1.5 degree pathway. A company can have a large carbon footprint today but a low temperature score if it is expected to transition away from high emitting activities.
There are also metrics like CVAR, which strictly is not a Value at Risk metric, but it's a risk-based measure that, under models the stress on a security or portfolio of the impact of climate under a certain scenario, over a certain timeframe.
Any of these give you a risk measure that you will then look to reduce or optimise and, often, an investor would look at more than one.
We touched on the role of asset managers earlier; how do you find that relationship? Do you find that asset managers are coming to you with solutions? Or do you find that you are the one driving them to think about these climate factors? And perhaps these relationships are evolving with time?
It's a mixed bag. On the whole, it is very good, especially here in Europe, where financial actors strongly believe in the case for embedding sustainability into strategy. You don't have the politics that you see in the USA. But the level of integration of sustainability varies with managers. For the larger, mainstream managers, you'll find that they tend to be proactive coming up with solutions and you can bounce ideas around with them. For the smaller, more niche managers, especially those focused on asset classes such as private credit or very specialised pools of money, they are still at an earlier stage of their sustainability journey and you might need to be more directional in terms of decarbonisation requirements.
But I think everyone recognises they have to up their game.