ESG · sector as it pertains to the stranded assets dilemma. We evaluate how climate risks and opportunities can be incorporated, with the relevant tools, into strategic asset allocation

ESGmattersEnvironmental, Social and Governance thought piece

Issue 11

Climate Special Issue: Sink or Swim

12 Interview with Andreas Utermann, Global CIO AllianzGI, and Jay Ralph, Chairman of Allianz Asset Management

08 Guest article by Christiana Figueres, Executive Secretary of the UN Framework Convention on Climate Change

Understand. Act.

FEATURES:

2

The Global ESG Team

LONDON

Bozena Jankowska, Global Co-Head of ESG

Marissa Blankenship, ESG Analyst

Jeremy Kent, Portfolio Manager, ESG Analyst

Robbie Miles, ESG Analyst

PARIS

David Diamond, Global Co-Head of ESG

Marie-Sybille Connan, ESG Analyst

Mathilde Moulin, ESG Analyst

FRANKFURT

Henrike Kulmann, ESG Analyst

Rainer Sauer, Proxy Voting Specialist

CONTACT DETAILS

For any further information please contact:

Bozena Jankowska

Global Co-Head of ESG

[email protected]

+44 20 7065 1468

www.esgmatters.co.uk

Design and Art Direction

Susan Lane, Allianz Global Investors

Imagery

iStock

Allianz Global Investors GmbH, UK Branch

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+44 20 7859 9000

© 2015 Allianz Global Investors

All rights reserved

Dear reader

In December, we will find out whether we are about to embark on a new chapter in the transition to a lower carbon world. No longer can we argue with science and question whether climate change is real or not, or indeed whether it is human induced. For the sceptics out there, ask yourself this question. Would you still eat a mushroom if 97% of scientific experts said that it was poisonous? Any rational individual would immediately work out that the odds are stacked against them and leave the mushroom well alone. With 97% of scientists agreeing that climate change is real and the result of our addiction to carbon based fuels, can we really then continue to hold out for the 3% chance that all will be fine? It’s clear that doing nothing is no longer an option. Climate change is a global, systemic risk which cannot be hedged away. Every part of the economy will be impacted in some way. Our job as investors and as part of the investment community is therefore to work out how best to minimise the risk and act on our conclusions.

In this Climate Change special edition of ESG matters, we debate the merits of divestment versus engagement and how banks’ exposure to coal investments creates a new risk for the sector as it pertains to the stranded assets dilemma. We evaluate how climate risks and opportunities can be incorporated, with the relevant tools, into strategic asset allocation. We discuss the myriad of options available for investors whose aim is to capture the investment opportunities in the transition to a low carbon and sharing economy. We analyse the potential outcomes of COP21 and look to our senior leaders to provide their perspectives on climate change and how they believe investors should be responding to both the risks and opportunities.

The future is in our hands. The decisions and actions we take today will determine our course and label us as either the future takers or future makers. I know which camp I’d rather be in….

Bozena Jankowska

Global Co-Head of ESG

Bozena JankowskaGlobal Co-Head of ESG

3

EXECUTIVE PAY

Contents

ESG Matters | Issue 11

08

32

16

04 COP21: Just a lot of hot air?

08 Investing in our future means thinking about the long term

12 Climate change and investment: Views from the top

14 Jeremy Kent infographic

16 Divestment or engagement: Fossil fuels are on the radar

for COP21

20 Assessing the investability of Thermal Coal over the next

20 Years – One author’s perspective

24 Cities taking action: A local perspective on the global climate negotiations

28 Resilience: surviving and thriving in climates of change

32 Integration of climate risks into portfolio strategy

20 24

44

COP21: Just a lot of hot air?MATHILDE MOULIN looks at the reasons behind the COP21 conference, what it hopes to achieve and discusses the three major topics that are under the spotlight: emissions reduction, reporting and funding.

In December, over 40,000 participants from across the world will gather in Paris for The Conference of Parties – COP21, the UN’s flagship symposium on climate change. But will the assembled delegates be able to reach a meaningful, historic agreement to tackle global warming, or will the event simply be a lot of hot air?

The stakes could not be higher. The target of this COP is to reach a binding universal agreement on the world’s climate that would come into force in 2020, limiting global warming to 2°C until 2100. The 2°C target was set by the Cancun COP16 back in 2010, but since then no COP has succeeded in articulating an action plan to actually meet it. The French Academy of Sciences (Institut de France: Académie des sciences) assessed that the world’s temperature rose by 0.8°C between 1870 and 20101, with scientists agreeing that this rise has accelerated sharply since 1975. According to the International Energy Agency (IEA), if there is no policy change from today, the globe’s temperature may rise by 6°C, triple the target, by 20402.

COP21/Section 1

Mathilde MoulinESG Analyst,Paris

55


6

COP21/SECTION 1

If we want to avoid this scenario, it is critical that greenhouse gas emissions (GHG) fall by between 40% and 70% over the 2010-2050 period. That means we need the emissaries travelling to Paris to agree on a concrete action plan and a detailed emission-reduction path: not promising to in the future, but agreeing it there and then. The COP21 really is the last chance saloon for us to lay the foundations for a binding global agreement on our climate that can be brought into force in any meaningful short-term timetable.

There will be three major topics on the table in Paris: the scope of each country’s emissions, the way those emissions are reported and funding. Each topic arrives at Charles de Gaulle Airport with significant excess baggage.

Emission reduction

Most people now agree that GHG emissions need to be cut, but the scale of each country’s reduction is yet to be established. In advance of the COP, each country was asked to submit its Intended Nationally Determined Contribution (INDC), giving details of the country’s GHG reduction emission target as well as the steps needed to meet it.

As of October 2015, an impressive total of nearly 130 countries, representing more than 80% of worldwide emissions, have communicated their INDCs. These INDCs are now being

consolidated into a final report for discussion in Paris. If they are considered to be insufficient in limiting global warming to 2°C, the debate will be fierce.

It is critical that the debate now moves beyond the long-held bipolar view of the world that sees the developed countries standing accused of being fully responsible for climate change and the developing world demanding exemption from reduction efforts.

This bipolar view stems originally from the principle of “common but differentiated responsibility” that was enshrined in the UN Rio Declaration on Environment and Development in 1992 and applied in respect of climate change by the UN Kyoto Protocol signed in 1997. The Principle’s interpretation is too binary (pitting developed countries versus the rest) and not in tune with the world we live in today. According to the IEA, while OECD countries were responsible for 66.1% of CO2 emissions from fuel combustion back in 1973, this had fallen to 38.3% by 2012, with some emerging countries like China or India are now among the top 5 world’s emitters3.

And yet, the bipolar view has persisted, stalling discussions with key COP constituents the US for example, which passed the Byrd-Hagel Resolution of 1997 stating that the US would not ratify the Kyoto Protocol or commit to any GHG reduction for as long as countries such as China or India did not commit to equivalent efforts.

7


For the upcoming COP to be a success, countries must reject the binary interpretation of the principle of “common but differentiated responsibility” and create a new coalition between major emitters to drive the negotiations forward. The US-China and the US-India joint announcements on climate change that have been made in the last year are positive moves in the right direction.

Reporting system

Countries must agree on a reliable independent measure and reporting verification (MRV) system for GHG emissions. Such a system already exists for Annex 1 countries (some 40 industrialised or in transition countries) however, there are various political obstacles to overcome before it can be broadened to all countries.

The MRV system must contain a malus mechanism that defines both the price to be paid for emissions above targets and make clear how this penalty money will be used. Even though there is no consensus of the price to be paid for the malus as of yet, this sanction – if consensus can be reached in Paris – should encourage countries to reduce their emissions.

Funding

The final key topic to be discussed is funding. Back in 2010 at COP16, developed countries committed to mobilise USD100bn a year by

2020 to help developing countries to finance climate change adaptation and mitigation. As of now, the Green Climate Fund that was created in 2011 to collect the funds has only received 10% of the pledges needed to reach the USD100bn target.4 Where the remaining 90% will come from is still an open question.

Discussions at COP21 must determine which countries will contribute to the Green Climate Fund, to what extent and which flows should be taken into account (Only public flows? Or private flows too?). One solution could be to mix public and private flows, leveraging public flows to attract private ones.

The funding issue is central to COP21’s success or failure. If we want developing countries to move beyond the bipolar view and to commit to GHG emission reductions, in turn, developed countries have to show willingness to help other countries to adapt and fight climate change.

The stakes are high, but there are significant grounds for optimism that a meaningful agreement will be signed. Nearly 130 INDCs have been submitted so far, compared to less than 100 at the Copenhagen COP15 in 2009. This proves that countries are now mobilising around climate change. The Climate Action Tracker (CAT), which analyses these emissions commitments, found that, if implemented, the current INDCs would succeed in limiting global warming to 2.7°C by 21005. That’s clearly above the 2°C target but it is the first time that the projected temperature rise has fallen below 3°C since the CAT began to track emission reduction commitments.

All in all, the COP can’t be viewed in pure black and white terms: as ‘good COP’ or ‘bad COP’. The final agreement may disappoint, but we must remember that some of the debates and issues will continue to be negotiated afterwards and that each INDC will be reviewed every 5 years. Besides, in the last few months, we have a wealth of inspiring climate initiatives launched by non-state actors (cities, regions and companies), whose involvement has an equally important role to play in the fight against climate change.

1 http://www.academie-sciences.fr/pdf/rapport/rapport261010.pdf

2 http://www.iea.org/publications/scenariosandprojections/

3 http://www.iea.org/publications/freepublications/publication/KeyWorld2014.pdf

4 http://news.gcfund.org/wp-content/uploads/2015/04/GCF_contributions_2015_apr_30.pdf

5 http://climateactiontracker.org/

“ The COP21 really is the last chance saloon for us to lay the foundations for a binding global agreement on our climate. ”

8

Investing in our future means thinking about the long term

CHRISTIANA FIGUERES the Executive Secretary of the UN Framework Convention on Climate Change (UNFCC) discusses the aims of COP21 and how significant the risks of climate change are for investors and the wider global economy.

The risks associated with climate change have the potential to undermine the longevity of investments worldwide. This is because climate change impacts every investment and, therefore, it must become a central consideration for every portfolio level investment decision.

This shouldn’t be news to anyone – there has been a surge in reports and assessments recently, spelling out these risks, but also the opportunities for those investors that take this reality on board.

Firstly, Citibank’s ‘Global Perspective & Solutions’ Report1, released in August, calculated that the necessary total spend on low-carbon energy over

Christiana FigueresExecutive Secretary of the UN Framework Convention on Climate Change

Investing in our future/

section 2

9

the next quarter century will be over USD190 trillion. This figure is less than the USD192 trillion estimated in the report’s ‘business as usual’ scenario – which essentially concludes that ‘inaction’ on climate change will cost more.

Then, in September, Mark Carney, Governor of the Bank of England, stated that climate change is a major financial and economic risk for investors and, more broadly, for the wider global economy.

His outlook was further reinforced by Christine Lagarde (Managing Director of the International Monetary Fund), during the annual meeting of the World Bank Group and the International Monetary Fund. She warned that failure to take much needed action on climate change would condemn humanity to unacceptable levels of risks and impacts.

What all this means is that investors now have a responsibility to generate more investment into better quality, more efficient infrastructure in order to maximize their returns over the long term. But despite this somewhat sobering outlook there is cause for optimism. Indeed, there have been many promising signals that investment is already moving in the right direction.

Take, for instance, the USD100 billion climate finance package – a pledge made by developed countries to developing ones as part of international efforts to keep a global temperature rise under 2 degrees C. A recent assessment by the OECD indicates that financial flows from North to South may have already reached over USD60 billion required for this package. In other words, the world is actually on its way to deliver the pledge by the agreed date of 2020.

And while trillions of dollars will be needed to catalyze a transition to a low carbon economy the USD100 billion represents not only a politically important plank of international cooperation, but an important vehicle for assisting the climate action ambitions of the poorest and more vulnerable countries.

Forward-looking investors can accelerate and, ultimately, aid the speed and scale of the now unstoppable transition to a climate resilient world.


10

As the suppliers of capital to corporations, small and medium-sized enterprises, governments and infrastructure projects, you play a pivotal role in facilitating the orderly phasing down of fossil fuels and the ramping up of clean energy and clean tech enterprises with the necessary investment that takes the world far beyond theory and into a very different development path.

The New Climate Economy’s Report – Seizing the Opportunity2 – puts a figure on this, recommending an annual spend of at least one trillion in clean energy. Currently the global spend is around USD270 billion a year – a far bigger figure than many had

thought possible just a decade ago but still behind what is needed.

Ahead of the Paris climate negotiations in December, fund managers and investors can provide confidence to governments who are on the brink of inking a new, universal climate agreement. Specifically, in the final weeks before the climate negotiations, commitments and announce-ments by investors can demonstrate that capital is shifting to support a just and ambitious transition.

There are many opportunities for investors to demonstrate their climate leadership, including: engaging with your companies

on climate change; measuring your investment portfolio carbon footprint; reallocating capital away from carbon risk assets; and reinforcing your efforts through advocacy.

Essentially, it is not just prudent to invest in low-carbon technologies and infrastructure, it is financially lucrative.

An organization like Allianz Global Investors, which is part of a company with a 125-year history, is used to thinking in the long term.

It is this perspective that makes you acutely aware that business of the next 125 years cannot be the same as the last. We need a

INVESTING IN OUR FUTURE/SECTION 2

11


new model of growth that can thrive in the vastly different risks that we face now, into the second half of this century and beyond.

You have a unique voice that simultaneously understands risk and understands climate change. Adopting an explicit long term vision will send a message to shareholders that value will be maintained, even as the physical impacts of climate change manifest themselves globally.

The Paris agreement is not an end in itself. It needs to deliver the pathways and the policies you need to put us on the road to a decarbonization of the global economy and

a point in the second half of the century were emissions are so low they can be easily safely absorbed by healthy forests and other natural systems.

Investing in these will be just as important as investing in clean energy and low carbon infrastructure.

2016 will be a year in many ways just as important as 2015 and the new agreement, because this is just the beginning of a new journey for everyone on this planet.

You are in a unique position to demonstrate that this signal has been received loud and

clear. In terms of taking decisive action on climate change, you can help show that while we may not have reached the summit, we have at last arrived at base-camp.

1 h t t p : // w w w . t h e g u a r d i a n . c o m /environment/climate-consensus-97-percent /2015/aug/31/cit i -repor t-slowing-global-warming-would-save-tens-of-trillions-of-dollars

2 http://2015.newclimateeconomy.report/

12

Investment/Section 3

Climate change and investment: Views from the top

With leading a global firm comes responsibility. It is crucial that the significance and impact of climate change is recognized from the top. We asked JAY RALPH, Chairman of Allianz Asset Management, and ANDREAS UTERMANN, Global CIO of Allianz Global Investors, to opine on the relevance of climate change for investors.

Andreas UtermannGlobal Chief Investment Officer Allianz Global Investors

Jay RalphChairman Allianz Asset Management

On the relevance of climate change for investment performance…

On what investors should be doing today to address long term climate change risks…

On what are the main challenges for investors when considering climate change risks and opportunities in their investment decisions…

13


JAY RALPH: From an Allianz Group perspective, climate change is very relevant. Being a big property and casualty insurer we are already seeing the impacts. Risks around stranded assets, the value of carbon intensive fuels and the potential implications on their value are a reality – particularly for long term investors. So it should be at the forefront of investor thinking.

JAY RALPH: One needs to understand where the risks are and where they may arise in order to be in a position to assess the impact on portfolios. This allows one to act and create a strategy around the portfolio. Allianz is starting to figure out how in the management of its assets, we can account for different material environmental, social and governance factors over time. Within the context of climate change, this applies to carbon based energy, such as coal and oil. For any long term investor it’s a matter of being ahead of the curve, understanding climate and carbon risks and still ending up with a well-diversified, de-carbonised portfolio.

JAY RALPH: I would echo that the three components, timeframe, materiality and disclosure and transparency are all important. The challenge is that climate change is something that happens over a long period of time and for this reason it may lack a sense of urgency for some individuals. If anyone has had the opportunity to visit either Beijing or Shanghai as I have, and experienced the bad pollution days, then you can see an immediate and very personal impact in terms of the air that one breathes. China’s crackdown on air pollution was a response to immediate health concerns. The result was relatively significant change in policy around coal and a greater emphasis on renewables that will have long term consequences. The challenge for investors today is capturing the future cost of policy change and the consequences of this. People are influenced by cost. As the costs of carbon become more tangible, and are passed on, the more rapid will be that shift in energy mix – we have seen this with alternative energy subsidies and their rapid adoption. The key is for investors to do their homework and to better understand the different moving parts in order to become smarter, better and more sophisticated investors around climate change issues.

ANDREAS UTERMANN: Regardless of climate change concerns, investors should as a matter of fact be including material environmental risks in their investment decisions. Environmental degradation in its broader sense even if it were to not lead to climate change outright, will have significant impacts on people’s lives. I believe this is especially the case in emerging markets. There, environmental standards are still in their infancy. One would therefore expect policy makers to respond by either making it more costly for companies to pollute by pricing in environmental externalities and favouring cleaner sources of energy, or by introducing anything else that may reduce the environmental impact.

ANDREAS UTERMANN: When analysing companies, we increasingly need to focus on non-financial, non-accounting factors that are usually not captured by traditional financial analysis. We need to take a view on management’s perspective on these, how they manage the risks in relation to public policy and how they are making the externalities pay. Although easier said than done, these issues have a place in long-term valuation and investment decision making.

ANDREAS UTERMANN: Time frames, materiality, lack of data and disclosure all present challenges for investors. But to me, the main challenge is that there is no clear understanding around climate change and no uniform public policy response being in place. The challenge therefore is to gauge what the public policy response may be and how it will change over time. For example, in the EU, one government suddenly banned outright nuclear power only to overturn its decision twice. Whereas at the same time, other countries are looking at nuclear power to reduce their carbon footprint because they view it being cleaner, net-net, than anything that is carbon or alternative energy based. For an investor evaluating this within the context of climate change policy and investment opportunities, it is tricky to assess and determine which companies will be the future winners and losers.

14

Rise and Fall of Global Emissions

Source: World Resources Institute and The World Bank. Measure is “tCO2e Per Capita” i.e. tonne of carbon emissions equivalent per capita. 1GtCO2e = gigatonnes of CO2 equivalent. *Forecast from Royal Dutch Shell that sees a strong role for government and the introduction of firm and far-reaching policy measures. The Mountains scenario imagines a world where government policy significantly influences society and largely shapes energy and environmental pathways. Cleaner-burning natural gas becomes the backbone of the world’s energy system, mostly replacing coal for power generation and seeing wider use in transport.

2012 Emissions / Projected Emissions 2025 / Projected Emissions 2030

GHG Emissions per capita

Australia

30.115.9

Canada

24.617.2

UnitedStates

18.513.7

RussianFederation

15.715.0

Japan

9.516.9

Brazil

9.05.8

EuropeanUnion

8.26.0

Indonesia

8.0

China

7.9

India

2.3

4.38m10.07m

What one tonneof carbon looks like

United States

5823

United States

4731

Europe

4132

Europe

3083

Australia

685444

China

10684India

2887Brazil

1823Brazil

1296

Russian Federation

2254Russian Federation

2013

Japan

2030Japan

1207

Indonesia

1981

IEA 2 degrees Scenario (GtCO2e1) Shell "Mountains" Scenario* (GtCO2e1)

36.936.9

37.937.9

40.040.0

44.144.1

48.048.0

50.151.7 47.3 46.7 44.1 40.9 39.5

32.6 32.2

1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Peak CO2 EmissionsEmissions 2012 / Projected Emissions 2025 / Projected Emissions 2030...

37.645.3 42.5

32.126.3

26.315.3

Data collated by:Jeremy Kent, Portfolio Manager, ESG Analyst, London

PEAK EMISSIONS/SECTION 4

15

Rise and Fall of Global Emissions

Source: World Resources Institute and The World Bank. Measure is “tCO2e Per Capita” i.e. tonne of carbon emissions equivalent per capita. 1GtCO2e = gigatonnes of CO2 equivalent. *Forecast from Royal Dutch Shell that sees a strong role for government and the introduction of firm and far-reaching policy measures. The Mountains scenario imagines a world where government policy significantly influences society and largely shapes energy and environmental pathways. Cleaner-burning natural gas becomes the backbone of the world’s energy system, mostly replacing coal for power generation and seeing wider use in transport.

2012 Emissions / Projected Emissions 2025 / Projected Emissions 2030

GHG Emissions per capita

Australia

30.115.9

Canada

24.617.2

UnitedStates

18.513.7

RussianFederation

15.715.0

Japan

9.516.9

Brazil

9.05.8

EuropeanUnion

8.26.0

Indonesia

8.0

China

7.9

India

2.3

4.38m10.07m

What one tonneof carbon looks like

United States

5823

United States

4731

Europe

4132

Europe

3083

Australia

685444

China

10684India

2887Brazil

1823Brazil

1296

Russian Federation

2254Russian Federation

2013

Japan

2030Japan

1207

Indonesia

1981

IEA 2 degrees Scenario (GtCO2e1) Shell "Mountains" Scenario* (GtCO2e1)

36.936.9

37.937.9

40.040.0

44.144.1

48.048.0

50.151.7 47.3 46.7 44.1 40.9 39.5

32.6 32.2

1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Peak CO2 EmissionsEmissions 2012 / Projected Emissions 2025 / Projected Emissions 2030...

37.645.3 42.5

32.126.3

26.315.3

Data collated by:Jeremy Kent, Portfolio Manager, ESG Analyst, London


16

Fossil fuels/section 5

17


-

As a starting point, “If you are worried about climate change and want to act as a responsible investor, do not sell your holdings in Oil & Gas companies, instead engage with them to promote low-carbon strategies and better disclosure on their carbon asset risk. Divestment simply shifts the risk around rather than reducing aggregate risk”. That’s what we heard at a debate hosted by Martin

accumulate to have a 50% chance of avoiding climate change beyond 2°C. The reality is that we have already used up to two thirds of that carbon budget!

The energy sector is responsible for two thirds of annual GHG emissions globally. Of these energy-related emissions, coal is responsible for 43%, oil 33%, gas 18% and 6% cement and flaring1.

Skancke, Chairman of the Principles for Responsible Investment and a former Director General of the Norwegian Government Pension Fund, at the Paris Climate Finance Day on May 22, 2015.

According to scientists, there is an absolute limit to the atmospheric concentration of greenhouse gas (GHG) that we can allow to

Divestment or engagement: Fossil fuels are on the radar for COP21

MARIE-SYBILLE CONNAN, discusses whether divestment is really a feasible strategy for investors and regulators, and how oil companies are responding to the threat of stranded assets.

Marie-Sybille ConnanESG Analyst, Paris

18

Against this backdrop, we can easily understand why the fossil fuel industry is being scrutinized and targeted by politicians, society and more and more by investors for its role in global warming. Carbon risk has definitely become a growing concern for many stakeholders. As such, we can cite divestment campaigns where ethical investors extend their exclusion policies to fossil fuels and local authorities and universities are challenged by the “Go Fossil Free” movements. Regulators have also embraced the issue. In a recent research agenda, the Bank of England acknowledged that climate change could have an impact on the financial markets and that the move to a low carbon economy could leave fossil fuel assets stranded. The French Parliament passed a law on energy transition making the disclosure of climate impact and carbon risk exposure for French investors mandatory. Also investors are mobilizing with initiatives such as the Montreal Carbon Pledge (whereby asset managers are committing themselves to measure and publicly disclose the carbon footprint of their portfolios annually) or the Portfolio Decarbonization Coalition (which is committed to the implementation of portfolio strategies towards climate-related objectives). In an unprecedented move, the six European oil majors sought United Nations backing for a carbon pricing system in a letter sent in June to the Head of the UNFCC Christina Figueres, our guest author for this issue, and the French Ministry of Foreign Office Laurent Fabius. The rationale behind this initiative was to explain how gas could replace coal in power generation if the carbon-pricing signal was efficient and hence to relieve the pressure the oil majors have recently endured over the question of stranded assets and the broader sustainability of their business models.

All in all, there is no doubt that the financial industry has finally realized that the question of stranded assets matters, but it remains unclear whether this risk may materialize and, if yes, then when. “When?” is the question often posed by our stakeholders who oppose our arguments on Stranded Assets – they want clarity over the time horizon. This issue has recently been relayed by the Governor of the Bank of England, Mark Carney, as the “tragedy of

FOSSIL FUELS/SECTION 5

horizon”2. A binding agreement on GHG emissions limitations at COP21 would make this risk more likely. The necessary components are there to make COP21 a success: 90% of GHG emissions are covered by Intended Nationally Determined Contributions (INDC),3 the two largest emitting countries, US and China, have jointly pledged to reduce their carbon emissions. Regardless of the outcome of COP21, the direction towards a lower carbon economy seems to be clearly set even though the journey will be long.

How will this direction materialize in the investment decision-making process? In our view, the investor’s approach will differ from one fossil fuel to another.

Coal is cheap and abundant but accounts for a large portion of carbon potential (65% of carbon content within proven reserves coming from coal4). Coal is definitely the uglier sister of fossil fuels. Investors seem to plead for divestment over engagement. For example, Axa committed to divesting by the end of 2015 from mining companies with over 50% of turnover from coal mining and electric utilities with 50% of energy from thermal coal plants, while Norway’s US$900bn sovereign wealth fund committed to selling off coal companies. Countries heavily reliant on coal for their power generation and which have large coal reserves are also showing their goodwill ahead of COP21. As such, India which is the third largest GHG emitter in the world in absolute terms after China and the US submitted its INDC and committed to reduce the emissions intensity of Gross Domestic Product by 33-35% by 2030 from 2005 levels, to have 40% of cumulative installed power-generation power capacity from non-fossil fuel sources by 2030 and to create an additional carbon sink of 2.5-3bn tCO2e (tons of carbon dioxide equivalent) through afforestation by 20305. Joint forces are then playing against coal. Companies exposed to coal for a large part of their business mix are clearly at risk but they are either marginally held in portfolios or are state-owned companies and then not on the radar screen of investors. We don’t expect a massive sell-off from the divestment campaign and therefore we think that the valuation impact will be less significant than the announcement effect.

19


For oil and gas, the situation is more complex and the exercise trickier for investors. Financial stakes are higher than for mining as the oil majors are significant constituents of indices and are then not marginal investments. Divestment doesn’t seem to be the preferred path for most investors. They appreciate the exposure of oil majors to gas. Gas can help in this transition to lower carbon economy as it emits half of the GHG emissions of coal but it remains a fossil fuel and as such is not the panacea. Investors are also sensitive to the arguments brought by the oil industry, such as the growing energy needs supported by demography and the lack of alternatives for oil in end markets. BP outlined in its 2035 Energy Outlook that energy demand should grow by 37% with two thirds met by fossil fuels6. Transportation is by far the largest end market for oil (54%7) and there is currently no affordable substitute for gasoline. However, technology disruptions can no longer be dismissed with better energy efficiencies for internal combustion engines, and the faster deployment of electronic vehicle (EV) technology. In this respect, China will be key as public policies have shifted towards incentivizing renewable energy, including EVs. China has already implemented tax breaks for EVs and is considering a US$16bn investment in EV charging stations in order to help boost demand for EVs. We can also cite the improving economics of solar photovoltaic and wind energies that could substitute oil in power generation. That’s why we think that engagement with oil majors makes more sense than divestment. Contrary to coal miners, oil majors have more options available. We think that they have a role to play in this transition if they don’t want to jeopardize their own future. Oil & Gas will remain their core business but they usually have the cash-flow to invest in renewable energy and then secure their long term prospects. Oil majors can become energy majors and play a key role in this transition to a low carbon economy. However, they need the support of their shareholders who have to change their own mindsets and will no longer see them as dividend stocks as majors will have to reinvest their cash-flow instead of distributing huge dividends. It may be a long journey but it’s our role to engage more with oil majors on this topic. It’s in this context that we noticed the recent change in

mindset of the CEO of Total, Patrick Pouyanné, when he stated at a roundtable with Sustainable and Responsible Investment investors in September that if Total was part to the Climate change problem, Total was also part to the solution.

Carbon risk caused by fossil fuels has never been so high on the agenda of previous COPs. Conditions to make COP21 a success have never been so well met. 90% of global emissions are covered by country pledges8. Institutional investors have joined the move and are to committing to decarbonizing their portfolios. European oil majors are embracing the topic. The market sentiment on fossil fuel companies has never been so gloomy. It is up to them to decide whether they want to be future takers or makers because regulatory pressures will not relax after COP21 whether it a success or not. We as investors will continue to engage.

1 https://ir.citi.com/wtWd7wazN%2FBD%2BbrpOuibzDdWoIxtowpaFrTro5CK%2B1EzCnsWb9ABEi9BOKvzcPW%2F

2 http://www.theguardian.com/commentisfree/2015/oct/04/observer-view-climate-change-mark-carney

3 http://www.bbc.com/news/science-environment-34510867

4 http://www.carbontracker.org/wp-content/uploads/2014/09/Unburnable-Carbon-Full-rev2-1.pdf (page 4)

5 http://w w w4.unfccc.int/submissions/INDC/Published%20Documents/India/1/INDIA%20INDC%20TO%20UNFCCC.pdf

6 http://www.bp.com/content/dam/bp/pdf/energy-economics/energy-outlook-2015/Energy_Outlook_2035_booklet.pdf

7 http://www.bp.com/content/dam/bp/pdf/energy-economics/energy-outlook-2015/Energy_Outlook_2035_booklet.pdf

8 http://www.bbc.com/news/science-environment-34510867

“ Oil Majors can become energy majors and play a key role in this transition to a low carbon economy. ”

2020

Assessing the investability of Thermal Coal over the next 20 Years – One author’s perspective

In the shadow of the fossil fuel divestment campaign and the availability of a host of alternative renewable energy sources, MARISSA BLANKENSHIP analyses the investability of thermal coal in the longer term.

The Center for Climate and Energy Solutions states that 44% of energy related CO2 emissions is related to the consumption of thermal coal using existing technology,1 which puts the Intergovernmental Panel on Climate Change (IPCC) goal of limiting temperature increases to within 2 degrees of pre-industrial levels by 2050 at risk. As an investor, the future investability of thermal coal is difficult to assess and is complicated by the media attention given to the coal divestment campaign, the lack of attention to the scale and power of state controlled coal mining and coal-fired utilities companies

Coal/Section 6

Marissa BlankenshipESG Analyst, London

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“ Portraying the investment decision as black and white ignores the fact that thermal coal is a complex issue as a significant contributor to the overall energy mix. ”

22

and the disruptive technologies emerging in solar and energy storage.

For fundamental investors, it is hard to overlook the dramatic decline in the global coal market. The Bloomberg World Coal Index has lost 54.1% in the last five years to 28 September 20152 while US coal miners Alpha Natural Resources, Walter Energy and Patriot Coal have filed for bankruptcy this year. Competitor Arch Coal, the second largest coal miner in the United States, is likely to follow in the near term.3 For investors who add a sustainability element to their philosophy by integrating environmental consider-ations into their investment process, evaluating how thermal coal can remain a viable investment, given the coupling of current fundamentals and climate constraints, is an important consideration.

The fossil fuel divestment movement, which includes thermal coal, was launched in 2012 with Bill McKibben’s climate movement called 350.org. Through October 2015, more than 440 institutions representing USD2.6 trillion in assets, including the Norwegian Sovereign Wealth Fund, Stanford University and Newcastle, the Australian City with the largest coal

port, have committed to divesting from fossil fuels. However, portraying the investment decision as black and white ignores the fact that thermal coal is a complex issue as a significant contributor to the overall energy mix.

According to analysis by Gerrit Heyns, co-founder of Osmosis Asset Management, if every listed fossil fuel business on the planet were to close completely, this would impact less than 70% of the world’s combustible carbon reserves.4 The majority of those reserves are held by state-owned companies in single commodity countries. Divestment results in a more concentrated ownership of listed fossil fuel businesses leaving those former investors without the formal mechanisms available as shareholders to ask for change. Interestingly, on 5th of October, the Guardian updated their ‘Keep It in the Ground‘divestment campaign, shifting to a more solutions-based approach, “If you take your money out of the problem, where should you put it as part of the solution?”5

The juxtaposition of the fossil fuel divestment campaign versus the behemoth state owned enterprises, which have a responsibility to provide access to

electricity, is just one aspect of the multi-faceted dilemma of how to assess the future investability of thermal coal.

Thermal coal is abundant and by far the cheapest energy source when externalities are not internalised. Electric renewables currently suffer from intermittency and viable storage solutions and are not very scalable. However, provocative research from Tony Seba, Lecturer in Entrepreneurship, Disruption, and Clean Energy at Stanford University and author of Clean Disruption of Energy and Transportation, suggests that if solar PV continues to grow at approximately 42% CAGR, 100% of all energy worldwide will be solar by 20306. While cleaner than thermal coal, natural gas is abundant yet often needs to be imported and is more expensive. Although safe, scalable and clean from an emissions perspective, ‘new’ nuclear energy suffers from perception problems. Coal, natural gas and nuclear could all be under threat however, as Mr. Seba challenges that the cost of rooftop solar will be lower than the cost of transmission by 2020 thus rendering these energy sources obsolete.

COAL/SECTION 6

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In September 2015, an article entitled, ’Assessing the investability of thermal coal over the next 20 years’7 was published in the Journal of World Energy, Law and Business. As an author of this article, when taking into account a range of options on a global basis, we were unable to distil down the decision to a comprehensive investable or not investable. However, by looking at a 20 year time frame in the context of scenario analysis, we were able to construct two divergent scenarios, protectionist and transformative, each with differing consequences for thermal coal across a range of geographies – China, India, Europe and North America and stakeholders – institutional investors, supranationals, mining, electric utilities and technology companies.

The results based on analysis, surveys, interviews and an affirmation workshop, enabled us to identify degrees of investability by developing drivers based on a range of social, technological, economic, environmental and political issues that investors can use as an early warning system in their investment process. Furthermore, strategic planning by investors allows for new drivers to be introduced into the system, such as an

accelerating solar PV growth rate, or current drivers adapted over time, such as a change in the divestment movement. As an example of how the degrees of investability by stakeholder culminated; our findings for institutional investors in a protectionist world suggested that investment opportunities in thermal coal will not remain in Europe, remain limited in China and North America and remain in India.

Finally, it is worth noting that the financing of both coal mining and coal-fired utilities was an important issue which fell outside of the scope of the article. The top 20 banks on a global basis have financed greater than EUR273 billion into the coal industry between 2005 and April 2014 with the four state-owned Chinese banks now representing close to 18% of the total8. Additionally, commercial banks have also scaled up both underwriting and corporate loans and in 2013 placed more than EUR66 billion which was a 360% increase over 2005, the year the Kyoto Protocol came into force.7 Financing from banks will be needed in both the protectionist scenario as access to energy is a key issue in emerging economies and equally in the transformative scenario where the transition to clean coal and renewable

energy sources is the crucial element for thermal coal to remain investable.

1 http://www.c2es.org/energy/source/coal

2 Bloomberg BWCAOL Index 28 Sept 2015

3 h t t p : / / w w w . r e u t e r s . c o m /a r t i c l e / 2 0 15 / 11/ 0 9 / a r c h - c o a l -bankruptcy-idUSL8N1315FF20151109#p8WAUMIkb0MfDV02.97

4 h t t p : // w w w . t h e g u a r d i a n . c o m /sustainable-business/2015/mar/30/the-fossil-fuel-divestment-campaign-is-inherently-flawed

5 h t t p : // w w w . t h e g u a r d i a n . c o m /e n v i r o n m e n t / 2 0 1 5 /oct/05/a-story-of-hope-the-guardian-launches-phase-two-of-its-climate-change-campaign

6 Clean disruption- Why conventional energy and transportation will be obsolete by 2030. Tony Seba 16th Sept 2015

7 http://jwelb.oxfordjournals.org/cgi/reprint/jwv021?ijkey=RDXJMyxkDQNJOvU&keytype=ref

8 http://www.banktrack.org/show/pages/banking_on_coal_2014_report

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Cities taking action/

section 7

25


Did you know that in the run-up to COP21 in Paris, countries were not the only parties that publically declared what actions they aim to take to support a new global climate agreement? In addition to the almost 130 INDCs received from states so far (Nov 2015), cities have also started to announce ambitious plans about how they aim to tackle climate change at the local level, independent from the announcement

“Compact of Mayors”. In September 2015, to showcase their ambition, 10 global cities (including Sydney, New York and Oslo) from five continents representing 58 million people and more than USD 3 trillion Gross Domestic Product (GDP), followed the lead of Rio de Janeiro and announced climate actions plans. They pledged to reduce greenhouse gas emissions, track progress and prepare for the impacts of climate

made by their national governments. Cities have formed global networks, in order to make their voices heard, learn from each other, coordinate views, and have emerged as new actors in international environmental politics.

One of the key global fora for cities to express their stance regarding climate change in the run up to Paris is the so called

Cities taking action: A local perspective on the global climate negotiations

While the world focuses on the countries contributing to the COP21 discussions, HENRIKE KULMANN examines the important role that cities are playing in supporting a new global climate agreement and how they can be central to tackling climate change.

Henrike KulmannESG Analyst, Frankfurt

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change, in compliance with the goals set by the “Compact of Mayors”. The Compact was launched at the UN Secretary General’s Climate Summit in New York City in September 2014 by the C40 Cities Climate Leadership Group, ICLEI – Local Governments for Sustainability and the United Cities and Local Governments (UCLG), as a global coalition whose members pledge to reduce greenhouse gas emissions and improve resilience to climate change. The collaboration empowers cities to make existing targets and plans public and report their progress in the Carbon Climate Registry (www.carbonn.org) or the CDP (www.cdp.net). To date, more than 240 cities representing 270 million people have committed to the Compact. In September, Barack Obama announced that 15 cities in the United States had joined and set a goal of 100 cities to become members before COP21.

The role of cities in climate change: contributor, victim and solution provider?

One might wonder why cities feel the need to collaborate independ-ent from national governments and what level of influence they could have – especially since governments negotiate at COP21, not cities.

Contributor to global climate change

Globally, urban populations contribute a disproportionate amount of emissions relative to rural populations. While 54% of people in the world lived in urban areas in 2014, they are responsible for more than 70% of the annual energy related emissions.1 Compared to 1950, this represents a 24% growth in urban population and by 2050, a further increase to 66 percent is estimated.2 China, India and Nigeria alone are projected to account for 37 percent of the growth. As a result of

CITIES TAKING ACTION/SECTION 7

the continued urbanization, challenges of sustainable development will increasingly center in cities.

Victim of the negative effects of climate change

At the same time, cities are not only contributing to climate change, they are also highly exposed to climate related risks such as temperature increase and heatwaves (78% cities who responded to CDP feel exposed), and frequent/intense rainfall (68%), drought (41%) and sea level rise (30%).3 Thus, the effects of global warming are highly local and call for adaption mechanisms customized to local requirements. Given the high level of vulnerability, it makes sense for cities to take the lead, become actively involved and help in setting the stage for Paris.

Solution provider for global climate change?

Cities are also in a position to tackle climate change, and networks such as the Compact of Mayors demonstrate that they are willing to take up the challenge. The Mayor of Rio de Janeiro, Eduardo Paes defines the role of cities in climate change and COP21 as follows: “Cities are climate leaders, they are in the best position to effect real change. The actions we take at a local level will have a global impact and, by improving our city, we will be helping create a better world for today’s urban citizens and generations to come.”4

Rio de Janeiro is amongst the most vocal cities to drive the global debate on climate change and has shown leadership through action. In August 2015, Rio became the first city to announce that it has set-up a local greenhouse gas emission inventory that leverages the Global Protocol for Community-scale GHG Emissions Inventory, which is considered the most robust standard for reporting GHG

“ While 54% of people in the world lived in urban areas in 2014, they are responsible for more than 70% of the annual energy related emissions. ”

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emissions. Moreover, it is the first city to systematically assess its vulnerability to climate change. In 2011, Rio set an emission reduction target of 20 percent by 2020 which is the equivalent of a 2.3 million metric tons emissions reduction in aggregate. Rio is also taking actions to avoid becoming a victim through measures such as the “Rio Resilient” plan which provides city planners with scenario analysis that can be incorporated in to future strategic planning.

Climate risk impacts cities’ economic competitiveness

Rio provides a framework of setting targets and how to implement policies that other cities can imitate. In our view, there are also long term economic incentives for cities that help to explain why they are taking action. Cities generate more than 80 percent of the global GDP5, according to the World Bank and compete against each other to become or defend their position as “economic growth engines”. We argue that going forward, the level of competitiveness of cities will also depend on their ability to adapt and mitigate the negative effects of climate change they are exposed to. City rankings already include benchmarking on climate change impact and local governments’ capacity to deal with flooding, heat waves or storms for example.

Climate change threatens business in cities and can lead to a wide range of disruption. Port cities, for example, are highly exposed to sea level rises, which can disrupt transportation systems, with consequences for supply chains and tourism. On this account, it is not surprising that 76 percent of cities reporting to the CDP believe that climate change could impact the local private sector.6 Cities that are more resilient are therefore better positioned to become a location of choice for corporates.

Moreover, cities are often considered innovation hubs that depend on attracting talent. In our view, cities that provide a high quality living environment for their residents are in a better position to succeed in this challenge. Topics such as air quality, noise levels, greening and urban transportation will become more and more relevant factors that businesses need to take into account when selecting a new location or deciding on expansion plans. From that perspective, it makes sense for cities to set themselves GHG reduction goals, consider the implementation of local regulation and enforce changes. As cities have a strong influence over policy levers such as buildings, public transportation, urban planning and waste management – all core sectors to reduce GHG emissions – they have tools in hand to make a difference. Thinking longer term, this should help them grow their local economies.

Risk and opportunities for companies

According to C40, cities are able to influence one third of the relevant future investments and policy decisions, are able to move quickly in implementing policies and programs on the ground, and, have policy tools to enforce action on the local level such as setting and enforcing

policy and regulation, control or influence over budget and via the control of own and operated assets. For businesses this means that cities themselves set regulation which companies might have to adapt to. To give an example, London introduced a low emission zone for the most polluting heavy diesel vehicles in 2008 to improve air quality and has since tightened the regulation. Plans for an ultra-low emission zone are under consideration. While this might expose some sectors to risks in the short term, longer term, they will benefit from a sustainable, resilient city environment that attracts the right talent and minimizes business disruption risks.

In addition, the actions taken by cities to fight climate change creates new opportunities for firms i.e. via investment in transportation, building and construction or waste management, which contribute to emission levels in cities the most. For companies, partnering with cities could help drive innovation and provide a testing ground for projects, while access to city networks could help scale new technologies. To give an example, the city innovation network “Morgenstadt” – City of the Future – in Germany brings together 21 industry partners (such as Bosch, Osram, SAP, Ikea etc.), 11 German cities and 10 research institutes to develop and implement solutions for sustainable cities. Companies get access to different cities facilitated by the research partner, access to national and international subsidies and can identify synergies with industry partners for potential cooperation.

To summarise, cities are in a position to act as a catalyst for climate change action, they have meaningful tools to play their part and become partners on the national as well as international level. They contribute to climate change, are affected by it but can also offer solutions. Initiatives such as the Compact of Mayors demonstrate that cities also shape the discussions at the COP21 by collectively showcasing their commitment.

1 Greenhouse Gas Protocol http://www.ghgprotocol.org/city-accounting

2 United Nations, http://esa.un.org/unpd/wup/Highlights/UP2014 -Highlights.pdf

3 CDP Cities Infographic 2014.

4 http://www.compactofmayors.org/press-release-rio-de-janeiro-first-fully-compliant-city-in-compact-of-mayors-tackles-climate-change/

5 V. Lall, Somik. “Planning, Connecting and Financing Cities – Now: Priorities for City Leaders.” The World Bank, 2013. http://documents.worldbank.org/curated/en/2013/01/17197253/planning-connecting-financing-cities-now-priorities-city-leaders

6 https://www.cdp.net/CDPResults/CDP-global-cities-report-2014.pdf

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Resilience/Section 8

Resilience: surviving and thriving in climates of change

ROBBIE MILES explains how the key ingredient to a company’s future success is resilience. With resource scarcity being headline news and energy demand increasingly being met by renewable energy, businesses must look to expose and take advantage of the opportunities created by this change in the hope of a more sustainable future.

The green movement’s focus has, thus far, been on raising awareness and highlighting the perpetrators of environmental degradation. It has been moderately successful, but the diplomatic and political response has been ineffectual at preventing the tragedy of the commons. When leaders met to formulate a plan to avoid the risks of catastrophic anthropogenic climate change in Rio in 1992, global emissions were 22.6 billion tonnes of CO2 per year. 23 years later, annual emissions have risen 35%.1 While people despair and governments discuss, businesses are finding solutions. In October, the Guardian newspaper, having spearheaded the divestment campaign, changed its tack to focus on the reinvestment opportunities within the transition to a clean economy; the sustainable revolution. It is the luxury of active asset managers to do the same. As a whole, the asset management industry is overweight the risk and underweight the opportunity. Institutional investors account for 35% of all fossil fuel securities but

Robbie MilesESG Analyst,London

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just 15% of all clean technology investments.2 Lowering the carbon intensity of portfolios is therefore a key focus for sustainable investors. To find appropriate companies to reinvest in requires analysis of a key business ingredient: resilience.

Resilience is a quality that takes many different forms but is essentially reducing exposure to risk; a key consideration in times of uncertainty and market volatility. Businesses should ensure their employees are content, that they are tech savvy with strong cyber security systems and that their supply chains are, robust, efficient, and clean. If evidence is needed for adopting policies such as a living wage, it can be found in the fact that British companies in the Times ‘100 Best Companies to Work For’ outperformed the market by 9% p.a. between 2001 and 2013.3 The retention and motivation benefits were similarly identified in the US where names featured in ‘Best Companies To Work For’ outperformed the market by an average of 3.6%/year over the last 3 decades.4 The advantages of staying abreast of technological developments are clear but cyber risk escalates in tempo with digitalisation. Cybersecurity experts like to divide the world into two categories: those who have been hacked, and those who have been hacked but don’t yet know it. Centralised systems such as a nuclear power plant or an electricity grid are particularly vulnerable. In contrast, decentralised/independent systems are more resilient.

Climate change and population increase are both on course to exacerbate resource scarcity and so a resilient supply-chain is essential. The circular economy, an evolution of the linear cradle to grave model, applies industrial ecology thinking (reducing waste through symbiosis), utilising spare assets (the sharing economy) and integrates circular supplies (renewable, recyclable or biodegradable resource inputs). Applying the principles of the circular economy into the supply chain can limit disruptions and save costs. It is also important to stress test the sensitivity of the supply chain to the impacts of climate change, paying particular attention to key resources such as water and other soft commodities. Nestlé, for example, have trained 21,000 cocoa farmers in sustainable agriculture techniques to mitigate the risk poor yields

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from disease and drought. Another shift in business model that is improving resource efficiency is supplying services rather than products. Instead of selling a jet engine, Rolls Royce charges airlines for the air miles that the jets propel. In the same vein, SolarCity are selling the electrons from the residential solar panels they install, rather than selling the panels themselves. This puts the incentive for efficient operating and maintenance responsibilities firmly with the experts and disincentives in-built obsolescence. The providers of essentials such as water, food and energy where sustainability is embedded into the strategy are also likely to be those that survive and thrive into the future.

Another key to resilience is to be the disruptor, not the disrupted. No-where are the implications of this more pertinent than in energy, the centre stage of the climate campaign. Cyclical opportunities in fossil fuel investments will, no doubt, exist for many years to come as commodity prices fluctuate but ultimately this 100 year old industry is in structural decline. Renewable energy met 22% of the global energy needs in 20135 and on-shore wind is now the cheapest form of electricity to produce in both the UK and Germany,6 even excluding subsides. This trend will inevitably continue for 3 reasons. Firstly, if history tells us anything, the improvements in efficiency and cost of clean technology will continue to beat expectations. Utility scale solar has fallen 66% over the past 5 years,7 far exceeding the forecasts of the International Energy Agency, the world’s leading energy authority. Secondly as renewable capacity is installed, the relative cost of fossil fuel energy increases because the commodities

RESILIENCE/SECTION 8

being burnt cost money while sunshine and wind remain free. Renewables will therefore always receive grid priority so fossil fuel power stations are utilised for less of the time, so their $/MWh ratio gets increasingly more expensive. This incentivises the adoption of more renewables, creating an exponential feedback loop that will leave fossil fuel assets stranded; the carbon bubble risk. The final tailwind for the energy transition is that fossil fuel subsidy removal is a low hanging fruit for politicians looking to decarbonise. Apple and SAP have ensured the resilience of their data centres by powering them off 100% renewable sources. The map above shows that solar is already cheaper than thermal generation in many key markets.

“ The providers of essentials such as water, food and energy where sustainability is embedded into the strategy are also likely to be those that survive and thrive into the future. ”

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Disruptive (which should perhaps be more appropriately named ‘deliverance’) technologies are blindsiding the incumbents. BP predicts that in 2035, Electric Vehicles (EV) will only make up 7% of car sales.8 Meanwhile, Apple, a company 12X bigger than Volkswagen, is planning production of their own EV in 2019. Tesla are edging EV’s up the Sigmoid curve with their planned production of a USD30,000 model with a 200 mile range. Were Elon Musk to announce a trip to meet Chinese leaders about building a battery factory, or if Narendra Modi were to proclaim that India’s next mass market car will be electric, the opportune moment for rebalancing to a lower carbon investment portfolio may have been missed. 50 years on from the 1960’s, we are in another era when an aspirational generation are willing and able to disrupt the status quo and create a better world.

Image supplied courtesy of Deutsche Bank Securities as at March 2015.

1 http://edgar.jrc.ec.europa.eu/news_docs/jrc-2014-trends-in-global-co2-emissions-2014-report-93171.pdf

2 Mark Fulton, http://parisclimateweek-2015-metrics.2degrees-investing.org/videos/player.php?v=ib8ai_SKwLs

3 Alex Edmans, Morgan Stanley Investor Roundtable, October 2014.

4 http://faculty.london.edu/aedmans/Rowe.pdf

5 http://www.energypost.eu/renewables-iea-underestimate/

6 http://www.bloomberg.com/news/articles/2015-10-06/solar-wind-reach-a-big-renewables-turning-point-bnef

7 http://www.energypost.eu/renewables-iea-underestimate/

8 http://www.bp.com/content/dam/bp/pdf/Energy-economics/Energy-Outlook/Energy_Outlook_2035_booklet.pdf

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Climate Risk/Section 9

Integration of climate risks into portfolio strategy

DR. STEFFEN HÖRTER provides a step by step guide on one way in which investors can integrate the risk of climate change into the Strategic Asset Allocations of their portfolios.

Relevance of climate risks for asset owners – the next black swan?

Most institutional asset owners focus their portfolio risk management on market risk factors such as, for example, interest rate, inflation, equity and credit risks. Some early adopters, mainly large public pension funds in Europe and the US as well as insurance companies, have started to add Environmental Social and Governance risk factors. The objective is to use ESG as a lens to get a more holistic picture on the ‘true’ long-term risk exposure.

In particular climate change is considered a key long-term ESG risk:

• It is systemic and global

• It has the potential to significantly impact the performance of assets

• It does not appear to be priced in yet by capital markets.

A key assumption for climate risk is that it results from global warming which is man-made and caused by industrial greenhouse gas emissions including carbon. From a climate balance sheet

Dr. Steffen HörterCo-Head Investment and Risk Consulting, Allianz Global Investors Global Solutions/risklab1

1 risklab GmbH (“risklab”) is an Allianz Global Investors company registered with Bundesanstalt für F inanzdienst leistungs aufsicht t (www.bafin.de) as a provider of financial services in Germany. risklab is not licensed to conduct business outside of Germany and its services are not available directly to persons outside of Germany. risklab provides risk management and strategic and dynamic asset allocation solutions to support the investment advisory activities of the properly registered and licensed affiliates of Allianz Global Investors.

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perspective there appear to be far more carbon reserves available than can ever be burned, if the aspiration is to keep global warming in check – the famous two degree target. In fact, the International Energy Agency estimates that approximately two thirds of the known fossil energy reserves cannot be burned. In this context, a broad scale carbon emission cap and trade regulation seem inevitable.

This leads to the fear of ‘stranded’, depreciated assets and broader financial markets risks in the worst case. In April 2015, the G20 powers asked the Financial Stability Board in Basel to investigate the possible fall-out faced by the financial sector as climate rules become much stricter. In a recent speech, the Governor of the Bank of England, Mark Carney, concluded that investors need to wake up to the potential for high losses from a sudden shift in regulations aimed to curb global warming and the use of fossil energy.

Integration of climate risks into the investment and risk strategy – show me how!

While for many asset owners, there is less need to discuss the potential financial materiality of climate change risk, it is more important for them to understand what should be done from a practical investment and risk management perspective. For this purpose, asset owners could perform a four-step plan to integrate climate risks into their portfolio strategy (see figure 1 overleaf).

Step 1 (Top-down): Integration of climate risks into Strategic Asset Allocation (SAA)

Objectives: analyze how climate risks may alter the asset allocation choice with respect to a reference portfolio. The key input is an analysis of what defines climate risk and how it may translate into future performance of asset classes. Climate risks may be linked to physical climate change, regulation aimed to mitigate and cap global warming as well as technological progress such as price and capacity development of carbon capture and storage facilities.

Step 2 (Top-down): Review new climate opportunity asset classes

Objectives: analyze how green bonds, private debt/equity green-tech, renewable energy infrastructure etc. may improve overall

“ The objective is to use ESG as a lens to get a more holistic picture on the ‘true’ long-term risk exposure. ”

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portfolio performance. A sustainable, transformational trend towards a low-carbon society will require massive efforts and financing needs on a global scale and may create attractive investment opportunities.

Step 3 (Bottom-up): Investigate climate risk optimization of existing asset classes

Objectives: Investigate how active invest-ment strategies within existing asset classes can be optimized with respect to climate risk exposure or opportunities. For example, equities could be changed to a low-carbon best-effort footprint investment approach. Additionally, a best-in-class active invest-ment strategy approach may be chosen for equities which selects expected corporate ‘climate change winners’.

Step 4 (Bottom-up): Aim to influence issuer performance with respect to climate risk

Objectives: review how an active asset manager may improve the performance of

selected corporates whose business success appears exposed to climate change risks through corporate engagement and proxy voting strategies.

While not all of the four steps may result in immediate portfolio changes they build the foundation of a structured and powerful review for an asset owner who aims to be prepared and react prudently to increasing climate change related investment risks on the horizon.

Climate risk integration into strategic asset allocation

From a strategic investment perspective asset owners may want to integrate climate and other ESG risks into SAA. Like climate risk, the SAA typically has a mid-to-long-term horizon, for example 5-20 years. It may determine up to 90% of an investor’s portfolio risks and is an established decision making tool for investment committees and boards. In fact, the recent 2015 Risk Monitor survey by Allianz Global Investors also revealed, that asset class diversification

strategies are the most common risk strategies applied by institutional investors world-wide.1

Today, there is no industry standard for climate risk integration into SAA. AllianzGI Global Solutions risklab has prototyped two methods:

1. Pricing approach: quantifying carbon emissions rights peek price risks and link into long-term economic scenario generation and capital market assumptions for equities and corporate bonds. The tail risk-adjusted investment assumptions are then used for the SAA analysis.2

2. Non-pricing approach: climate risk scoring of a broad set of asset-classes using heat-map expert input by Allianz Climate Solutions (see figure 2) and ND-GAIN climate adaption index3. The SAA optimization is then performed subject to a maximum portfolio climate risk budget which may not be exceeded through the asset class mix.

CLIMATE RISKS/SECTION 9

Figure 1: Four-step plan to integrate climate risks into portfolio strategy

1

1

KEY Leading to a reduction in

Climate Change Risk Exposure

Step 1Step 2

Step 3Step 4

Review asset allocation

Add new asset classes

Optimise existing assets

Influence issuers

Integration of climate risks into Strategic Asset AllocationAnalyse how climate risks may alter the asset allocation choice.

Review new climate opportunity asset classesAnalyse how ‘green assets’ may add to overall portfolio performance.

Investigate climate risk optimization existing assetsInvestigate how active investment strategies reduce climate risk exposure and create alpha.

Aim to influence issuer climate risk performanceCorporate engagement and proxy voting with focus on climate change business risk.

Top-down

Top-down

Bottom-up

Bottom-up

Source: risklab GmbH. 1For illustrative purposes only. This does not reflect actual data or show actual performance and is not indicative of future results.

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The pricing of climate risks into capital market assumptions and scenarios used for SAA analysis is high-end from a financial engineering perspective. In practical terms, its advantage is that this key input – Capital Market Assumptions – which determines SAA results to a large degree, is extended in a transparent and quantitative way. It’s caveat is that it adds a number of additional assumptions and modelling complexity that not every investment committee will feel comfortable with.

In the non-pricing approach, ‘standard’ capital market assumptions are used as input for the SAA. However, the relative risk and return attractiveness of each asset class is amended by adding a relative climate risk score using the expert input by Allianz Climate Solutions. In this holistic, top-down optimization, for a broadly diversified portfolio with a higher share of risky assets, you would typically see the following effects: emerging markets equities and bonds tend to lose portfolio share while developed markets assets and

various alternative assets would gain allocation, such as private market renewable energy. Of course, this outcome is largely driven by the input assumptions. For example, if an asset owner plans to invest into a low-carbon risk equity strategy the risk sensitivity input should be lower compared to the original assessment in the climate risk heat-map.

In order to have full transparency on portfolio effects and to gather controlled insights, we envisage performing an SAA optimization without consideration of climate change risks and then adding related analysis in a second step. Ultimately, our recommendation is to document all key climate risk assumptions and possibly amend investment beliefs. Such a statement could be: “We expect climate risk factors to have a material impact on the financial performance of our assets over the mid to long-term. We assume there will be a pricing of environmental risk at some point in the future. However there is no certainty about when this will happen and how high

Figure 2: Climate risk asset class heat-map

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Climate Solutions. For more details please go to: https//www.allianzgi.com/en/Risk-Management/Pages/The-heat-is-on.aspxSource: risklab GmbH.

the impact will be exactly. Therefore, we aim to minimize the exposure to climate risk in our investment portfolio with minimal opportunity costs today.”

1 http://w w w.allianzgi.com/en/Risk _Monitor_June_2015/Pages/default.aspx .

2 For more details please refer to http://w w w.esgmatters.co.uk/en/Thought Leadership/AllianzGIWhiteResearch Papers/Pages/default.aspx Responsible Investing Reloaded. Dr. Steffen Hoerter, Allianz Global Investors, Capital Markets Analysis, 2011.

3 The “Notre Dame-Global Adaptation Index (ND-GAIN)” is a free open-source index that shows which countries are best prepared to deal with superstorms, droughts, security risks and other vulnerabilities caused by climate disruption, as well as their readiness to successfully implement adaptation solutions. For further details see www.gain.org.

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ALLIANZGI AND ESG/SECTION 10

Marissa Blankenship ESG Analyst

Marissa Blankenship is an ESG analyst with Allianz Global Investors, which she joined in 2011. As a member of the firm’s Environmental, Social and Governance (ESG) team, she is responsible for conducting sustainability research on the financial sector. Marissa has 14 years of investment-industry experience. Before joining the firm, she worked as an associate in the equity-strategies group at Hall Capital Management. Ms. Blankenship also conducted sustainability research on a wide range of sectors, companies and funds at Truestone Impact Investment Management and Incofin Investment Management. She has a BS in Economics from the University of California, Davis, an MSc in Latin American Economic Development from the University of London and is currently completing a Master’s in Sustainability Leadership from the University of Cambridge. Marissa holds the IMC designation.

Marie-Sybille Connan ESG Analyst

Ms. Connan is an ESG analyst with Allianz Global Investors, which she joined in 2008. As a member of the firm’s Environmental, Social and Governance (ESG) team, she is responsible for the energy, media and telecom sectors. Ms. Connan was previously a fund manager and credit analyst with the firm. She has 16 years of investment-industry experience. Before joining the firm, Ms. Connan was a senior credit analyst at Fortis Investments and Aviva Investors; before that, she worked at Natixis AM as a fund manager and equity analyst, focusing on IT and software. Ms. Connan has a master’s in finance from the ESC Montpellier Business School. She is a member of the French Society of Financial Analysts and a graduate of the Centre de Formation des Analystes Financiers.

Christiana Figueres Executive Secretary, UNFCCC

Christiana Figueres has been Executive Secretary of the UN Climate Change secretariat since 2010. She has worked extensively with governments, non-governmental organizations and the private sector on climate change and sustainability issues, including as a board member of the Clean Development Mechanism, Vice-President of the Climate Change Conference, as well as many non-governmental organizations. Ms Figueres has greatly contributed to literature on climate solutions and holds a Master’s Degree in Anthropology from the London School of Economics, a certificate in Organizational Development from Georgetown University and an honorary Doctor of Law degree from the University of Massachusetts. She was born in San José, Costa Rica in 1956 and has two daughters.

Dr Steffen Hörter Co-Head Investment & Risk Consulting, Allianz Global Investors Global Solutions-risklab

Dr Steffen Hörter is Co-Head Investment & Risk Consulting, Allianz Global Investors Global Solutions-risklab. He advises institutional investors in Europe on investment strategy, risk management and sustainability. In recent years he has published various studies about incorporating sustainability into investment strategy. Prior to joining Allianz Global Investors, Dr Hoerter worked as a Management Consultant for banks and risk management at an international consultancy firm. Dr Hoerter studied Business Administration in Regensburg, Edinburgh and Ingolstadt/Eichstätt. He holds a doctorate from the Catholic University of Eichstätt-Ingolstadt, where he worked as a lecturer at the Department of Finance and Banking at WFI – Ingolstadt School of Management.

Bozena Jankowska Global Co-Head of ESG, ESG Research

Bozena Jankowska is a Director and the Global Co-Head of ESG with Allianz Global Investors, which she joined in 2000. Being the co-head of the firm’s Environmental, Social and Governance (ESG) team, Bozena is responsible for directing the firm’s global ESG research, engagement and proxy voting platform which supports both specialist SRI funds and ESG integration. Bozena also leads the firm’s efforts to provide insights into sustainability issues, and establishes and manages research partnerships within the firm and with external research institutes and academic institutions. In 2006, she was responsible for the design, launch and management of the Global Ecotrends Fund which became a significant global fund franchise reaching assets under management of EUR 1bn. Between 2012-2014 she was Chair of the UK SIF Analyst Committee and is representing Allianz Global Investors on the Cambridge Institute for Sustainability Leadership Investment Leaders Group. She previously worked at John Laing PLC as their business and environment advisor. Bozena has a B.Sc. in environmental science from the University of Sussex and an M.Sc. with distinction in Environmental Technology from the Imperial College of Science, Technology and Medicine. In 2009, she was named as a Financial News Rising Star in Fund Management.

Please find below biographies of the contributors to this edition of ESG Matters:

Biographies

Jeremy Kent, CFA Portfolio Manager, ESG Analyst

Jeremy serves as deputy portfolio manager for the Global Sustainability strategy and is an ESG analyst responsible for covering Industrials. Jeremy joined AllianzGI in 2008 through the graduate programme, starting an 18 month rotation of roles within the company which include investment management and research analysis. Jeremy graduated from California State University in 2007 with a BA in Entrepreneurial Management. Jeremy is a CFA charterholder and holds the IMC designation.

Henrike Kulmann ESG Analyst

Henrike Kulmann is an ESG Analyst with Allianz Global Investors, which she joined in 2011. After more than three years of working in our Hong Kong office responsible for conducting ESG research and coordinating proxy voting as a member of the Asia Pacific Proxy Voting Committee, Henrike transitioned to the Frankfurt office in late 2014. She continues to be part of the ESG team with a research focus on the consumer discretionary sector and palm oil industry. Henrike has four years of investment-industry experience and more than 6 years of overall experience in the ESG field. She previously worked at Deutsche Post DHL in environmental-strategy management and corporate-responsibility evaluation. Henrike has an M.A. in political science, with a focus on business communication and economics, from Friedrich Schiller University of Jena, Germany.

Robbie Miles, ACA ESG Analyst

Robbie is an ESG analyst with Allianz Global Investors, which he joined in 2014. He has analytical responsibilities on the Environmental, Social and Governance (ESG) Research team for the utilities and industrials sectors. He has three years of sustainable finance experience. Robbie qualified as a chartered accountant with PwC and holds a BA in Environment and Business from the University of Leeds.

Mathilde Moulin ESG Analyst

Ms. Moulin is an ESG analyst with Allianz Global Investors, which she joined in 2007. As a member of the Environmental, Social and Governance (ESG) Research team, she has responsibility for industrials, healthcare and non-corporate issuers. Ms. Moulin has nine years of investment-industry experience. Before joining the firm, she was a consultant at Eurogroup. Ms. Moulin has a master’s degree in management from HEC Business School. She is also a member of the jury for the United Nations Principles for Responsible Investment (UN PRI)/French SIF European research prize.

Jay Ralph Chairman, Allianz Asset Management

Jay Ralph is Chairman at Allianz Asset Management and a member of the Board of Management of Allianz SE. Jay joined Allianz’s asset management division as Chief Operating Officer. In January 2010 Jay became a Member of the Board of Management of Allianz SE, responsible for the Insurance Operations in the NAFTA Markets. Since April 2009 he has acted as Chairman at Allianz Life Insurance Company of North America, Minneapolis. Jay has been with Allianz since 1997, initially as President and CEO of Allianz Risk Transfer, Zurich and later as CEO of Allianz Re within Allianz SE, Munich. Jay started his career in 1981 as Senior Auditor at Arthur Anderson & Company, Chicago. In 1984 he changed to Northwestern Mutual Life Insurance Company, Milwaukee, acting as Investment Officer. In 1991 he became President and Managing Director of Centre Re Bermuda Ltd, Bermuda. Jay Ralph was born in Milwaukee, USA in 1959. He holds an M.B.A. in Finance and Economics from the University of Chicago and a B.B.A. in Finance and Accounting from the University of Wisconsin. He is also licensed as a Certified Public Accountant (CPA) and is a Chartered Financial Analyst (CFA) charter holder.

Andreas Utermann Global Chief Investment Officer, AllianzGI

Andreas Utermann is Global Chief Investment Officer (CIO) and co-head of Allianz Global Investors. Andreas joined Allianz Global Investors and its Global Executive Committee in 2002, initially as Global CIO Equities. Between his joining and the end of 2011, Andreas was also Global CIO and Co-Head of RCM. Andreas holds a number of non-Executive positions in the industry, including Board Memberships of the CFA Society of the UK and the AMIC Council of the ICMA. Prior to joining, Andreas worked for 12 years at Merrill Lynch Investment Managers (formerly Mercury Asset Management), where he was the Global Head and CIO, Equities. Before joining MLIM, Andreas worked for twy years at Deutsche Bank AG. He holds a BSc in Economics from the London School of Economics and an MA in Economics from Katholieke Universiteit Leuven. Andreas is an Associate of the Institute of Investment Management and Research and is fluent in English, German, French and Dutch.

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The last word...One could be forgiven for thinking that herding cats would be a far easier task than reaching global consensus on a binding agreement to curb global warming to 2oc. But the optimist in me thinks that although we might not reach a binding agreement, we will get a positive outcome that will spur further growth in alternative energy and green finance. In both instances, governments and the private sector have a crucial role to play. For investors, it presents opportunities. In this special edition of ESG Matters we have presented a broad range of views and perspectives of how climate change and the myriad knock on impacts will shape and change our world. For the first time however, I sense a real change in the air. There is a real critical mass building, attitudes are shifting and collective action is resulting in a rethink of the status quo. So binding agreement or not... we might still end up feeling like the cat that got the cream.

BOZENA JANKOWSKA, Global Co-Head of ESG

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Disclaimer

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Is should not be assumed that any securities mentioned were or will be profitable.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

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For more ESG related articles please visit our website:

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