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  4. Episode 37: Climate Risk Integration: Regulation, Disclosure and Pivotal Trends

Guest speaker:

Sarah Bratton, Head of Sustainability North America at Schroders Investment Management,

Elena Philipova, Refinitiv’s Global Head of ESG.

Climate Risk Integration: Regulation, Disclosure and Pivotal Trends

Episode 37 | Duration: 24 minutes

What are the most critical trends that ESG investors should know about when it comes to integrating climate risk? To mark the 2020 Climate Week, we met to discuss the regulatory landscape, challenges related to the disclosure requirements, and opportunities to tap into here and now.

  • Keesa Schreane [00:00:00] Hello, everyone. This is Keesa Schreane, welcome to our special Climate Week episode. We're going to discuss the landscape of climate research, what's happening now in policy, the need to incorporate this type of research, and insight into investment decisions and the regulatory landscape, as well as disclosure. A lot of great insights today. And we're going to be discussing this with Sarah Bratton, head of Sustainability North America at Schroders Investment Management, and Alena Philipova, Refinitiv's global head of ESG.  

    Keesa Schreane [00:00:38] Now, we know that climate change is certainly part of the central issues we're discussing in 2020. For example, there is a talk about climate change in the context of the pandemic. How one may impact the other. Also, climate change and environmental injustice, especially in underserved communities, is a topic that is finally front and center. Now Elena, what are your views about what we're seeing broadly around environmental policy changes in the EU and what are the global impacts of those changes?  

    Elena Philipova [00:01:11] Thanks, Keesa. Hello, everyone. I think it's important to start by saying that the potential costs and risks of climate change are of concern to stakeholders around the globe. And like other challenges that we face, including the global COVID pandemic and the push for human rights and equality, the problems are very much systematic in nature. So it's really a team effort and it does require different stakeholders to come out of the sidelines and step up their game. That's what European regulators really decided to do a few years ago when in 2018, the EU commission announced a very comprehensive and arguably the most ambitious to date action plan on financing sustainable growth based on the recommendations made by a group of experts called HLEG. The action covers 10 different action spanninf across the full value chain of capital markets, aiming to enable and enforce the shift of both public and private financial flows towards a sustainable economy. And these measures, the European Union, the European regulators believe, will enable to sustain economic and social prosperity in the future. There are different components of the action plan and many are in progress, but probably worth mentioning two of them. The first is the European Taxonomy, which is a foundational block of the action plan on financing sustainable growth. And what it is in very simple terms, is a classification tool that aims to help investors, as well as companies, consistently determine whether any economic activity is environmentally sustainable or not. It provides very specific quantitative thresholds on the environmental performance of  economic activities to be considered complying with the taxonomy.  

    Elena Philipova [00:03:23] The second piece of the regulatory movement led by Europe is the disclosure regulation. And this impacts both financial institutions and disclosure about the reconsideration of negative adverse impacts into capital allocation decisions, as well as disclosure requirements at a product level for products branded as sustainable products. And within the next 5 to 10 years, my personal opinion is that this will be how capital markets will operate globally, probably in different phases around the world. But this will become business as usual for everyone. What we see really happening in the EU will impact global disclosure requirements, and asset managers globally will have to follow these tools and requirements as they do have a license to operate in the EU as well.  

    Keesa Schreane [00:04:25] So we're talking a lot about these. What's going on in the EU, how it's going to impact globally?So Sarah, at least in the U.S., we're really not seated yet. Could you give us some background and insight into what we're seeing around recent U.S. policy and how it might impact us in the future?  

    Sarah Bratton [00:04:43] Great. Thank you. Thank you to the audience for today. Yes. Just a couple of comments on the EU initiative from a U.S. perspective. I think what is being a little bit missed here in the US is that all major asset managers that have that license to distribute in Europe and have over 500 employees are going to have to abide by the EU policy rules, which will result in increased demand from asset managers. They'll be asking more of their companies in terms of disclosure.  

    Sarah Bratton [00:05:18] And if I just take a step back, looking at ESG regulation globally, not just the EU, I feel like the EU gets a lot of the headlines. But globally, in 2017, we had just over 110 regulations regarding ESG policy. Since then, that has doubled by 2019. That number has doubled and most of that policy is supportive of integrating ESG into investment decisions here in the US. That's not the case right now. We've had a little bit of a cold shower put on ESG integration in terms of what we've seen come out of the deal - in the past two months, built on the efficacy of integrating ESG into investment processes and thinking about it in terms of sacrificing returns, which is not what ESG integration is at all. It's a very inclusionary approach today. It's about getting better long term risk-adjusted returns.  

    Sarah Bratton [00:06:22] And then just recently, we've seen the DOL come out and challenge on the proxy voting side, having plans, vote on environmental and social issues. From that perspective, we've had sort of this headwind on ESG adoption here in the US. What I will say is that that could change very quickly, depending on the upcoming election cycle, where you have the Biden / Harris campaign, which has come out and has a history of being a lot more in favor of climate justice and some of the initiatives that are on the table, particularly the Climate Equity Act that Harris announced just five days prior to her V.P. nomination. There's no irony in that for me.  

    Keesa Schreane [00:07:17] So let's go from there to talk directly about the investor community. Why is this statement true? Investors can no longer ignore climate change in terms of how they go about investing. Talk to us about that statement.  

    Sarah Bratton [00:07:32] So from our perspective, climate change is one of the key structural events that's going to evolve over the coming years. And we are long-term investors here at Schroders. And for us, integrating climate change into our investment decisions is all about identifying those long-term structural trends that are going to change. And that will result in better risk-adjusted returns for our clients. All of these events are intricately linked, whether it's pandemic's, whether it's climate change, whether it's global inequality. And these problems are too big for us to ignore. And we have to be honest with each other. It's going to take private capital to solve these problems. And from a risk perspective, if you think about it, many of us have our assets are locked up into long terms, whether it's our retirement plans, whether it's 401Ks. What we're going to see evolve in terms of climate and climate change and climate policy and climate action. It's just too big for us to ignore. Given the long-term holding period that many of us have in our retirement assets.  

    Keesa Schreane [00:08:42] Great. So moving from there. Let's talk about the tools, the research tools that investment teams can use and incorporate into their allocation strategies to meet their needs.  

    Sarah Bratton [00:08:57] So from our perspective, it's a little bit too simplistic just to look at a company's carbon footprint to assess their climate risk. There's no silver bullet, too. There's no silver bullet to assessing the climate risk. You have to look at it in multiple different angles. So we've developed a very broad toolkit for how we look at sustainability first, starting with our climate progress dashboard, which is measuring the speed and scale of change across four major indicators. And it's really trying to assess that timing question and what the progress we are making is towards the Paris goals. And then we've developed a toolkit to help us understand what would be the investment implications of whether it is a carbon tax, whether it's stranded assets. What would be those investment implications? And how do you turn that into investment tools and how do you get investors on board to assess it? Well, you have to turn it into the language that investors speak, which is data and dollars. It's very rare that an investor speaks in a carbon footprint. So you take that carbon footprint, you assess, you turn that into a model that would assess what would the impact be on this company's profitability? Say carbon was taxed at one hundred dollars a tonne. And then you're turning that into the language that investors speak, which is dollars.  

    Sarah Bratton [00:10:27] We've also developed a physical risk model to help us assess stranded asset risk. But it's not just about corporates. And I think many people are always focused on corporates. You have to assess all of your investments. So we have a country sustainability dashboard that looks at country climate risk. And here in the US, we've actually developed a muni sustainability dashboard that looks across all thirty one hundred counties here assessing their sustainability risk. On the climate side, we're looking at physical risk. So what's their risk to tornadoes, hurricanes, flood.,,a number of factors, but we're also looking at well-being risk, understanding what the water quality is, what the air quality is. So looking at all of these, trying to build a holistic toolkit to look at climate risk across all of our investments rather than simply just looking at something like a carbon footprint.  

    Keesa Schreane [00:11:25] I love that the investors speak data in dollars, not carbon footprint. There's a lesson to be learned there. So we are gaining greater awareness around the climate issues on the investor side, as well as how to literally speak the language that we need to use to convey these issues at the same time. It's important to gain awareness about what's going on on the regulatory side. Elena, could you dive a bit more into the expectations for the future in terms of regulations? 

    Elena Philipova [00:11:57] Sure. For all of us, for the world really to avoid the worst consequences of climate change and other systematic challenges, consumption behaviors need to change. So consumers, businesses, regulators really need to get off the passive sidelines observing what's happening and act only when it's too late and contribute boldly with the right sense of urgency. And as mentioned, we do see some of those actions happening and taking shape. Some industries are already advanced in terms of transformation. There is great sustainability, climate leadership emerging from across the food economy. And these different stakeholders embarking on this transformative journey really are leading and causing a much more focus from a corporate standpoint of view on climate change, a better understanding of the implications, and thus improve disclosure on climate impacts - both in terms of the impact that businesses have on the environment, as well as the environmental changes and challenges have on businesses and their ability to deliver superior performance to different stakeholders. And I do believe that within the next five to 10 years, sustainability will be how capital markets, and the financial industry in particular operates. But broadly speaking, how the economy operates and in some regions. I do expect to see that happening sooner, primarily led by mandatory regulatory compliance requirements that will be put in place in other regions it may take longer. But we shouldn't forget about the challenges that these initiatives, these regulatory text, and principles that are put forward are aiming to solve for global problems that the economy and the society is facing. And I think it's also interesting to look at data and what data tells us.  

    Keesa Schreane [00:14:23] I love that, particularly focusing on how these mandatory requirements in the future are going to help to lead us to solve these global issues, societal issues. Sarah, what are your views about the progress that corporations have already made toward climate goals? If we want to look at the glass half full here.  

    Sarah Bratton [00:14:41] I think that there's definitely been significant progress on disclosure. I think we still need to see some progress in the actual action. But I just want to hit on some of the points that Elena said on the demand side and move it back to investor demand and end-client demand. The demand is there and the demand is broadening. It's broadening from a demographic and geographic perspective. So if I think about it, just sitting here in the U.S., we are definitely seeing additional demand from clients, questions around it. ESG, sustainability, climate risk comes up in almost seventy-five percent of our conversations here in the US. Now, that number is probably close to 100 percent in Europe. And we're also seeing it in pockets of South America as well as in Asia, where you're really seeing some of these countries from a policy perspective, try to jump ahead and rebuild a cleaner economy. But from a demand perspective, from a client perspective, we're continuing to see that growth.  

    Sarah Bratton [00:15:48] And when I said across demographics, I find this one to be one of the most interesting. We release a global investor survey every single year. And every year historically, it has been the women or the millennials that had the most demand in sustainable investing and climate change investing. We saw a shift in 2019, where Gen X, which is the population above the millennials, really jumped ahead in the survey, saying that they wanted more options, they wanted more funds where they could contribute to a more sustainable future. My personal opinion is because Gen X is old enough to have their own children, friends' children, nieces, and nephews that were out protesting for the climate change protest right along Gretta. And they really looked at themselves and said, we want to be more sustainable. We want to live a more sustainable future for our children and our children's children. And I'm always interested in seeing the results of this year's survey, as we've seen the pandemic hit here, we've seen the protests around inequality in the US. We will see climate once again come to the forefront. And what we've seen is all of these issues are intricately linked, often hitting the most vulnerable in society. So I'll be interested to see, as we have this culmination of issues coming together, particularly alongside the election here in the US, how this will play out and what the demand patterns will continue to be growing in the future.  

    Keesa Schreane [00:17:30] Thank you for that. Elena, the future. What is the future in terms of corporate disclosure? Where do you see the greatest progress happening around this time disclosure as we head into the next few years?  

    Elena Philipova [00:17:46] Yeah, I mean, in terms of the progress that the companies are making, I couldn't agree more with Sarah mentioning that there is a lot of progress in terms of intentions and commitments. So our job of at least raising awareness, ringing the urgency bell has worked. Companies are certainly noticing that. And if we look at data, what we see is that a lot more companies are now not only setting generic policies and commitments, towards the issue of climate change or generic targets. They are starting to set very specific, measurable science-based targets as well for the reduction. About 30 percent of the companies in our universe set some sort of a measurable reduction target. Some, I assume companies that are really starting the journey will set, small targets in the likes of five percent / six percent / seven percent for a short period of time, so usually for the next year, to really start working on the agenda in terms of actual actions and implementation. Other companies that are more mature and have been on this journey for a while do set more ambitious longer-term reduction targets like 30 percent by 2025 or 50 percent by 2030. And I think that it's also worked to highlight here is the European commitment to reach carbon neutrality by 2050. This is the first global commitment to reach carbon try. And it is part of the Paris agreement agenda and commitments that all nations, with minor exceptions, committed to.  

    Elena Philipova [00:19:46] So that cannot happen in isolation. It really needs to start with consumers, with businesses, and with capital allocation decisions made by both the private and the public sector. But I agree that there is too a gap in terms of actual deliverables, actual actions. To give you an example, also in terms of disclosure gaps within the Refinitiv ESG database, which represents more than 80 percent of global market capitalization, around 60 percent of the companies still do not disclose their direct CO2 emissions, scope one emissions, which is arguably the easiest information and data that companies already have easily of hand. And it's a matter of just making it publicly available to stakeholders. When we look further down into indirect emissions scope two, or even scope three missions, the disclosure is dramatically reduced. For the last five years, what we've actually observed, for example, across cope three emissions, is the disclosure on scope three emissions, has improved from about 25 percent of the companies to about 30.  

    Elena Philipova [00:21:09] And although these numbers sound very high, actually, the vast majority of these disclosures is incomplete. And to compare it at scale, the data needs to be standardized and comparable. And as we remove all of these incomplete numbers, we're really looking at very low single digit percentages and that is insufficient for proper integration of climate risk into investment decisions. So we do expect and hope to see in the next couple of years a lot broader agreement on standards and standardization in terms of what companies are expected, and frankly speaking, should be mandated to disclose on the issue of climate change anE eSG, broadly speaking. So there is an urgent need for a single common accepted set of EU metrics and this is really now a priority.  

    Keesa Schreane [00:22:18] Wow. So many key takeaways here. First of all, the European regulatory movement is in full swing. Action planning in Europe is enabling the shift of flows toward sustainable economies. The global ESG  regulation also is following suit - we've seen an increase in ESG policy, supporting the integration of ESG into investment decisions. We know that it will take private capital to help us solve these issues, as well as the other sources.  

    Keesa Schreane [00:22:46] And there is no silver bullet in assessing climate risk. We understand that there is importance in speaking in the same language that investors speak, which is data and dollars. So tools are being created to speak in this way, so investors really understand the benefits. Countries are focused on building cleaner economies and companies are setting more science-based targets, although we need to see more complete disclosure and standardization and comparable data. Data is the way to get us there. So interconnectedness of climate change, as well as other key societal and justice issues, continue to be really front running. And as always, the end-client demand is really important. And we see theclimate demand now broadening in the demographic area, as well as geographically. Sara Bratton and Elena Philipova, thank you so much for a great conversation.