Guest speaker: Bridget Realmuto LaPerla, Head of ESG Research at State Street Associates, Voting Member of Columbia University’s Advisory Committee on Socially Responsible Investing for the University Trustees.
Decarbonization Factors: Current State & Future Projections
Episode 5 | Duration: 19 minutes
In this episode, we discuss how the performance of low carbon strategies is linked to aggregated institutional flows and how strategies that vary by region and construction tend to perform better when supported by institutional flows. With the help of Bridget Realmuto LaPerla, a co-author of Decarbonization Factors, we dive deep into the factors driving an evolution in the ESG landscape and climate finance.
Keesa Schreane: Welcome to the Refinitiv Sustainability Perspectives podcast, where we share examples of leadership and innovation. Small entrepreneurial businesses, large megacorporations and all types of enterprises are seeing a global shift in perspectives around the role of business and society, from ESG investing to sustainable finance to social impact in our communities. We're on a journey to leverage data and intelligence to make the best business decisions possible. Enjoy the podcast.
Our guest is Bridget Realmuto LaPerla, head of environmental, social and governance research at State Street Associates. Bridget has over a decade of experience as a sustainable finance specialist. She advises the Columbia University trustees as a member of the Advisory Committee on Socially Responsible Investing and serves on the ESG Integration Group as a policy expert at the Emerging Markets Investors Alliance.
In August 2019, State Street, in partnership with Harvard, released the paper Decarbonization Factors, which explores decarbonization factors in investing. And you had a huge contribution to this. We want to speak about that. But first, we want to know how are institutional investors driving interest in ESG, investing in green bonds and that sort of thing?
Bridget Realmuto LaPerla: Thank you so much for having me here and thank you for asking that question. For institutional investors, and when we talk about institutional investors, think of pension funds, insurance, and mutual funds. There’s an increased number of investors who see climate change as an economically significant event, not just in the long term, but affecting portfolio performance now.
We see this happening slightly differently in two different regions. So in Europe and the U.S. -- Europe being much more of a regulatory driven market and the U.S. really being market driven, so less regulation in that space. But what we're finding is there is a relationship between flows and the risk return profiles of the investments that they're investing in, which is traditional.
We see this in other factors as well. We had not yet seen it for low carbon strategies. So it's what's exciting about this space and what we see in the European space if we dive deeper. So this is a regulatory space. They have carbon pricing schemes that have gone on, really got serious in 2012 but before 2012. When you take a razor focus to France, they have legislation like Article 173 that really maps different frameworks.
This kind of patchwork of standardization of ESG really maps that guidance from the task force for climate related financial disclosure into that legislation. In that country, we saw one of the first sovereign green bonds demonstrating that this is really a systemic level and so a systems level approach to climate finance. So if we're thinking about how institutional investors are driving us, we're seeing a lot of movement and a lot in these different regions.
Schreane: That's right. You talk about what Europe is doing and the regulation that we're seeing there versus the U.S., not as much regulation. One thing I think that I love to talk about, one way Europe is responding to climate change specifically is by instituting a pricing system for carbon emissions. So could you tell us more about that system and how businesses are impacted? And also, what does it look like for America? Could that possibly be the case here? I've heard rumblings about establishing some sort of pricing system. So do you see that coming about soon?
LaPerla: In Europe, they start at the pricing, so it's the EU ETF. So emissions trading system and they started it before 2012. The reason why 2012 we see an inflection point in our research is because that's the Kyoto Protocol. So there was a global agreement to start to lower emissions and that's when those kind of deliverables really started to come to fruition for Europe.
And that's when we see an uptick in these low carbon strategies in Europe, but also in inflows for the U.S. The EU has this system to work together and a group of democracies working together in that space. In the U.S., we do have some states that have carbon pricing. I don't know how much I can predict it being at a federal level. That being said, there's new legislation coming from the House Financial Services Committee on ESG. So that's H.R. 4329, which just came out September 13th. So this might be a change, we can't yet say. It’ll be interesting to see what comes.
Schreane: Absolutely. Sounds great. You talked a bit about the legislation requiring public companies to disclose ESG metrics and possibly the impact that could have in terms of what's going on with the House Financial Services Committee. So I guess stay tuned on that front.
LaPerla: Yes, very much so. Oh, and one other thing I wanted to add.
Our CEO, Ron O’Hanley, went to the Vatican this summer and there was a committee of financial institutions and also a group of financial institutions, as well as oil and gas companies that signed an agreement saying that this is something that they think could help the economy. And when you were asking about what this means for companies, having a price on carbon when carbon is something that's material to your operations really provides clarity on these economic externalities and how that's actually hitting your impact. It's quantifying it and it's putting it on your balance sheet. So that's from a company perspective, it's quite real and from an investor perspective it only kind of helps clarify this integration of environmental metrics into valuations.
Schreane: So how how does that work? So it's been implemented in Europe and we're beginning to see, OK, once this is implemented, we see this as a result. What's been the result? Have companies voluntarily pushed back in some way? Do we see this moving in a positive direction? So if it does happen in the states or in any other region, what could they expect to see based on what we're seeing in Europe now?
LaPerla: This was the decarbonization factors paper that we just put out with collaboration with George Serafeim and my colleagues at State Street Associates, Alex Cheema-Fox, Stacie Wang and David Turkington. What we're finding is there's alpha to find in this space from an investor perspective. So we defined six decarbonization factors in the U.S. and Europe to really fine tune and hone in to your point, what are the impacts of carbon pricing? And really, this transition to a low carbon economy and what we find is that not only do the most aggressive decarbonization strategies produce the most alpha over time. And this is a 2009 to 2018 period. But that that's actually across both regions. And we actually find low correlation between the regions, which is to say there is a lot of differences. So this was one similarity that we actually found quite striking. So this is an opportunity for investors to get involved in and happy to extrapolate more about the relationship with flows into these factors and what insights we can pull from there.
Schreane: That's a great insight. Just lay out for us just to frame this. What was the objective of decarbonization factor? So what did you set out to prove? And then as you were saying. What did you prove? Even some things that you maybe didn't set out to prove, but you found what came from that paper.
LaPerla: We wanted to understand the relationship between a really fine tuned metric. So we didn't want to study ESG as kind of an aggregate, you know, an environmental, social and governance metrics all aggregated up at once and potentially getting a muddled signal. We wanted to get a clear signal on carbon intensity. So carbon emissions per million dollars of revenue.
We wanted to understand, how is this metric interfacing with other factors in the market with size, with investment, with momentum, with other traditional factors? And what we found was a lot. We found a lot more than we went looking for. We found that timing matters around this. This is not static.
So the performance of low carbon strategies changes over time. We saw an uptick in returns after 2012 for both regions. But for the U.S., we saw outflows for investors after 2016. So there seemed to have been an inflection point in the U.S. that we didn't see in Europe.
The other thing that was interesting to us - the timing matters. I had mentioned how you decarbonize matters, those least restrictive, most aggressive, low carbon strategies, picking the best firms across the market produced the strongest alpha over time.
Decarbonization matters, regionality matters. So your exposure to these two regions matters. And that speaks to the inflows and the risk return profile in both. Not that you're sacrificing, but that it's much stronger in Europe, both with the inflows and the alpha. So timing, decarbonization, flows matter and the regional exposure itself. And so we found a lot and we studied this with flows that were at the same times as these trades were happening, and so we want to tweak it for more of a lead lag relationship to identify predictive measures.
Schreane: So you mentioned an inflection point at 2016. I'm curious what was going on then to cause this inflection point?
LaPerla: So this is very much data driven research. I am not a policy expert for this space. But I will say what happened in the U.S. was there was a big change in administration and that it was interesting that we did not see that impact really -- the European strategies.
But three or four of our strategies in the U.S. saw a stark outflow of institutional money, which is to say that investors were less confident in the risk return profile and in the fundamentals around low carbon strategies after the change of administration. We've seen since then a rollback of EPA regulations and and confusing messages from the S.E.C. around fiduciary duty and incorporating ESG metrics. So investors are cognizant of what's going on in their region and investing accordingly.
Schreane: I'm wondering too noting you're not a policy expert in that way. Do you see Brexit as maybe having the same sort of impact, just considering where things are now versus where things were when you began the paper, perhaps?
LaPerla: I think that's a really great point. I will say there is such a trend in Europe and there are so many other large institutions at play.
I cannot have clarity on that impact, if that will be outflows in Europe, even subtle and a subtle inflection point. And when that will happen, as none of us have entire clarity on when exactly this is happening. But it could be another inflection point. And it goes to where studying Europe as a whole and not just England and that space.
Schreane: So I want to dive into some figures from your paper and some of these figures were quite alarming, to be frank. In your paper, you say that we're seeing an average sea level rise of over 2.6 inches with the rate of annual increases accelerating. So we don't see that slowing down and particularly startling given about 3 billion people or 40 percent of the world's population live within 200 kilometers of a coastline, with that number increasing, given urbanization trends.
We also see from the paper that the U.N. has already linked climate change to increasing land degradation and desertification to rising hunger exemplified by severe water shortages in major metropolitan areas like Cape Town. Alarming and sobering. I want to just talk a bit about the faces, the reality behind these numbers and behind the paper. Does the paper lead us to any sort of clarity in terms of how we see the structure changing, how we see these big metropolitan areas changing, or just how humans will be impacted by these events?
LaPerla: So I'm really glad that you brought up these, to your point, really startling figures. I'm excited about this research that we're doing because it engages investors who were previously potentially scared about sacrificing alpha to be in this space, to leverage capital markets, to make progress and basically hope to hold off some of this inclement weather and desertification and rising sea levels that we're seeing.
I think in terms of empowering the market, I think that having more research and being that it's moving to this more quantitative space leading to easier integration into investment processes, I think that that's exciting. And I do think that the uptick in investor interest has continued to increase. And to be honest, while I talk about outflows and 2016 in the U.S., the U.S. is still seeing a trend up. And so while it's slightly less strong in the U.S., in Europe, it's still quite persistent. And it's why we're encouraged to continue to do research in this space.
Schreane: So what is the boldest correlation that you feel this paper makes, for example? Are you saying that the paper makes it clear that climate change directly impacts what investors are expecting from their portfolios? What bold declarations can we say that this paper makes in terms of alpha and in terms of the relationship between alpha and climate change?
LaPerla: Investors need to pay attention to carbon in their strategies. It can drive alpha. Investors are looking for it. They need it. Previously this was a risk conversation and now we're having an alpha conversation. So you're leaving it on the floor. If you're not looking at this. Also in terms of the actual environment that you're working with and in the regulatory environment that you're working with, investors are not only concerned about the physical risks and the alpha that they're potentially losing, but also the regulatory risks in the space. There's a growing uptick in regulation and transparency in Europe around ESG metrics and integration.
It's a trend that we anticipate will continue at different speeds globally.
Schreane: So in terms of moving forward, we see this is not slowing down.
LaPerla: Carbon is definitely something you need to consider for your strategies.
Schreane: I want to talk a bit about the bridge between financial services and academia, as we mentioned earlier. You support the board for Columbia University. And do you see these types of partnerships between financial services are big corporations in general and academia? Do you see these evolving in terms of how it can add to the narrative and the conversation around sustainable investing and how so?
LaPerla: Yeah, I think it's really exciting when you when you think of universities, it's really their members, right? So kind of like a pension fund. A university has an endowment and they want to represent their members and kind of the thoughts and sentiments of those members. So there's definitely a trend with universities to take ESG metrics into consideration for managing their endowments.
This is very encouraging that they're thoughtfully assessing their strategies rather than oftentimes it's sent to them. You know, management team and kind of out of sight, out of mind. And so I think it's really encouraging. It's a continued trend in terms of conversations that I've been having over my years in this space. You've got these institutions and universities, but also nonprofits that, again, want to align their investments with their constituency and their missions.
Schreane: Last question, what is the big idea? What do you see in terms of trends, in terms of these types of partnerships are just overall, in terms of where we can find alpha as related to the changes in the climate. What do you see as the big idea that's going to really take us by surprise in the future?
LaPerla: Well, one thing that won't take people by surprise, but is a huge idea that investors have really grasped onto is materiality is important. And it's not going anywhere. Materiality is the concept that not every E S and G metric is created equal and different ESG metrics are important for different industries and firms.
What's exciting about this and what I think is what we're speaking to for what's up next is diving deeper rather than having things aggregated at an ESG rating at the top, what's kind of the big ideas to dive deeper and really scope research so that we understand and can quantify the relationship for an ESG factor, an E factor an S factor, a G factor, with other factors in the market. And so that allows us to identify and let us really create bespoke strategies to drive alpha for different portfolio managers and investors in the space.
Schreane: So quantifying the relationships between environmental, social and governance with other factors to drive the alpha -- great big idea. Bridget, thank you so much for joining us.