Looking back on Climate Week 2020, a key theme emerged: investors and other stakeholders have coalesced around the notion that the pandemic of 2020 will have served as a ‘test-case’ for the eventual challenges of climate change. Toward this end, the current global crisis has driven home an understanding that our individual and collective resilience, flexibility, and response frameworks will determine outcomes for years into the future. This reckoning with risk has in turn driven investor expectations of public companies to new heights: calls to address climate change are now commonplace across nearly every industry, voting decisions and investor-to-company dialogue are increasingly focused on this topic, and expectations of Boards continue to rise.
Why are investors feeling the heat?
Several dynamics – internal and external – are accelerating investors’ interest in climate change. For active managers, a growing body of research[1] and internal analysis[2] supports fund managers’ conclusions that ‘alpha’ can be found through investing in companies that best mitigate climate-related risks and capitalize on climate-related opportunities. For both active and passive managers, climate change poses systemic risks to the broader financial market, threatening the long-term viability of capital markets and their portfolios. As a result, we are seeing investors (a) continue to add ESG talent, (b) integrate climate risk variables into their investment process, and (c) engage with academics and climate research institutes[3] to further their understanding of idiosyncratic and systemic risks. They’re also addressing these risks by rolling up their sleeves in greater numbers than ever before, joining task forces such as Climate Action 100+ and the “Test of Corporate Purpose” initiative.[4]
Investors are likewise under increasing external pressure to take greater action on climate change. From a business perspective, investors are tuning in to expectations that fund flows will continue to favor ESG products[5] with projections broadly calling for ESG-mandated assets to comprise half of all managed assets in the U.S. by 2025. Investors are also keenly attuned to the regulatory prospect that potential Democratic Party victories in November could lead to a ‘greening’ of the financial sector, similar to that occurring in Europe; a recent report from the U.S. Commodity Futures Trading Commission concluded that climate change poses a major risk to the stability of the U.S. financial system.[6] Moreover, growing criticism from non-governmental organizations – and public opinion – has targeted the financial sector, and equity investors in particular, for not doing enough to address the climate crisis. A recent report from Majority Action, in which asset managers such as BlackRock and Vanguard are ‘named & shamed’ for failing to support most climate-related shareholder proposals, is indicative of the news headlines that asset managers now have to explain to their own clients, employees, and other stakeholders. As these outside pressures compound, so too will the pressure that investors exert on portfolio companies.
How are Investors Responding?
Compelled by this confluence of internal and external forces, investors are ‘raising the bar’ on public companies, in four key areas:
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Disclosure – TCFD and SASB have become table stakes. BlackRock’s January 2020 “CEO letter” unlocked the floodgates of support for SASB and TCFD reporting and has been followed by a significant uptick in investor support for these frameworks – including from hundreds of the world’s largest institutional investors.[7] We see the strong investor alignment behind TCFD and SASB standards as a disclosure ‘floor,’ and there has been a sharp increase in the count of companies aligning their climate reporting to these two frameworks. During Climate Week, the World Economic Forum and Big 4 accounting firms unveiled a new set of ESG metrics and disclosures, offering what seems to be yet another set of disclosure options. Rather than create further diffusion of investor focus, however, we expect that this initiative will drive continued momentum for these frameworks, as the WEF-supported framework is largely an aggregation of existing disclosure frameworks – primarily, SASB, TCFD, and the Global Reporting Initiative (GRI).
Critically, we see heightened risks for companies that fail to disclose relevant climate information that conveys their climate strategy on their terms. Using scenario analysis[8] as an example, investors are building their own scenario analysis engines (using tools such as Paris Agreement Capital Transition Assessment and Transition Pathway Initiative) and relying on third-party reports (such as Carbon Tracker’s “stranded asset” analyses). These analyses may have different assumptions and are modeled without the non-public information embedded in a particular company’s projections. As a result, the obvious risk is that investors derive significantly different outputs than the companies’ own.
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Accountability – through targets and execution. Over the past year, demands for companies to set emissions reductions targets aligned with the goals of the Paris Agreement have grown rapidly and, in many cases, now receive a majority of investor backing. Climate Action 100+, which has sought these types of targets for several years, received a significant boost when BlackRock joined the initiative in January. In the spring, Vanguard also began encouraging companies to set targets aligned with the Paris goals, and began supporting some related shareholder proposals. Likewise, the two largest proxy advisors, ISS and Glass Lewis, continued to recommend that investors vote in favor of proposals seeking Paris-aligned goals.[9] Fueled by this momentum, proposals seeking emissions reduction targets passed at three different companies during the 2020 proxy season, a swift uptick from the 2019 tally of zero. We expect this trend to continue in 2021.
Companies have responded: heading into 2020, approximately one-quarter of the Fortune Global 500 had made a public commitment to be carbon neutral, use 100% renewable power, or meet a Science-Based emission reduction target (SBT) by 2030,[10] and Climate Week saw big corporate pledges from the likes of Walmart, General Mills, PepsiCo, and AT&T. One repeated theme from Climate Week, however, was that investor attention is now equally focused on whether and how companies are executing on these targets. And as investors demand accountability for these plans, objectives viewed in prior years as climate-friendly may confront shifting attitudes,[11] as more scrutiny and skepticism is applied to reviewing these plans. For example, Climate Action 100+ recently sent a letter to the Chair and CEO of its “focus companies” announcing its development of a new “Net-Zero Company Benchmark” designed to evaluate company action, and not just ambition, in tackling climate change.
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Lobbying – and corporate intentions – in the spotlight. In light of the upcoming U.S. election, one of the hottest topics during Climate Week was the role of corporate lobbying practices in influencing climate-related regulation. Pointing to the recent Senate Democrats’ report on climate action and its discussion of ‘dark money’,[12] numerous institutional investors took the position that companies’ public positioning on climate change often does not match their political strategies, particularly as executed through trade associations, and that greater investor action was needed. This concern is indicative of a broader trend, as investors seek more transparency on whether, and how, companies’ political activities align with the Paris Agreement’s goals. Several investors have recently shifted their voting policies to enable support for shareholder proposals seeking greater disclosure here, and the proxy advisors ISS and Glass Lewis typically supported these proposals in 2020 (even at companies whose political activity disclosure was ranked higher than peers). As a result, average support for these proposals continued to grow in 2020, including one proposal on climate lobbying that received majority support. More broadly, investor groups such as Climate Action 100+ have made Paris-aligned lobbying a central part of their engagement agenda, a sign that this issue will continue to lead the discussion.
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Growing attention to the “G” of the “E.” Investors are increasingly seeing prudent climate risk oversight as inextricably linked to good governance and management accountability:
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Board-driven oversight: The role of the board of directors in overseeing climate-related risks and opportunities is increasingly in focus. Passive asset managers and other governance-minded investors have long sought to engage directly with independent directors to understand how they oversee climate and other ESG risks. Now, fundamental active managers (such as Wellington Management Company) are asking to engage more often with independent directors to assess a board’s effectiveness and, in certain instances, challenge their approach. As part of this inquiry, significant attention is generally devoted to the board’s ‘climate competency.’[13] Companies – and their directors — should expect to receive more investor questions on this subject in the coming months and years.
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Climate-linked executive compensation. Today, less than 10% of U.S. companies include transparent ESG targets in their executive pay structure.[14] However, investor pressure at companies such as BP, Shell, and Chevron has led to portions of pay being tied directly to emissions reductions, and we anticipate that this trend will gain momentum – particularly in sectors such as energy, materials, and utilities. By proactively addressing this issue before investor scrutiny reaches a crescendo, companies have an opportunity to demonstrate their thoughtfulness on the issue.
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The increased attention to the COVID-19 crisis has not diminished investor attention to climate issues; in fact, in many ways the pandemic has provided a real-time translation of ESG ideas into ESG actions. While many companies may have only released their climate reports in recent weeks, planning to address these rising investor expectations should begin immediately – and, given the rising bar, quickly become a continuous Board and management oversight process.
[1] For example, Serafeim, Khan & Yoon, “Corporate Sustainability: First Evidence of Materiality”, and Balvers, Du & Zhao, “Temperature Shocks and the Cost of Equity Capital: Implications for Climate Change Perceptions”.
[2] For example, BlackRock, “Adapting Portfolios to Climate Change,” Wellington, “Physical Risks of Climate Change (P-ROCC)” and T. Rowe Price, “Rising Climate Change Risk Not Yet Factored in by Markets”.
[3] For example, BlackRock’s partnership with the Rhodium Group, and Wellington’s partnership with the Woods Hole Research Center.
[4] Climate Action 100+ counts the backing of over 360 investors with more than $34 trillion in assets under management (AUM). The TCP initiative includes representatives from M&G, Wells Fargo, LGIM, General Pension Investment Plan of Japan (GPIF), Calvert, Liberty Mutual, Neuberger Berman and other large investors.
[5] CNBC, “Money Moving into Environmental Funds Shatters Previous Record,” Deloitte, “Advancing Environmental, Social, and Governance Investing,” US SIF, “Report on US Sustainable, Responsible and Impact Investing Trends”.
[6] CFTC, “Managing Climate Risk in the U.S. Financial System.” Among the other conclusions of the report, which was a first-of-its-kind from a U.S. regulator, were that U.S. financial regulators should move urgently and decisively to measure, understand, and address these risks, and that existing statutes already provide U.S. financial regulators with wide-ranging and flexible authorities that could be used to start addressing financial climate-related risk now. The sub-committee responsible for the report included such large investors as Vanguard, Wellington Management, JP Morgan, Morgan Stanley, Citi, Allianz, and BNP Paribas.
[7] The Investor Advisory Group for SASB has grown to more than 50 institutional members with over US$41 trillion in assets under management (AUM), and a combined 477 investors representing over $34 trillion in AUM signed a public letter last year calling upon G20 leaders to support the TCFD recommendations.
[8] Scenario analysis applies probabilities to different possible outcomes and decision trees. In the context of climate change, an investor may wish to know the expected value of an asset or portfolio assuming a 1.5°C, 2.0°C, 2.5°C, or 3.0°C rise in average global temperatures by 2050.
[9] While the policies of ISS and Glass Lewis indicate that each advisor considers these proposals on a case-by-case basis, on a practical level they each recommend that shareholders vote in favor of these proposals more often than not.
[10] Nature Capital Partners, “Deeds Not Words”.
[11] For example, the advocacy group As You Sow, a frequent proponent of shareholder proposals, has been leading a campaign against natural gas, viewed by many for years as a necessary ‘transition fuel’ throughout the low-carbon transition.
[12] Senate Democrats’ Special Committee on the Climate Crisis, “The Case for Climate Action: Building a Clean Economy for the American People,” August 2020.
[13] As Vanguard described in its June white paper, it expects boards to appoint directors with relevant experience, seek diverse perspectives , and participate in ongoing climate education.
[14] Sustainalytics, “The state of pay: executive remuneration & ESG metrics”.
