Climate change

The investment
perspective
 Climate-related risks
are too far-reaching for
financial institutions to
avoid entirely. They will
impact all sectors, and
require tangible actions
to address these issues.

Contents

Executive summary 1
The complex financial impact of climate risks 2
How did we get here — and what comes next? 4
Climate and the investment value chain 8
Challenges and responses:
Asset owners 11
Asset managers 13
Consultants, advisors and ratings agencies 14
Banks 15
Conclusion 16
Executive summary

The risks posed by “stranded assets” — assets that unexpectedly lose

value as a result of climate change — are rapidly climbing the
investment industry’s agenda.

The 21st annual Conference of the Parties (COP 21), Despite these obstacles, financial institutions are taking
held in Paris during December 2015 and ratified in early tangible actions to address climate-related challenges.
October 2016 by 74 signatories, has propelled global This not only allows them to begin identifying risks and
warming toward the top of the financial services agenda. opportunities. It also shows that external stakeholders
Even so, the sheer scale of the issue makes it a such as regulators, individual investors and the media are
challenging one for many institutions. playing an active role in the energy transition.
Stranding may have grabbed the headlines, but it is The report will address a number of specific steps that asset
arguably the tip of an iceberg. If commitments to limit owners, asset managers, banks and other players, such as
global warming to 2°C are to be fulfilled, then the coming consultants and advisors should consider taking. These vary
decades will see a worldwide “energy transition” with vast between institutions, but consistent themes include:
financial implications. Financial institutions face many
interrelated and highly complex climate-related risks. On • Developing investment beliefs
the upside, research suggests that investment opportunities • Strengthening governance and risk management
arising from the energy transition will actually outweigh • Working with clients to develop investment strategies
climate-related risks in the long term. • Engaging with other financial institutions and
The scale of these issues calls for an urgent response across nonfinancial companies
the investment value chain. Individual firms also have a Above all, it is vital for financial institutions to understand
fiduciary duty to address climate-related opportunities to that addressing stranding risks and other financial risks
enhance value of the investment. Indeed, climate-related and opportunities of climate change is not a one-off
risks are too far-reaching for financial institutions as the process. It needs to become a permanent part of
possible value creation or erosion can be significant. They everyday decision-making.
will impact all sectors, including extraction industries
(mining and energy), manufacturing, and carbon sinks* Addressing climate change requires collective action
such as forestry. A dearth of consistent, reliable data and and collaboration across the investment value chain.
an absence of credible analytical models also mean that But individual institutions bear ultimate responsibility for
investment professionals trying to address climate change managing climate-related risks and opportunities on behalf
are largely working in the dark. of their clients and their own shareholders. Those that
respond proactively will create value for their clients, give
themselves a competitive advantage, reduce systemic
financial risks and make an invaluable contribution to
society as a whole. However, those who fail to take action
will soon experience the implications across the whole
investment value chain, resulting in significant costs
and damage to economies.

1
* A carbon sink is a forest, ocean, or other natural environment viewed in terms of its ability to absorb carbon dioxide from the atmosphere.
The complex financial impact of
climate risks

The Paris Agreement of December 2015, ratified in early This simplified list is only a starting point for assessing
October 2016, provides a milestone achievement in a series climate-related risks. Scientists expect many physical
of events, speeches and reports that have propelled the effects of climate change — such as polar melting — to be
issue of climate change to prominence over the past self-reinforcing. Different types of these risks can interact
two years. with each other in complex ways, for example when physical
effects lead to migration, causing economic instability or
The potential financial consequences of climate risk are
underinvestment, all contributing to the stranding of the
often debated in terms of “stranded assets.” The value of
core asset. Other external factors also have huge potential
global financial assets at risk from climate change has been
to complicate or enhance climate-related risks. These
estimated at US$2.5t by the London School of Economics,1
factors include oil, gas, coal and energy prices, the potential
and US$4.2t by the Economist.2 For comparison, the annual
for emerging renewable technologies to render existing
Gross Domestic Product (GDP) of Japan, the world’s third
infrastructure uneconomical, and the views of consumers,
largest economy, is worth about US$4.8t.
lobbyists and nongovernmental organizations.
The staggering scale of these potential losses has done a lot
As complex as climate risks may be, they only represent
to raise awareness of climate risks in investment circles. But
half the story. Global GDP is expected to triple by 2060,
“stranding” is only part of a complex range of climate risks —
driven largely by developing markets.3 Yet, today, 1.3 billion
each of which creates its own opportunities. Climate risks people in those markets still have no reliable access to
can be summarized as: electricity.4 Delivering the power that global development
• Physical: damage to land, buildings, stock or will require represents a vast investment opportunity.
infrastructure owing to physical effects of climate-related Research suggests that the economic benefits of
factors, such as heat waves, drought, sea levels, ocean investment will outweigh the costs of inaction. Studies
acidification, storms or flooding by both the London School of Economics and Economist
• Secondary: knock-on effects of physical risks, such as (referenced earlier) expect total global output to be higher
falling crop yields, resource shortages, supply chain under a lower emissions scenario; Citigroup expects
disruption, as well as migration, political instability investment in climate change mitigation to generate
or conflict attractive and growing yields;5 and Mercer believes a 2°C
scenario will not harm diversified returns to 2050, and
• Policy: financial impairment arising from local, national would be accretive thereafter.6
or international policy responses to climate change,
such as carbon pricing or levies, emission caps or Of course, the precise balance of investment risks and
subsidy withdrawal opportunities will depend on future climate scenarios, and
• Liability: financial liabilities, including insurance claims what investment decisions will be made — whether through
and legal damages, arising under the law of contract, conventional means, e.g., coal-fired power stations, which
tort or negligence because of other climate-related risks add to global warming and climate change, or through
low carbon means to help mitigate the problem. But, in
• Transition: financial losses arising from disorderly or aggregate, the post-Paris “energy transition” should
volatile adjustments to the value of listed and unlisted not present fears for well-prepared investors.
securities, assets and liabilities in response to other
climate-related risks
• Reputational: risks affecting businesses engaging in,
or connected with, activities that some stakeholders
consider to be inconsistent with addressing 1.3 billion people
climate change
in the developing markets still
have no reliable access to
electricity.

2
1. Dietz, Bowen, Dixon & Gradwell, Climate value at risk of global financial assets, Nature Climate Change, April 2016
2. “The cost of inaction”, Economist Intelligence Unit, July 2015, © 2015 The Economist Intelligence Unit Limited
3. “GDP long-term forecast (indicator). doi: 10.1787/d927bc18-en”, OECD, (Accessed on 19 July 2016)
4. “World Energy Investment Outlook”, International Energy Agency, June 2014, © 2014 OECD/IEA
Climate change scenarios

Climate change scenarios are used by public and private sector bodies as a basis for policy decisions and economic
planning. Financial institutions can develop their own scenarios, but many will find it easier to adapt those used by
expert bodies, such as the Intergovernmental Panel on Climate Change (IPCC). Climate change scenarios are often
described in terms of post-industrial temperature rises (e.g. “a 2°C scenario” or “a 4°C scenario”), but are properly
defined by both probabilities and temperatures. For example, the IPCC’s Representative Concentration Pathway 2.6
(RCP 2.6) offers a 50% chance of limiting global warming to 2°C.

The IPCC’s latest scenarios are:

• RCP 2.6 — a “severe mitigation” scenario where significant efforts are made to transition from fossil fuels to
alternative energy sources and to try to limit post-industrial global warming to 2°C.
• RCP 4.5 — an intermediate scenario with material efforts to reduce emissions.
• RCP 6 — a higher greenhouse gas emission version of the intermediate scenario.
• RCP 8.5 — a high greenhouse gas emissions (or “inaction”) scenario with no additional effort to limit emissions.

Each scenario makes assumptions about the levels of greenhouse gas emissions and the capture mechanisms
required to achieve it. Understanding and questioning those assumptions is crucial to gaining valuable insights from
scenario planning.
Source: Pachuari, Meyer, “Climate Change 2014: Synthesis Report – Summary for Policymakers”, Intergovernmental
Panel on Climate Change, 2014, © 2014 IPCC

3
5. Channell, Curmi, Nguyen, Prior, Syme, Jansen, Rahbari, Morse, Kleinman, Kruger, “Energy Darwinism II”, Citi, August 2015, © 2015
Citigroup5“World Energy Investment Outlook”, International Energy Agency, June 2014, © 2014 OECD/IEA
6. “Investing in a time of climate change”, Mercer, April 2015 © 2015 Mercer LLC/International Finance Corporation/UK Department for
International Development
 How did we get here, and what
comes next?

Sustainability campaigners have tried for years to use Reporting Council (IIRC) and the World Bank’s Carbon
the financial industry as a lever for environmental action. Pricing Leadership Coalition (CPLC). Approximately 90%
However, direct activism has often been counter-productive of FTSE 100 and 80% of Fortune Global 500 companies
and deterred financial institutions from engaging with participate in at least one of these schemes.1
climate-related issues.
At the same time, institutional investors such as pension
In contrast, research-led campaigns — such as Carbon funds and insurers have made commitments to improve the
Tracker’s influential Unburnable Carbon reports — have disclosure of the carbon footprints of their investments. For
done much more to raise awareness of stranding risks and example, 2014 saw the Montreal Carbon Pledge signed by
spark debate over other climate-related factors. Figure 1 92 institutions managing US$6t in assets, and the Global
from the Carbon Tracker Initiative reflects the surplus of Investor Statement on Climate Change signed by 347
oil and coal that exists that would not be useable in a 2°C institutions managing US$24t. The Carbon Disclosure
scenario. This awareness has led to the development Project (CDP) has also been a key contributor in this
of more than 400 national and international corporate area, not just for carbon.
disclosure schemes, such as the International Integrated

Figure 1: Carbon dioxide emissions potential of listed fossil fuel reserves

The below graph shows the relative 2 degree carbon budget against listed fossil fuel reserves. It demonstrates the large
disconnect between what is being invested and what the Paris Agreement will allow.
800
Gas
37.34
GtCO² (cumulative carbon budget)

600
565
Oil
319.13
2°C
Remaining
global carbon
budget
400

Coal
200 389.19
2ºC

149 Listed
carbon
budget

Source: Unburnable Carbon Report, Carbon Tracker Initiative

4
1. Mark Carney, “Breaking the Tragedy of the Horizon – climate change and financial stability” speech given at Lloyd’s of London,
29 September 2015
 Timeline on climate action
1987–2016
1987

The World Commission on Environment and

Development issues the report Our Common
Future with the most commonly accepted definition
of sustainability as: “Sustainable development is 1990
development that meets the needs of the present
without compromising the ability of future UN General Assembly negotiations on a
generations to meet their own needs.” Framework Convention begin in December. The
Intergovernmental Negotiating Committee (INC)
1991 held five sessions, where more than 150 states
discussed binding commitments, targets and
The United Nations Framework Convention on timetables for emissions reductions, financial
Climate Change (UNFCCC) opens for signature at mechanisms, technology transfer, and “common
Rio Earth Summit in June, bringing the world but differentiated” responsibilities of developed
together to curb greenhouse gas emissions and and developing countries.
adapt to climate change. 1997

Kyoto Protocol is adopted in December 1992,

establishing for the first time in history global
commitments to reducing carbon emissions
2001 and to fight climate change.
The seventh Conference of the Parties (COP7),
held in Marrakesh in November 2001, formalized
the agreement on operational rules for
International Emissions Trading Association (IETA), 2002
the Clean Development Mechanism (CDM) and
Joint Implementation (JI) along with a compliance The Global Reporting Initiative (GRI) and the
regime and accounting procedures. Extractive Industry Transparency Initiative
(EITI) are launched, increasing corporate
2005 transparency, allowing stakeholders to hold them
accountable for their contributions to sustainable
The UN-backed Principles for Responsible development.
Investment (PRI) are launched, a catalyst for
financial markets to adopt responsible investment
approaches. 2005

EU Emissions Trading launches in January 2005 —

the first and largest emissions trading scheme in
the world, launches as a major pillar of EU climate
2006 policy. Installations regulated by the scheme are
collectively responsible for close to half of the EU’s
The Stern Review concludes that climate change emissions of CO2.
damages global GDP by up to 20% if left unchecked,
and climate change emerges on the global business
agenda. 2010

The Cancun Agreements establishes the Green

Climate Fund in December 2010.
2014

The European Union issues a new directive on

nonfinancial reporting, requiring all large public
interest entities with more than 500 employees to
report on policies, risks and outcomes related to 2014
environmental, social and governance (ESG)
matters. The Intergovernmental Panel on Climate Change
(IPCC) releases the synthesis report of its fifth
assessment report, which underlines the urgency
2015 of climate action in March 2014.
In December 2015, the 21st Conference of the
Parties (COP21) convenes countries and forms an
agreement to limit temperature rise to two degrees.
This may mean that far-reaching measures must be 2016
taken, such as limiting fossil fuel extraction,
implementing carbon pricing mechanisms on a In October 2016, the landmark Paris Agreement,
global level, and company disclosure on emissions requiring 55 countries representing 55% of global
intensity of asset portfolios. emissions of greenhouse gases, is ratified after 10
more countries formally endorse the deal.

5
The volume of financial debate on climate change increased Financial institutions are also increasingly aware of
significantly in 2015. In May, France introduced Article 173 international efforts to honor the Paris Agreement’s third
of a new law on energy transition, requiring institutional objective: making “finance flows consistent with a pathway
investors to disclose how they manage climate risks. In towards lower greenhouse gas emissions and climate-
June, a UN report on responsible investing stated that resilient development.” In particular, the Financial Stability
pension funds in the developed world have an obligatory Board’s Taskforce on Climate-Related Financial Disclosure
duty to consider sustainability as part of their fiduciary (TCFD) aims to facilitate this “energy transition” by
responsibilities.1 In September, Bank of England Governor improving global transparency over climate-related
Mark Carney explicitly linked climate change to financial reporting. The TCFD’s final report, due in February 2017,
stability in a major speech.2 The year also saw a range of will intend to suggest historic and forward-looking
eye-catching commercial research findings focused on quantitative and qualitative disclosures, as well as making
stranded assets: recommendations for securities issuers, listed companies
and financial institutions.
• Standard & Poor’s stated that climate risks influenced its
downgrade of Volkswagen and could affect 299 other Furthermore, financial institutions are realizing that the
ratings3 transition to a lower-carbon future, including understanding
• HSBC calculated that fossil fuel equities could fall by which assets are likely to become stranded, will also create
40-60% in a low emissions scenario4 investment opportunities. The potential upside of the
energy transition has received relatively little attention
• Barclays predicted that Germany’s coal generation assets
to date, but that is changing fast. One example of this is
could be effectively worthless by 20305
contained in the G20 Green Finance Synthesis Report,
In retrospect, it seems clear that Mark Carney’s Tragedy of which highlights the voluntary options that could enhance
the Horizon speech and the landmark Paris Agreement the ability of the financial system to mobilize private capital
represent a major turning point in the climate debate. for green investment.6 The rest of this paper considers what
Institutional investors can be in no doubt of the potential actions different financial institutions can take to mitigate
for climate risks to lead to financial ones. climate risks and maximize the related opportunities.

Diane Larsen, Assurance Partner, Ernst &

Young LLP, in our Americas’ practice is
the EY representative on the Taskforce
on Climate-related Financial Disclosures
(TCFD). EY is one of the four project
managers on the task force providing
recommendations across sectors on how
companies can identify, manage and
evaluate climate change risks and
opportunities.

6
1. “Sustainability is not only important to upholding fiduciary duty, it is obligatory”, UNPRI, June 2015
2. Ibid
3. “VW downgrade underlines climate change role on ratings, S&P says” Bloomberg News, 23 October 2015
 7
4. Paun, Knight, Chan, “Stranded assets: What next?” HSBC Global Research, 16 April 2015, © 2015 HSBC Bank plc
5. “Barclays: German coal ‘worthless’ by 2030”, cleanenergywire.org, 18 March 2016
6. “What is the G20 Green Finance Synthesis Report, and why is it important?”, Responsible Investor, 7 September 2016
Climate and the investment
value chain
Investment decisions are already reflecting climate risks. As Julian Poulter of the Asset Owners Disclosure Project
This is illustrated by the US$20b decline in the market (AODP) describes it, “the scale and breadth of these
capitalization of Peabody Energy over the past few years, risks mean they simply cannot be avoided or diversified
a textbook example of stranding.1 away. They will impact all sectors and asset classes in
different ways.”
However, reducing exposure to coal or any other sectors
cannot protect investors from climate risks.

Which sectors will climate risks affect, and which assets will they leave stranded?

The short answer is that climate risks impact every sector.

It is simply not possible to say that any climate change
scenario is either “good” or “bad” for a specific industry.
US$20b
decline in the market
Every sector requires energy and has some carbon
capitalization of Peabody
exposure, including knowledge-based industries such as
energy over the past few
financial services, pharma or healthcare. Each company’s
years, a textbook example
exposure will depend on business models, strategies,
of stranding.1
locations, assets and liabilities.
• Coal mining and transportation
• Oil and gas
• Natural resource extraction
• Power generation and utilities
The scale and breadth of these
Other sectors that are heavy users of energy risks mean they simply cannot be
or particularly emission intensive are: avoided or diversified away. They
• Chemicals will impact all sectors and asset
• Steel classes in different ways.
• Industrial manufacturing
Julian Poulter, Asset Owners Disclosure
• Construction Project (AODP)
• Transportation
And there are sectors that act as “carbon sinks”, such as:
• Agribusiness
• Forestry
However, it is just as important to stress that individual
companies within all of these sectors could also offer
investment upsides. Looking forward, other established and
emerging sectors that could help to mitigate climate risks
might also include:
• Manufacturers and operators of renewable energy assets
• Energy efficiency technology
• Climate capture and storage
• Batteries and other forms of energy storage

8
1. “Collapsed Peabody is ghost of oil future”, Reuters Breaking Views, 13 April 2016, © 2016 Reuters
Nor are risks clear-cut, as illustrated by the complexity of Financial institutions are also working without robust
the “unburnable carbon” debate. Despite estimating that investment models. Macro-level Integrated Assessment
only 700-800b of the world’s 1.7t proven barrels of oil will Models (IAMs), such as the “social cost of carbon” (SC-CO₂)
be required under a 2°C scenario, the International Energy model used by the US EPA have serious limitations and do
Agency (IEA) still believes significant investment in oil not support individual investment decisions.
exploration and production is required. That reflects a
range of factors including oil prices, OPEC policy, geo- The problems of data and analysis will not be resolved
politics and the different costs of producing oil from sands, overnight. Furthermore, financial institutions need to
shale, onshore and deep water sources. respond to the actions of other players in the investment
value chain, not to mention the shifting agenda of
Unfortunately, it is difficult for financial institutions to stakeholders including governments, regulators, customers,
make precise judgements about climate risks — or related staff and the media (see figure 2). Even so, actors in the
investment opportunities. One major problem is the investment value chain need to address climate risks sooner
absence of sufficiently detailed, reliable and consistent rather than later. The sections that follow consider what
data. The TCFD is widely viewed as the most encouraging specific actions different players can take to try and
disclosure initiative to date, but it is far from an ideal optimize their own responses.
solution. In the opinion of Ben Caldecott, leader of the
University of Oxford’s Sustainable Finance Programme, “the
TCFD is a step in the right direction, but much greater detail
is required for meaningful analysis to be possible. Investors
need a scientific approach based on detailed emissions data
at individual asset level.”

Figure 2: The investment value chain

Government and regulators

Consultants
Asset Asset
Asset Owners Investee Physical
and rating
owners managers companies assets
agencies

Beneficiaries, employees, public, media and activists

The efficient movement of capital up and down the value chain depends on every player’s ability to provide the others with useful and accurate
information and guidance.

9
 There are steps that all
asset owners can take to
optimize their response
to climate-related issues.

10
1. “Tomorrow’s Investment Rules 2.0”, EY Climate Change and Sustainability Services, October 2015, © 2015 EYGM Limited
2. “Investor Expectations of Electric Utilities Companies – Looking down the line at carbon asset risk”, Institutional Investors’ Group on Climate
Change, April 2016 © 2016 IIGCC
3. “Green Bond Market Will Grow”, Bloomberg News, 26 January 2016
Challenges and responses:
Asset owners

Insurers, pension funds and other asset owners are Fortunately, there are steps that all asset owners can
increasingly keen to address the financial aspects of climate take to optimize their response to climate-related issues.
change. Institutions want to show regulators, their own “Insurers, pension funds and other institutions can ask
investors and the public that they can manage climate- themselves some key questions to assess their readiness,”
related risks and opportunities — just as they manage says Christina Larkin, Manager, Climate Change and
other investment variables. Sustainability Services practice, Ernst & Young LLP.
• EY’s 2015 survey of institutional investors shows that Are we prioritizing climate-related issues? Clear
36% of respondents divested assets during the previous leadership from the top of the organization is essential.
year in response to ESG factors, with a further 27% Asset owners need to show that they intend to take
planning to monitor this risk more closely in future.1 advantage of their unique influence to shape the financial
• AODP’s 2016 Global Climate 500 Index shows that 97 of debate over climate change.
the world’s 500 largest asset owners are taking tangible Have we set up a climate change governance framework?
action on climate risks, compared with 77 in 2015. A Developing investment beliefs or policies that reflect the
further 157 are taking initial steps to address climate- house view on ESG issues, such as climate change, is vital
related factors. to developing a coherent strategic response.
• Major institutions are beginning to publicize investment
decisions around climate risks, citing their fiduciary duty Are we translating investment beliefs into decisions
to address sustainability. In 2015, the Government about asset allocation or investment strategy? This
Pension Fund of Norway began screening for material could mean factoring climate-related risks and opportunities
coal exposures; the Rockefeller Foundation plans to into sector views, even if the impact is rarely clear-cut.
withdraw from fossil fuels; and Aviva, AXA and Aegon Asset owners might also review their balance between
are all looking to reduce their carbon exposure. passive assets and those actively managed with an eye
to climate-related risks and opportunities.
• Major asset owners are working collectively to
demand better climate-related disclosure from investee Are we engaging with prospective and current asset
companies. For example, a recent report by the European managers? Asset owners need to scrutinize managers’
Institutional Investors Group on Climate Change called for climate-related beliefs and procedures, their research and
investee companies to provide greater clarity over energy investment strategies, their skills, capabilities and access
consumption, “transition pathways” and the internal use to data, their top-down views of asset allocation, and their
of carbon pricing.2 approach to bottom-up stock picking. Asset owners may
• Institutional investors are increasingly willing to provide also find investment consultants and other advisors to be
direct finance for renewable assets, or to invest in green a useful source of guidance as they consider the risks and
bonds and other debt instruments backed by renewable opportunities of a range of asset classes and investment
energy revenues. Recent research by HSBC predicts that vehicles (see next page).
the global total of outstanding green bonds could be as Are we engaging directly with investee companies?
high as US$158b by the end of 2016.3 Asset owners have a fiduciary duty to consider ESG
Even so, many asset owners are only beginning to respond issues when evaluating long-term value drivers. Financial
to stranding and other risks. Many lack the in-house institutions can take direct action to ensure that companies
expertise to develop an informed view about climate change are addressing climate risks adequately. This can take place
scenarios. As one UK pension fund trustee put it “we just in private or, if required, by publicly challenging companies
don’t have the ability to critically evaluate the decisions of on their attitudes to climate change. Investor pressure for
asset managers in this area.” More broadly, asset owners more detailed climate-related disclosure was a notable
find it hard to incorporate climate risks into investment feature of two oil majors’ AGMs in May 2016,5 and EY’s
strategies while meeting their solvency and performance survey shows that 64% of investors believe corporations
benchmarks. EY’s survey shows that only 24% of are currently making ESG disclosures that are inadequate.6
institutions frequently factor ESG considerations
into their investment decisions.4

11
4. “Tomorrow’s Investment Rules 2.0”, EY Climate Change and Sustainability Services, October 2015, © 2015 EYGM Limited
5. “Exxon, Chevron shareholders narrowly reject climate change stress tests”, Wall Street Journal, 25 May 2016
6. “Tomorrow’s Investment Rules 2.0”, EY Climate Change and Sustainability Services, October 2015, © 2015 EYGM Limited
Asset classes and investment vehicles

A wide range of asset classes can expose financial institutions to climate-related risks and returns. Looking forward,
credit markets may offer the greatest potential for growth. Investor demand for yield is strong, and renewable energy
and energy efficient assets have the potential to generate stable cash flows to fund the costs of debt.

• Secured debt — Senior, secured debt offers low risks • Listed equities — Common equity exposes investors
and returns. Despite current low yields, secured debt to comparatively high risks and returns. The losses
is ideally suited to financing renewable energy or some investors have made on the equity of listed
other growing industries. However, low sovereign coal producers illustrate the potential downside, but
credit ratings make it hard for asset owners to find equity can also offer significant capital or yield upside
attractive opportunities in emerging markets. when issued by high growth companies.
• Subordinated bonds — Green bonds are an • Property and real estate — On one hand, existing real
increasingly popular vehicle for fixed income estate assets can be highly vulnerable to the physical
investors seeking an environmental return as well effects of climate change. On the other, one third of
as a financial one. Green bond markets have grown global greenhouse gas emissions are a result of
significantly in recent years, with a record US$41.8b energy use in construction, presenting large
issued in 2015. The scope for growth is enormous, opportunities for climate change mitigation.
given the potential for green bonds to finance • Asset-backed securities (ABS) — Securitization offers
the infrastructure, such as low carbon transport, growing scope for large asset owners to invest in
required to achieve an effective energy transition. small-scale assets, such as rooftop solar or wind.
• Project finance — Asset owners are increasingly Residential solar ABS has been issued in markets
willing to provide initial project finance for the including the US and China.
development or construction of real assets in areas,
such as solar power generation or windfarms.

12
Asset managers

The financial implications of climate change represent a 2. Communicate with asset owners. Asset managers need
major challenge for asset managers. Asset owners and, to understand investors’ qualitative and quantitative views
increasingly, regulators expect them to demonstrate and factor them into investment decisions. Firms also need
specific policies and processes to identify and mitigate to ensure that they are being as open as possible with asset
stranding risks. owners about their own governance arrangements, risk
management controls and investment processes, and
However, many are struggling to provide anything more
taking a flexible approach to environmental investments —
than general reassurances about existing risk management
as suggested in a recent report by Barclays.1
procedures. This is especially true for managers investing
in emerging markets. The problems of reliable data and 3. Explore “tilting” investment strategies. It is not
analysis also strike at the heart of asset managers’ business feasible to incorporate climate-related factors into entirely
models. Many are frustrated by the difficulty of obtaining passive strategies, but there are several possible quasi-
climate-related information from investee companies. passive approaches to follow. Mutual or exchange traded
Portfolio managers specializing in oil and gas, energy, funds can be set up to track low-carbon or ESG versions
mining or utilities often struggle to reconcile third party of major indices, such as S&P Dow Jones’ series of Carbon
academic and economic research with the plans and Efficient indices. Asset managers can tailor broad-based or
projections they receive from investee companies. multi-asset funds for major investors. Firms can also set up
retail impact funds incorporating environmental factors, as
The good news is that there is a major opportunity on BlackRock has done.
the other side of these challenges. Asset managers that
can limit climate-related losses and seize on investment 4. Establish active management and stewardship. As yet,
upsides have a chance to claim a valuable advantage in an there are no proven quantitative mechanisms for factoring
extremely competitive industry. The prospect of increasing climate-related factors into asset valuations. Active
scrutiny from consultants and other observers will only portfolio managers may be used to judging intangible
enhance the benefits for early adopters and champions factors, but many will find semi-quantitative screening a
in this space. useful starting point for traditional stock-picking. Active
asset managers also have a unique role to play as stewards
There is no such thing as a perfect climate strategy for of investee companies. This includes questioning them
asset managers, but there are a number of positive steps rigorously, voting on climate-related resolutions,
that asset managers can explore, if they have not done emphasizing the value that investors place on climate-
so already: related disclosure, and stressing the potential valuation
1. Adapt governance and culture to overall business upside from engaging with the issue.
strategy. Change existing governance and risk 5. Engage and collaborate with the industry. Engage
management frameworks to take account of climate-related with policymakers and regulators to ensure that incoming
risks and opportunities. The United Nations Environment disclosure schemes meet the requirements of investment
Programme’s Financial Institutions framework is one analysis. Talk to investment banks to understand current
example of best practice that firms can adopt. Developing and potential vehicles for investment in renewable energy,
a statement of investment principles or beliefs on climate carbon capture and other emerging technologies in both
change will help to prevent contradictory decisions and developed and emerging markets. Use industry bodies and
avoid any appearance of inconsistency — something asset other groupings to compare notes with peers and speak
owners are increasingly sensitive about. with one voice on climate-related issues. Consider the
creation of a shared industry database of asset-level
carbon risk data.

13
1. “Investing in the Environment”, Barclays, March 2016, © 2016 Barclays Bank PLC
Consultants, advisors and ratings
agencies

Investment consultants, ratings agencies and other advisors negatively impacting investment performance. Consultants
have a valuable opportunity to help asset owners navigate can also help investors to balance their portfolios — perhaps
their way through the uncharted waters of climate-related by offsetting a large slice of passive assets with smaller
investment. active mandates. Mid-tier institutions, such as local
authority pension funds are likely to be especially grateful
Investment consultants in particular can help to bridge
for guidance.
the gaps that can develop between investors and asset
managers. It is not unusual for climate-related factors As already mentioned, credit ratings agencies
to be overlooked, with asset owners assuming that asset are beginning to incorporate climate risks into their
managers are taking charge, while asset managers feel ratings methodologies. In time, there may be scope for
unable to take decisions without specific instructions. an incumbent or a new entrant to provide a ratings service
dedicated to ESG metrics including carbon emissions.
Investment consultants can help to ensure that asset
In the words of Herve Guez of Mirova, “an ESG equivalent
owners make their priorities clear through investment
of Moody’s, Fitch or S&P will take time to emerge, but
agreements or via statements of investment principles —
would create a huge amount of value across the
as institutions such as the UK Environment Agency Pension
investment universe.”
Fund have done. In doing so, they may need to convince
investors that they can tackle climate-related issues without

14
Banks

Banks, investment banks and broker-dealers play a wide Banks’ advisory activities as facilitators of investment
variety of roles within the investment value chain, both represent the second way they can respond to climate-
as providers of finance and as facilitators of investment. related issues. Sell-side research is one aspect of this,
and has a key role to play in shaping the debate on
Regulators, shareholders and activists, aware of this pivotal
environmental economics. Sell-side analysts hold
role, are encouraging the banking industry to address
companies to account by questioning and critiquing
climate-related risks and opportunities. Given their complex
companies’ performance and plans. Investment banks’
business models, it is particularly important for banks to
research teams are also the most likely source of credible
develop a consistent view on climate-related issues that can
valuation techniques for investors, asset managers and
serve as the basis for strategic and operational decisions
others to use. “I would love to see the sell-side suggest new
across a range of business units. As for asset owners and
valuation approaches that go beyond current models — for
asset managers, banks also need to incorporate climate
example, by setting out a way to value oil and gas majors
risks into their overall governance and risk management
during the energy transition,” says Mark Campanale of
frameworks.
Carbon Tracker Initiative.
The banking industry can respond to climate-related issues
Finally, the advisory businesses of corporate and
in two ways. The first is through their own balance sheets.
investment banks can help shape the finance industry’s
Many banks are taking steps to monitor their balance sheet
response to climate change. “Banks have a huge role in
exposure to stranding risks, often adapting frameworks
helping their clients to evolve,” explains a director from a
supplied by specialists, such as Carbon Tracker. For
major UK bank. “It is banks that can do more than any other
example, several Australian banks have publicly
institution to help large corporates adapt and move in new
documented their adoption of a top-down approach that
directions.” The banking industry has been instrumental in
combines internal sector exposure data with external
the development of green bond markets, and can help
emissions data to estimate the carbon intensity of their
develop new investment routes for a changing world. For
lending books. Even if this can only offer an approximate
example, financial vehicles that would allow institutions
measure of risk, it still provides a starting point for future
from developed markets to invest in emerging market
assessments of balance sheet exposure.
assets at investment grades could unlock a powerful new
Banks can also take climate-related factors into account wave in clean energy investment.
when making forward-looking lending decisions. This is
In short, there is a huge opportunity for the banking sector
particularly true given the long-term nature of many
to use its central role in modern financial systems to help
lending commitments and the consequent risk of exposure
other financial institutions create value as they transition
to unpredictable policy shifts. Like other financial
to a low carbon economy.
institutions, banks are limited in their ability to make
quantitative judgements about climate-related data.
However, that does not prevent them from developing a
lending strategy that combines their views on the energy
transition with other strategic considerations, such as
growth targets or geographic priorities. Banks can also
contribute to collective organizations, such as the 2°
Investing Initiative, exploring new tools for assessing
climate-related investments. At a micro level, banks also
need to ensure that they are taking note of specific risks to
assets or borrowers from local changes, such as energy
efficiency regulations.

15
Conclusion

The growing public debate over climate risks, particularly stranded

assets, means that financial institutions are increasingly aware of
the potentially vast scale of climate risks. Even though divesting
these risks entirely is impossible, many have already taken tangible
investment decisions in response.

Institutions such as insurers and pension funds are also Depending on their role within the investment value chain,
waking up to the opportunities arising from the transition to firms can take a number of tangible steps including:
a low carbon economy, and are working to improve the data
and expertise they can call on. Nonetheless, few financial • Developing a considered view of climate change and a set
institutions would claim that they have mastered climate- of related policies or goals
related issues, nor that they fully understand the systemic • Strengthening governance and risk management in line
risks they pose to the stability of the financial system. with best practice frameworks
Players throughout the investment value chain are
struggling to get to grips with this uniquely complex issue — • Adapting their business models to the changing demands
one made even more challenging by the unpredictability of of investors
future political and regulatory responses, and a lack of • Engaging with nonfinancial companies and other
reliable data. institutions in the investment value chain
There is much that financial institutions can do to address Financial institutions around the world have a unique
climate-related risks and opportunities. Collective action opportunity to shape the global transition to a low carbon
can be a powerful tool when facing such an intimidating economy. This will help their clients to optimize climate-
issue. The Portfolio Decarbonization Coalition — launched by related risks and opportunities. It will play an invaluable role
the United Nations Environment Programme (UNEP) and in reshaping the global economy. It will reduce the risks of a
the Carbon Disclosure Project, and supported by a range systemic financial crisis. And it will help individual firms to
of large insurers, endowments, pension funds and asset emerge as winners from the rapidly changing
managers — is one such example. economic order.
Above all, individual actors in the investment value
chain have a fiduciary duty to optimize their responses to
climate change — as they do for all risks and opportunities.
Institutions need to incorporate the management of
climate-related issues into their day-to-day activities.

16
EY’s experience and knowledge

EY Financial Services and EY Climate Change and Sustainability Services practices operate globally and draw
together financial services and sustainability knowledge to provide effective services for our clients. We have wide
experience of advising asset owners, asset managers, banks, corporates, governments and regulators on climate-
related matters. Some examples of our experience include:
• Reviewing the potential physical risks of climate change associated with real asset investments on behalf of
major asset owners
• Helping to shape authoritative risk management guidelines such as the UNEP’s Financial Institutions framework
• Auditing climate related and other ESG disclosure on behalf of clients
• Advising institutional investors on developing a consistent view on climate-related issues, along with a
supporting strategy designed to tackle related risks and opportunities
• Supporting nonfinancial corporations in raising finance via Green Bonds and other investment vehicles
For further information or to start a conversation, please get in touch with one of our EY contacts below.

Further information:
If you would like to discuss this report, please contact:
Alex Birkin Mark Fisher
Partner, EMEIA Financial Services Executive Director, Climate Change and
Wealth & Asset Management Lead, Sustainability Services
Ernst & Young LLP Ernst & Young LLP
abirkin@uk.ey.com mfisher@uk.ey.com
Shipra Gupta Christina Larkin
Senior Manager, EMEIA Financial Services Senior Manager, Climate Change and
Corporate Sustainability Sustainability Services
Ernst & Young LLP Ernst & Young LLP
sgupta@uk.ey.com clarkin1@uk.ey.com

To find out more about our sustainability services,

visit ey.com/fssustainability.
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