Getting your ESG and LDI journey in to focus after the effects of Covid-19

Published by Pete Smith on

Estimated reading time: 5 minutes

Like me, do you yearn for a time when we can change our obsession with risk management?  When a trip outside your door is not based on an analysis of the R number, does not involve 30-second hand washes and ignores the availability of toilet roll? 2020 is the year when risk management took on a very personal face. 

 What lessons can we take from this into our professional lives? 

  1. Identify developing risks early.
  2. Know the weak points in your current strategy, and their financial consequences.
  3. Have a plan to deal with them early to reduce the negative impact of their consequences.
  4. Monitor developments to ensure your plan does what you think it should.

These lessons may have been brought front and centre during 2020, however, they are not new.  Identifying, assessing, planning and monitoring is risk management 101. We have been here before.  Until now, the effects of every financial crisis could have been mitigated against. Whether that was avoiding buying tulips in 1637 and so avoiding the world’s first speculative bubble, to having in place interest rate hedging and diversification as we approached the Great Financial Crisis (‘GFC’) in 2008.

This time is different. Covid-19 has let us see first-hand the devastating effects of a non-financially driven crisis.  It has had a devastating personal effect on those who have lost loved ones, whose jobs have been lost and whose futures have become uncertain, and indeed this crisis has touched each of us to some extent. The UN has estimated the cost of Covid-19 will be $1 trillion globally.

"Covid-19 has let us see first-hand the devastating effects of a non-financially driven crisis."

This non-financially driven risk has emerged as we are trying to wrestle with the magnitude and management of another. Climate risk. With an estimated cost of $1.2 trillion, efforts to manage it cannot take a back seat.

Are the lessons we are learning from the Covid-19 crisis relevant to climate risk? Yes. So too are some of the lessons we learned from the GFC. Early risk management was and is vital for each.

Cast your mind back to 2003. It was the year Liability Driven Investment (LDI) started to gain some prominence. Those who strived to understand the complexities behind these new tools, and the risks they were managing, were rewarded by being materially better off as they emerged from the GFC. As we emerged from the crisis, the problem became more obvious and the tools that were used to, helped address interest rates and inflation risk had been proved to work. The use of LDI has continued to grow, and is now almost universally used in the defined benefit pension scheme world.

There are similarities to the growth in the use of tools to help manage climate risk. We better understand the problem than we have in the past so we ask, will the current Covid-19 crisis push us forward in our efforts to actively manage the risk of climate change early? I believe there will be a vaccine for Covid-19 – giving it a finite lifespan and therefore a finite impact. There will be no vaccine for climate change. It is a risk, and a growing one, that we will all have to learn to live with.

Although climate change itself emerges over a long-timescale, its effects on asset values will be felt sooner and more sharply as the inevitable policy changes required to combat the risk lead to repricing, and in some cases stranding, of assets. Like LDI helped manage interest rate risk, the tools below enable all trustees and asset owners to manage climate risk.

Asset class Comment
Passive equities •    There are a variety of funds available that track low-carbon or ‘better’ carbon indices.
•    More recently, we have seen the launch of indices that specifically are aligned with the Paris Agreement.
Active equities •    The active equity space offers many solutions for trustees looking to reduce their carbon exposure.  
•    These range from funds that take a greener tilt on an existing philosophy and process to those with a particular Paris alignment/goal.
Bonds  •    Again the funds available range from tilts to an existing strategy to those that hold green bonds and have a much more targeted approach.
Alternatives •    We are seeing developments in the DGF market that help make a greener approach accessible to almost all schemes.
•    For others renewable infrastructure, early stage private equity to exploit some of the new technological advantages and more efficient property funds are all worthy of consideration.

Building on feedback from our recent independent trustee roundtable on Environmental, Social and Governance (ESG) investing, over the coming weeks we will be delving into each of these in more detail, and providing case studies to help illustrate how we have helped trustees form and implement their views on issues such as climate change. 

I mentioned that 2003 was the beginning for LDI, it was also the year that DVD overtook video in popularity. The real winners when we look back on this period weren’t those who backed DVD sales, it was those who looked even further ahead and invested in a little firm called Netflix. In five years’ time are you still going to have a climate risk management policy that equivalent to DVDs in 2003, or by looking further ahead, will you have recognised the game changers like Netflix? We are here to help you get your ESG journey in focus, manage these risks early and ensure it reflects not just today’s trends but the needs of the future.
 

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