On Aon Podcast: What Climate Risk Means for the Future of Responsible Investing

Intro:
Hi everyone, and welcome to the award-winning “On Aon” podcast, where we dive into some of the most pressing topics that businesses and organizations around the world are facing. Today we hear from Daniel Ingram and Tim Manuel on decarbonization and responsible investing. Now, please welcome this episode’s host, Heather Myers. 

Heather Myers:
Hello, my name is Heather Myers, and I'm partner and non-profit solutions leader at Aon. In today's On Aon episode, we'll be discussing decarbonization and investment. Discussing climate risk within investments feels a bit like Everything Everywhere All at Once. There are many vocal market participants taking strong and unwavering stances on how investors should approach climate risks and opportunities. Yet, they express widely different views.

The ability to effectively navigate and understand the broader landscape of climate-related investment risks and opportunities has never been more important. Climate-related investment advice, data, tools, and solutions can help clients make more informed decisions in alignment with their fiduciary duties, regulatory requirements, and values or commitments. With me today to discuss is Daniel Ingram, partner, head of Responsible Investment North America, as well as Tim Manuel, head of Responsible Investment UK. Thank you both for being here today.

Daniel Ingram:
It’s great to be here. Thanks, Heather.

Tim Manuel:
Hey, Heather, good to be here today.

Heather Myers:
I’m going to start with our discussion that we’ll walk through a few questions discussing decarbonization, different approaches investors are taking, and how we can build climate resilience in our portfolios. Let’s get started. Tim, let’s start with you. What does decarbonizing mean for investors?

Tim Manuel:
This is a great time to be having this conversation as well, just as we kick off 2024. We’ve just come out of a year where we saw record global temperatures. I think it’s become really obvious that limiting global warming is really an urgent global imperative. We’re seeing climate impacts here now. The impacts, along with the costs of that, are accelerating.

Daniel and I work with large institutional investors and asset owners like pension funds, endowments, and foundations, helping them invest their assets. In those conversations with them, we’re hearing them ask the question, “What does all this change mean for us?” I think there’s really two lines of thought to that. First of all, as an investor, how can you protect yourself and your assets from that risk of a changing climate? But also, what can you do to make that change less likely to happen in the first place? How do you play your part?

First, I thought it might be helpful just to provide a bit of color about the nature of the investment portfolios that institutional investors hold because I think this is relevant and then what decarbonization means in the context of those portfolios. Firstly, most institutional investors hold very diversified portfolios/lots of different types of assets. They might own companies, lend to companies, lend to governments, own real stuff like property and infrastructure. In fact, they own and lend to lots of different types of entities beyond this and also invest in more complex structures and strategies like hedge funds, which can hold all sorts of different financial instruments. Now, at the same time, those assets are likely to be really well-diversified globally, located all around the world, and many of those assets being based somewhere other than where the investor themselves are located.

What does this mean in the context of decarbonization and climate change? Well, as a globally diversified investor, your investment portfolio will look like, to some degree, the global economy. What that really means is for investors that want to maintain that diversification, well, their own decarbonization goals and whether they will meet those goals are inextricably linked to the decarbonization progress in the wider economy. Investors can’t decarbonize in a vacuum.

Back to those two lines of thought earlier, as a very large investor, you could argue that the best way to protect from climate change/the best way to support that global decarbonization challenge is to do everything you can in your power to prevent that climate change happening in the first place. I think some of the challenges for investors as they think about that... I’ll set out two that we can perhaps discuss a bit more on as we go through today. But some of the challenges are how do investors think about portfolio decarbonization versus real-world decarbonization. It’s not only about how investors measure the change in their own portfolios, but it’s about the actions that they take to enable and make more likely that real-world change. But the other challenge is about agency... I think is the posh word, thinking about what is the point of influence or the point of most influence that you have as an investor to take action to encourage that change. That’s some of the contexts, and those are some of the challenges that investors have.

Daniel Ingram:
I agree with you, Tim. It's nice to be here, by the way. I still feel now, even having been involved in discussing climate risk/climate opportunities with institutional investors now for 15 odd years, that a lot of investors still don't really know what decarbonizing means for them or their portfolio. Tim, you work in the UK and Europe. Obviously, there are big investors, big public pensions, sovereign wealth plans that have made pledges to reduce their carbon emissions, to take action on climate through things like the UN-convened Net Zero alliances. But the reality is for most investors, particularly the ones that I work with/Heather works within in North America, is that they really need some help to discover for themselves what, if anything, decarbonizing means for them, what actions they might want to take, if any, and why.

I think the big question there is the why and really we want to try to step back a little to understand the motivations behind why you would seek to address/manage climate risks and opportunities. You might come at this very much from values... or your reputation amongst your stakeholders might be what drives you to take action. It may be your beneficiaries or your donors, or your sponsors that are taking action themselves. They've set a net-zero goal either as a corporate entity or on a university campus. They're busy decarbonizing the real estate on campus. They're looking for alignment with their values with that of the investment portfolio. That's one motivation that we see.

I think the other is risk management. Climate risks, as we hear time and time again on these Aon podcasts, are really multifaceted. It is likely to play out across different time horizons/multiple generations across different parts of the economy. There's no point looking at climate risk in the rearview mirror like climate is not a problem of the averages, where we could just rely on a reversion to the mean. The biggest problem of climate is of the extremes, as we know, and of so-called tail risks, low probability, high impact events. We know, as investors, the future risks from climate to, say, our real estate portfolio, our infrastructure portfolio, or our emerging market portfolio. We know those risks are materializing faster than we thought. There are losses. The value at risk is rising, whether that's from flood damages, or droughts, or impacts to supply chain.

Values, risk management... and then we get into impact. This is where you might be motivated to try to do something around limiting net emissions. As an impact investor, you're looking for positive environmental impact alongside financial returns. You might use your capital or stewardship to try to influence the behavior of your investee companies.

Then, last but not least... and for the conventional investor in particular, there's investment returns here. There's investment opportunity, this huge transformation to a low-carbon economy. Some estimates are $5 trillion net new investment. There's new technologies, new products, and services that are going to come out of this, opportunities in energy storage, battery technology, resource efficiency, sustainable mobility.

Looking at now, some of the data coming out from the end of last year, 2023, over a million electric vehicles sold in the US. That's up 50 percent from 2022. That's still under 10 percent of all new vehicle sales. But the point is there's real growth here. When investors are looking for returns and growth, even conventional investors, the reality is that there will be money to be made by investors, given the scale of this transition and the scale of the investment opportunity. That presents opportunities for both conventional investors and impact investors. There's a lot of different types of motivations here: values, risk, impact, returns. Trying to understand what's motivating you as an investor is a really important part to determining what decarbonizing means for you.

Heather Myers:
Thank you. Let's just pull on that thread a little more. Let's talk about the different approaches investors are taking. When is one approach more suitable over another? Can you get into that, Tim?

Tim Manuel:
We talked to a really wide range of investors. I think Daniel's touched on this already when he made the point about... Different investors based in different jurisdictions are confronted with different challenges depending on the jurisdiction or differences. Often, those differences are based on a different regulatory environment, cultural background, or fiduciary standards, or interpretation of fiduciary duty. I mean, Daniel and I talk about this a lot. We just happen to be based on either side of the Atlantic. But in the UK, for example, well, both the regulatory and the political climate for investors, which would include things like pension plans for example, is much more attuned to the consideration of climate issues and much more developed. There's a much wider range of tools and analytics that are used on a regular basis to assess some of the issues, including the use of climate scenario analysis, for example.

Now, I guess we've touched on the what, and Daniel talked through the why, so what's the how? Generally speaking, there are some core approaches that investors are taking to implement their decarbonization or their climate goals. To some degree, these actions are independent, but they can be combined. Everything exists on a spectrum. But some of those means that investors have to implement their goals are... Well, I suppose the first would be divestment, sometimes also known as exclusion. This is essentially choosing to disinvest from or not invest in or provide capital to certain companies and assets, say, because they might be high carbon today or those that aren't necessarily committed to decarbonizing in the future. Divestment is not the same as boycotts. In divesting from an asset, you're just selling it to someone else. It's really just an exchange of ownership. That high-emitting company that you just sold still exists and still emits that carbon. You could question the real-world change that you've really enabled as a result of that divestment. But it's still there as one of the tools at investors' disposal.

I suppose another tool is where you invest and seeking to invest in solutions. What I mean by that is directing your capital explicitly towards companies or projects that are making a direct and meaningful impact on emissions reductions. Arguably, this approach is much more effective when you are providing capital to projects that wouldn't otherwise have happened or wouldn't have otherwise taken place without your investments.

There's what don't you invest in, or what do you invest in? But then, the third big tool really is, I guess, what we call stewardship. There's lots of different definitions of stewardship. I might shorten it to the responsible and engaged ownership of the assets that you invest in. As an owner of an asset or as a provider of capital, you have and can have a very powerful influence over what that company does and how they behave. Stewardship in the context of climate change and decarbonization is really about engaging directly or through third parties that you work with, engaging with those companies to encourage them and support them in adopting more sustainable practices, which could, for example, include setting and implementing their own decarbonization plans. As you do that, you can prioritize and focus on the parts of your investment portfolio that are the highest emitting today, or those that are making the biggest contributions of climate change or are the parts of the economy that really need to embrace the transition.

There's these tools of where you invest, where you don't invest, and how you exercise your influence over those companies that you do own. Now, in reality, there's always going to be some combination of all these actions to some degree that might be appropriate to investors. But really, it all ties back to what is it you want to achieve and how.

Daniel Ingram:
The action flows from the motivation or the belief of what's going to be the most effective approach to reducing emissions. Tim talked about some of the views that we have around divestment in particular. I think he's made this point that just by purely withdrawing capital from a business doesn't necessarily change the level of emissions in the atmosphere. From an investment perspective, that reduction of the opportunity set ex-ante is likely to harm returns. For those conventional investors, investors focused on returns in addition to real-world impact, that's not going to be the best or most effective approach for them.

I think where we have seen a lot of changes over the years... I think around 2015, a group of asset owners started talking about portfolio decarbonization. As Tim said, this is different from decarbonizing the real economy. Quite often, there's a focus on shifting to investment securities with lower carbon emissions. That might involve divesting from entire sectors like oil and gas, for example. Sometimes, that approach is marketed as a way to make portfolios resilient to climate risk. But the reality is simply having exposure to companies with lower carbon emissions isn't the equivalent of reducing a portfolio's exposure to climate risk. Whether a company has a higher or lower relative carbon emission today, tells us very little about how vulnerable or resilient its business model will be to climate risks in the future.

In some ways, portfolio decarbonization alone is not enough to mitigate against climate risks. This is where, for a lot of clients who invest through external managers, it's really important that those external managers start to demonstrate some skill in how they're able to balance climate risks with other factors as they're making investments. That might still involve investing in carbon-intensive assets and trying to engage with those companies to try to help them transition and valuing the speed of that transition by those companies.

There's this whole integration piece and approach that I think is often underlooked as a key approach for investors. That's certainly a big focus for how to spot what good integration by active investment managers looks like, integration of climate risks in their investment process.

Heather Myers:
Well, thank you, Daniel and Tim. You have provided a lot to think about in terms of what this means. For our final question, as an investor, what can they do today to start building climate-resilient portfolios? How do they even begin?

Daniel Ingram:
The good news is there's several ways. I think we've talked about three of those. There's investing in climate solutions. We talked about stewardship, engaging with companies to encourage them to transition from highly carbon-intensive business models to more efficient business models, and then engaging with active managers to understand how they're taking into account climate risks and how they value assets, for example. But I think that part of the challenge here is the... To your question of “where do we start?”, I think part of the challenge is just getting started. There's often a quite long but important stage of discovery and deliberation that goes on where we look for perfection in terms of building these climate strategies and climate plans.

But the fact is there's pretty big market movements happening now. Some of the transitions we've talked about, electric vehicle sales, for example. These are live investment opportunities that should be appraised now alongside other investment opportunities if you're seeking returns and you're seeking growth. We've got, particularly in the US, pretty significant stimulus at the moment in terms of things like the Inflation Reduction Act, where tax credits of around $270 billion are being deployed over the next decade. There's real live opportunities in the market environment that we could be considering now rather than waiting 10 years to see whether those returns play out over a 10-year time period. There's deals and opportunities to be explored today.

Tim Manuel:
As I talked to investors about thinking about climate resilience in their investment portfolios, I think there's some principles here that are important. One is one of humility. No one body or entity or person is going to solve climate. It requires everyone to play their part globally. But there is some part for everyone to play. There's no perfect answer to this. There's no such thing as a net-zero portfolio today. There's no such thing as a perfectly resilient portfolio. But what is important is to start in the direction of travel. I think in order to do that, you've really got to throw yourself into this and start to get a hand around the issue, get hands around the relevance to your own portfolio, and start to map out what it might mean to you and what you might do in the future.

I think that the best way to do this is, one, set your baseline. Understand the nature of climate risk in your portfolio today. Give yourselves that starting point to work from so you know what your challenge is today. It gives you a measure that you can consider progress against in the future. What's your starting point?

Two, start to define what your goals, objectives, and ambitions might be. Decisions for institutional investors are never made by one individual. There's always wider stakeholders involved in that decision. It's really important to engage them and educate them, if necessary, around why it is you want to pursue a certain course of action.

Three, start to map out your plan. What are the actions that you're going to prioritize? What are some of the time scales you're going to set/the milestones you're going to set? Start to map out at least those initial plans that are going to start moving you towards that goal that you've defined. They're all planning at this stage, though.

The fourth step is just really get out there and talk to the market, the managers, your advisors, your network to understand the nature of the fund solutions and the investment opportunities that might be suitable to you and fit with your goal and your plan.

Heather Myers:
Wonderful. Thank you so much for joining us, Tim and Daniel. That's our show for today. Thank you all for listening. In the next months, we'll have episodes covering more elements of climate risk as well as other human capital topics. Until next time.

Outro:
Thanks for tuning in to the latest episode of “On Aon” with our episode host, Healthier Myers and today’s experts, Daniel Ingram and Tim Manuel, for a discussion on decarbonization and responsible investing. If you enjoyed this episode, don’t forget to subscribe wherever you get your podcasts, and stay tuned for our next conversation featuring industry experts bringing you the latest on topics, including climate risk, workforce wellbeing, ESG trends, and much more. Be sure to check out our show notes and visit our website at Aon dot com to learn more about Aon.