Most people don’t work in finance or investment and so the mechanisms of the investment chain where money is passed down through various parties until it is invested in stocks, bonds or other assets is a mystery. Most people also aren’t lawyers and so when, in the context of investment, we see another definition of that elusive term ‘Fiduciary Duty’, we might ask what is really going on?
Actually it is fairly simple. The largest pool of money in the world is held by the big pension and superannuation funds – called the ‘Asset Owners’. They have a fiduciary duty to us (yes, we own it all!) to invest wisely and the unique risk-return challenge of climate change and other ESG issues (environment, social, governance) have prompted us in recent times to question whether they are carrying out their duties.
The problem arises because we know that the asset owners give our money to fund managers who in turn invest in companies. And sages that we are, we have a sneaky suspicion that some of the investments aren’t sustainable and that in the context of climate change, we might wake up one day with the mixed news that the low carbon economy is fully underway but our retirement savings portfolios that are currently stuffed with high carbon assets are worth dramatically less than they were yesterday.
And when this sudden low-carbon tipping point occurs, causing inevitable portfolio destruction, it won’t be like the sub-prime crisis where the highly technical complexity of the issue engaged us all for months allowing everyone to avoid true scrutiny. No, this is climate change – it’s simple and we’ve been talking about it for years and trustees cannot now escape.
Last week’s landmark Baker & McKenzie report on fiduciary duty for fund trustees over their management of climate risks is critical to both the finance and legal communities and for anyone who wants to understand how the capital is going to be created for the low-carbon economy.
The report represents disturbing news for trustees and excellent news for us – the fund beneficiaries. The conclusion is clear: trustees have an obligation to demonstrate they are managing climate risks, period. And if they don’t, and any one of the six paths to the low carbon economy occurs, damaging the dangerously high proportion of high carbon assets the funds hold in our portfolios, then they will be held legally responsible.
So now the problem for trustees is threefold. First, we know from the current crisis that no-one can escape crashes from systemic risks. The sub-prime crisis once and for all destroyed the myth that the fund managers have enough insight into these risks to sell our assets for good prices before the market tanks. Secondly, the trustees are responsible for the whole system including incentives for everyone down the chain so now they have to get the entire house in order for climate risk to be managed as most of the assets that emit greenhouse gases are very long term, 25 years or more in life. And thirdly, and perhaps most disturbingly for trustees, they will have to guess the future, manage the uncertainty to ensure that in the event of any one of the six paths to the low carbon economy occurring, that our money is not totally lost.
No-one knows whether US politics, Chinese politics, convergence of regional schemes, innovation, investor allocation or physical impacts will spark the sudden direct or shadow carbon pricing impact that will signal the climate change crash. But to manage this uncertainty is now clearly the fiduciary responsibility of the trustees. That is their job.
Given they cannot insure, avoid or diversify themselves out of climate change, they can only ‘hedge’ the risk i.e. they must make an immediate and significant investment allocation in low carbon assets of all types to lift the level way beyond the current 2 per cent of portfolio to counter the 55 per cent or more in climate-exposed assets.
Worse still for trustees of laggard funds is that their beneficiaries may well seek to sue them first, so even the protection of traditional herd mentality cannot protect them. The first index of how these funds manage climate risk is to be published by the Asset Owners Disclosure Project during the Qatar negotiations at the end of November showing which funds are doing more. Quite simply, those at the bottom will need more expensive lawyers come the tipping point in the low carbon economy.
If you believe governments will create brave coordinated policy to limit the world to 2 degree warming with global stockmarket pain in the short-term or you believe the innovators will shortly arrive with miracle technologies to out-gun fossil fuels, then you already sleep easily.
If like me you don’t, then you must hope that new capitalism, represented by the largest funds on earth, does its job and manages these risks for us to ensure a smooth transition that protects our money.
Beforehand, this was highly desirable. Now it’s the law.
Julian Poulter is Executive Director of Asset Owners Disclosure Project and Business Director of the Climate Institute.