Environmental Audit CommitteeWritten evidence submitted by Aviva Investors
Executive Summary
Aviva Investors welcomes the opportunity to provide both written and oral evidence to the EAC’s inquiry, which we believe is incredibly important and is an issue that we take seriously as investors.
As a founding signatory to the UN Principles for Responsible Investment (PRI), we believe that companies conducting their business in a sustainable and responsible manner are more likely to succeed over time. This is why we have a dedicated Global Responsible Investment (GRI) team that works with fund managers and analysts globally and across all asset classes to integrate environmental, social and corporate governance (ESG) issues into our investment decision-making and analysis.
From an equity perspective, Aviva Investors is largely long-term and risk-averse, investing for our clients over long periods of time. Looking at the broader dynamic in the capital markets, however, the pressures are clearly to the short term, which ultimately affects both investor and company behaviour. This short term focus undermines the ability of capital markets to deliver sustainable economic development, and reduces the long term return potential for our clients—hence our interest in the EAC’s inquiry.
Policy Recommendations
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2. To understand the potential systemic risk that climate change may pose to the financial market and how to most effectively manage this risk, the Bank of England should investigate the impacts of the UK’s exposure to high carbon investment and how to manage this threat. In the same way we look to companies to integrate sustainability considerations into their business strategy, it would be helpful for government to look at how sustainability considerations are factored into and affected by policy and budgetary decisions.
3. To support investment in greener economy we require a stable, predictable and simple policy framework within which to make the most efficient investment decisions. Ideally, we would like to see clarity both in terms of policy and pipeline.
4. To implement a trade cancellation fee in place of the Financial Transaction Tax.
5. To develop a capital raising plan for sustainable development that includes a view on the money that can be raised via infrastructure investment, project finance, corporate debt, foreign direct investment, equity investment as well as sovereign and MDB debt.
The Scale of the Problem
The Intergovernmental Panel on Climate Change (2007) estimates that $1 trillion/year between 2012 and 2050 must be raised to fund mitigation and adaptation measures to avoid a 2 degree rise in temperature.
Currently, the FTSE100 represents the fourth most carbon intensive index globally (measured as GtCO2/US$ trillion market cap) based on current reserves and the third most carbon intensive based on probable reserves. Most pension funds will be invested actively or passively in this index. It is therefore an issue for all investors, companies and policy-makers to address.
In the oil, gas and coal mining sectors we have a situation where companies are valued on their proven and probable reserves in these resources but burning them would generate so much carbon dioxide that it is like to bring us above the 2 degree global temperature rises above which we are likely to see the more extreme impacts of climate change
The key questions to consider are what may cause these assets to become “stranded” and when may this happen? And given the degree to which carbon is embedded in the value of major global indices, such as the FTSE100, what does this mean for the institutional investors, and ultimately the pension savers, many of whom are invested in these indices?
How the Capital Markets Undermine Sustainable Ddevelopment
This inquiry asks whether the financial markets are effective at matching available finance to the required investment in renewable energy and other green projects. However, there is a wider challenge within financial markets, namely that sustainability is not integrated at each part of the capital market value chain. This routinely results in investment not being directed at the most sustainable companies or projects.
There are two closely related reasons for why the capital market acts as a constraint on sustainable development: market failure in general and investor short-termism in particular.
The specific market failure argument for capital markets is that governments have failed to sufficiently internalize companies’ environmental and social costs. As a result of government’s failure to internalize these costs on company balance sheets (through, for example, fiscal measures, standards, regulation, market mechanisms, and so forth), the capital market does not incorporate companies’ full social and environmental costs.
What’s more, until these market failures are corrected through government intervention of some kind, it would be irrational for investors to incorporate companies’ full social and environmental costs since they do not appear on the balance sheet and, therefore, do not affect companies’ profitability or earnings per share over the relatively short time horizon over which most investors hold stocks. As a consequence, a company’s cost of capital typically does not reflect the fundamental sustainability of the company, with unsustainable companies having a lower cost of capital than they should and vice versa. And in this sense, the market can be seen as failing to motivate sustainable corporate practices.
This is compounded further by the fact that at every stage in the investment chain, from the pension fund holder up through the investment at institutional level and the advice that investment consultants make, to the relationship between asset owners and their asset managers, and more broadly, the various information flows that help oil that system, actors are incentivised to behave in a short-term manner. This causes the capital markets to discount the future in a way that policy makers should not.
Increasingly institutional investors, such as pension funds, understand the impact that sustainability issues can have on their investments. Likewise investment consultants, such as Mercers are highlighting the impact that climate change in particular can have on portfolios. However, there are also a number of barriers both within pension funds (such as the resources available to robustly challenge their fund managers on how climate change for example is integrated) and more broadly, such as the level of disclosure of these risks to a company’s business strategy by the company themselves. There is also clearly a need for greater accountability between pension fund and fund managers and the underlying beneficiaries on how their money is being invested.
We suggest that there are three key areas that policy makers can take to address these issues:
1. Integrated Sustainability Reporting
As an institutional investor we believe that better long-term investment returns come from companies that conduct business in a sustainable and responsible manner. Aviva Investors has been calling for some time for a global convention on sustainability reporting. We would like to see all large companies report on their material sustainability issues throughout their reports and accounts. This would allow investors to easily assess whether all potential risks have been taken into account throughout a company’s operations and business strategy.
Despite the UK’s narrative reporting requirements, a recent study commissioned by Aviva Investors showed that London ranks 14th amongst the world’s stock exchanges in terms of sustainability disclosure.
We can see that reporting often drives changes in behaviour for the company board, for example When the Co-Op group started reporting its emissions in 2006, it reduced them by 600,000 tonnes per year. For investors looking to integrate ESG issues into their investment decisions, this information is crucial to making those decisions and directing capital flows towards more sustainable investments
This is about helping business and investors consider the impact that environmental, social and governance issues have on the business strategy. This will go some way towards integrating sustainability within the capital value chain and channelling investment towards more sustainably companies and investments.
We are supportive of the European Commission proposals on non-financial reporting and would like to see the UK support them to be passed in this Parliament.
On a project-level we are also proposing that a standard or “passport” is developed, drawing on the Equator Principle requirements which can be used by investors to understand the environmental (and social) impacts of a particular infrastructure project.
2. Fiduciary duties
The fiduciary duty is essentially the requirement for the managers of other people’s money to act in the best interests of the beneficiary. We would argue that part of exercising that fiduciary duty involves understand the risks that social, governance and environmental issues, such as climate change, have on the investments we make on behalf of our beneficiaries.
Similarly, we believe that taking environmental, social and governance issues into consideration as part of our investment analysis and decision-making is in line with the duty to maximise returns over the long-term rather than short-term.
The UN Environment Programme Finance Initiative has produced two reports on this issue. It commissioned Freshfields Bruckhaus Deringer to form a legal opinion and was clear that fiduciary duties should consider long-term factors; however, this is not specified in statute and ambiguity persists. This is despite the fact that during the passage of the Pensions Bill, Lord Mckenzie, then Parliamentary Under Secretary of State for DWP, said:
Current law already requires the trustees of pension schemes to prepare a statement of investment principles which must be made available to members and prospective members. It sets out the guidelines which fund managers must follow in investing members’ funds. In the statement of investment principles, trustees of pension schemes must already state to what extent social, environmental or ethical considerations are taken into account.
That is an obligation on trustees—not simply a right or an option.
and
There is no reason in law why trustees cannot consider social and moral criteria in addition to their usual criteria of financial returns, security and diversification. This applies to the trustees of all pension schemes.
The Law Commission is currently consulting on this point and should be encouraged to clarify that fiduciary duties should include consideration of the longer-term issues and of stewardship and should clearly apply to anyone who is responsible for managing or advising on others’ money in the investment chain.
3. The Stewardship Code
The Stewardship Code sets out clear good practice yet the take up and/or disclosure on the Code by asset owners has been more muted than amongst asset managers. This is an area where considerable uncertainty and lack of conviction still exists.
Policymakers need to build on the solid foundations provided by the UK’s Stewardship Code and should establish mechanisms that promote, encourage and require investors to maintain an appropriate oversight role of companies; for example, investors could be required to publicly disclose their voting record and pension trustees to report to their beneficiaries on how their ownership rights have been exercised.
There should also be regulatory enforcement measures of the stewardship codes and improved accountability of voting agencies, which have considerable power to either influence or control a substantial portion of the market at shareholder meetings. The voting recommendations of voting agencies are based on best practice, but cannot take sufficient account of individual circumstances. In some instances, this creates a box-ticking approach to corporate governance. This situation could be improved if proxy voting agencies were to explain their processes and explain the rationale for their voting decisions.
From the perspective of fund managers’ clients, there is a further stewardship market failure of information asymmetry. In this case, the information asymmetry is that fund managers have perfect knowledge of the stewardship work that they conduct, while their clients rely on the reporting the fund manager produces. We believe a standard for Stewardship, similar to the ISO14001 standard on environmental management, would represent an important step in addressing this. Such a standard would be for fund managers to use on their marketing material and enable asset managers and intermediaries to easily communicate that their performance on responsible investment and stewardship meets certain standards. This would be useful to asset owners who, in many cases, do not have the time or resources to accurately assess this. This would facilitate greater oversight of asset managers by their asset owners and ultimately better governance of the companies in which they are shareholders.
The Role of the Bank of England
To understand the potential systemic risk that climate change may pose to the financial market and how to most effectively manage this risk, the Bank of England should investigate the impacts of the UK’s exposure to high carbon investment and how to manage this threat.
The Financial Policy Committee (FPC)’s mandate is “to contribute to the Bank’s financial stability objective by identifying, monitoring, and taking action to remove or reduce, systemic risks with a view to protecting and enhancing the resilience of the UK financial system”. It therefore has a clear remit to investigate how Britain’s exposure to polluting and environmentally damaging investments might pose a systemic risk to the UK financial system and prospects for long term economic growth.
As this inquiry has already demonstrated, Britain’s collective financial exposure to high carbon and environmentally unsustainable investments could become a major problem as we approach environmental limits. Five of the top 10 FTSE 100 companies are almost exclusively high-carbon and alone account for 25% of the index’s entire market capitalisation”; this risk will exist in other indices and in bank loan books. The Bank of England therefore has a responsibility to investigate the potential impact of climate change and the economic implications of stranded assets.
A Stable and Predictive Policy Framework
Above all else, investors require policy certainty and stability. Whilst we appreciate the political challenges in delivering certainty on energy and climate change policy, there are steps that the Government could take that would help in this area. For example, a decarbonisation target would significantly improve the UK’s chances of attracting investment into infrastructure and new, low carbon power sources.
The current lack of a 2030 decarbonisation target is exacerbating policy risk. In many cases, this increases the cost of capital and deters major investors, manufacturers and project developers from investing in the UK and creating jobs. For example:
A PwC report outlines that a 2030 decarbonisation target needs to happen before 2016. To delay the setting of a target to after the next general election will affect investment decisions being made now.
EY state that the prospect of waiting until 2016, for even the possibility of a 2030 target being addressed, has “left investors with a sense of uncertainty”.
An REA survey of leading UK low carbon companies showed a “2030 target is seen as of major significance, and its absence is undermining confidence in investment in renewable energy and its supply chains”.
A statement by UK Energy Research Centre (UKERC) explains that: “The absence of a 2030 decarbonisation target may not persuade investors of the need for new manufacturing assets in the UK, as there is a risk that these could be stranded after 2020 once the current targets have been met”.
The Committee on Climate Change recommended that this target should be in place by 2014, which we would welcome as the most cost-effective pathway to meet the UK’s 2050 goal of cutting emissions 80% on 1990 levels, while triggering significant growth opportunities for the UK.
The Financial Transaction Tax
The Financial Transaction Tax may present a viable option to tackle a number of the issues that are being raised by this inquiry—taxing high frequency trading, supporting green investment. But the impact assessment accompanying the EU’s own initial proposals recognised not only that it may lead to a significant relocation of activities and substantial hikes in the cost of capital, it could result in a reduction of long-run economic growth in the EU by an estimated 1.8%, and that impact will not fall evenly between member States.
Ultimately much of the cost of the tax would fall on (i) consumers rather than high net worth investors in hedge funds or financial institutions and (ii) the more traditional long term investors, who would also find that it was no longer economical to run liquidity and cash funds as part of an overall investment strategy.
An alternative option would be a trade cancellation fee, which would target the more troubling end of high frequency trading. We understand that around 60% of trades on behalf of passive HFTs who market make in illiquid stocks are posted and cancelled in micro or milliseconds.
A Capital Raising Plan for Sustainable Development
The International Energy Agency estimates that incremental investment in the energy sector alone will need to reach around $1 trillion a year from 2012 to 2050 in order to keep global average warming below 2 degrees Celsius. More capital will also be required to finance the Millennium Development Goals and the Sustainable Development Goals that look likely to succeed them. The MDGs were the most broadly supported, comprehensive, and specific poverty reduction targets the world has ever established but no mechanism was agreed for how they could be financed.
While the precise amount is open to question, it is clear that significant sums of money will be required. Raising this money will need considerable planning, effort and international coordination.
Failure to tackle this will have serious economic consequences in the relatively short term. The Stern Review on the Economics of Climate Change conducted for the UK treasury in 2006 found that without action, the overall costs of climate change will be equivalent to losing at least 5% of global GDP each year, now and in perpetuity. Including a wider range of risks and impacts could increase this to 20% of GDP or more, also indefinitely. Stern believes that 5–6 degrees of temperature increase is “a real possibility.”
As an insurer, we are accustomed to dealing with financial arguments that point towards the benefits of taking preventative and mitigating action before a much more expensive disaster unfolds. The economic losses from natural catastrophes and man-made disasters totalled $56 billion in the first half of 2013 according to Swiss Re, with $17 billion covered by the global insurance industry and caused by natural catastrophes, mainly flooding.
History has shown that political will often depends on the presence of a crisis. We believe that the implied changes to the global economic system associated with a 5–6 degree change and unsustainable economic development present such a crisis.
Fortunately, with over $50 trillion invested in the global stock markets, and a further $100 trillion of sovereign and intergovernmental debt, on the face of it, there should be no shortage of capital available.
The short fall we perceive is a broad enough understanding of how to harness capital markets to raise new capital, move existing stock of capital and harness the influence of asset owners in a concerted, integrated and focused way.
Intergovernmental organisations have traditionally been good at sourcing public financing but not yet as successful in leveraging private finance. If we are to raise this money in an efficient, effective and sustainable manner, we need to challenge the international community to develop a well considered capital raising plan that includes a view on the money that can be raised via infrastructure investment, project finance, corporate debt, foreign direct investment, equity investment as well as sovereign and MDB debt.
Raising and or diverting capital on this scale is likely to provide a significant number of practical challenges that policy makers developing such a plan will need to consider.
In order to catalyse policy makers into developing a set of capita raising plans this, we propose the following actions:
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Annex 1
PROPOSAL TO LAUNCH A RESEARCH PROJECT ON AN EQUATOR PRINCIPLES RISK PASSPORT
Proposal: a government-IFC research project, funded by the Cabinet Office and a group of investors to explore how the IFC performance standards on environmental and social sustainability could be made relevant to asset classes beyond project finance, with a particular focus on equities, corporate debt and private placements.
Objective: to develop a standard that listed companies could use for communication with institutional investors and other stakeholders.
Purpose: to enable companies to easily communicate the percentage of the projects they are involved with that comply with IFC performance standards. This would be useful to investors who do not have the time, expertise or access to data enjoyed in the project finance due diligence process.
Context: the Equator Principles are a credit risk management framework for determining, assessing and managing environmental and social risk in project finance transactions.
We know that environmental and social issues can present risks to a company’s financial performance and are therefore important to all investors, active or passive. The difference between the two lies in the extent to which they are able to engage with and influence the behaviour of the investee, an important part of risk management.
At one end of the spectrum, where providers of finance are proximate to the asset, eg development and project finance, providers utilise a range of environmental and social risk management (ESRM) tools, such as the Equator Principles. These tools are used to identify, quantify, allocate, price, manage and mitigate (where possible) the environmental and social risks to which the underlying asset/project and financial supporters could be exposed throughout its lifetime.
At the other end of the spectrum, listed funds are remote from the asset and typically invest in corporate entities whose businesses may comprise many individual assets, some on balance sheet but many ring-fenced off-balance sheet in special purpose vehicles (SPVs).
Fund managers lack the practical tools to manage environmental and social risks effectively at this end of the spectrum. However, they draw significant comfort, across commercial and political risk from recognised expert involvement. Equity investment in a company can be more complicated and may require ESRM tools at least as rigorous as those employed by lenders.
The Equator Principles (EP) have proved successful specifically to project finance in signing up 79 financial institutions, including in emerging economies. They have raised awareness at sponsor level and built a consensus around the need for sustainable finance. Arguably, the most significant criticisms of EP relate to financial externalities that go beyond project finance. This is why it is desirable that the Principles are broadened in their applicability and usefulness to other asset classes.
We propose that the Equator Principles could be developed into a type of Risk Passport, or standard. The underlying information is already reported and collated for ESRM at the asset level (eg provided to senior project lenders). What is needed, however, is a framework specifying how that information can be formatted for use all the way along the investment chain, and research into the necessary institutional framework to support this change.
13 December 2013