PGIM Policy Insights: Improving the SFDR
The Sustainable Finance Disclosure Regulation (SFDR) has carved a new path by requiring ESG disclosure for asset managers.
The multifaceted impact of climate change for asset owners is hard to fully comprehend. Not only will climate change have material effects on the companies that asset owners invest in, but there could be extreme impacts on investor liabilities.
Shehriyar Antia, Head of Thematic Research at PGIM, joined Institutional Investor’s 2021 Asia-Pacific ESG Forum. During the session titled, Climate Change – The Opportunities & Risks, Antia explored the risks climate change may pose for institutional portfolios, and discussed solutions for addressing and managing these risks. Antia also shared insights and key investment considerations from PGIM’s Megatrends research, Weathering Climate Change, including:
>> Our greatest threat in thousands of years, climate change.
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>> Welcome to this session titled, Weathering Climate Change: Opportunities and risks in an altered investment landscape. I'm thrilled to be joined by our expert speaker, Shehriyar Antia, head of thematic research at PGIM. Shehriyar is an award-winning macroeconomist with capital market experience in Asia and the US. He spent several years in Tokyo on foreign exchange and bond trading desks before returning to his native, New York City. Following graduate work in economics, he joined the Markets Group at the New York Fed. There he led several analytical initiatives around the Fed's QE programs, the senior policymakers in Washington. In 2013, he established a bespoke economic research shop, Macro Insight Group which provided independent macro research to institutional investors primarily in Europe and Asia. In 2017, he was appointed chief US economist at Nippon Life Global Investors and joined PGIM in 2019. PGIM is dedicated to sustainable investing and believes active investors must be on the front group, predicting and responding to the impacts of climate change in the economies and markets they operate. Shehriyar, many thanks for taking the time to join me today from New York. I'll hand it over to you now to share your presentation and insights and afterwards we'll have some Q&A that's been sourced from our delegates.
>> Terrific. Thank you very much for the kind introduction, Matthew. I'd like to thank Institutional Investor for hosting this very important conference and for the invitation to present today. Next slide please. So as Matthew noted, we recently published a new white paper called Weathering Climate Change focused on how climate change is transforming the investment landscape. Today I'd like to share with you an overview of our research. Turning to slide 3. First, a bit about PGIM's thematic research team, we are other main authors of the award-winning Megatrends series. Our research focuses primarily on broad secular macro trends that unfold over years or even decades and we offer a multi-asset investment perspective across public and private debt, equity markets, real estate, infrastructure and even other alternative assets. We try to identify hidden risks and emerging opportunities around these themes. As you can see here, in the past, our Megatrends papers have touched upon issues like aging populations, urbanization, accelerating technology. Climate change is the latest transformative theme we're looking into. Turning to slide 4. So our current paper, Weathering Climate Change, is broken up into five sections or chapters and the logic flow here is pretty straightforward. We start with active climate signs that are most relevant for investors. We move on to the macro impact of climate change in Chapter 2 and then get into how markets are pricing this in Chapter 3. The last two chapters are dedicated to the investment implications of all this. So my presentation today unfortunately will not be able to cover the entire paper. I will cover some aspects of the first four chapters. So let's get started. Turning to slide 5. It's undeniable the air and water on our planet are warming and this global warming is accelerating. We have identified three key implications of this for investors. First, global warming is creating a surge in weather variability. We have -- which we have defined at the top of this slide. I like to say if there was a VIX index for weather it would be at all-time highs now. Second key implication, amid all those long-term uncertainty, there's a good deal of certainty about the next 15 years or so. That is the ongoing transformation of our planet and our climate will continue for at least the next 15 years, really under all climate scenarios. This ongoing change is already baked in and the actions we take today will impact the world only after this timeframe. And the third point here, basically climate change is already happening now. It's materially impacting macro. It's materially impacting markets and it will continue to do so through the investment horizon of almost every investor. It's becoming very clear climate is a material factor for all investors and it's no longer optional. Turning to the macro picture in slide number 6, climate change directly impacts economic growth through three channels which we have listed here at the top of the slide. We've identified some underappreciated macro elements and I'd like to highlight two of them for you today. The first point, climate will impact almost every country but the impact will be nonlinear and highly uneven. You can't really say there'll be winners and losers when it comes to the physical risk of climate change. More like small losers and big losers. I'll speak more about this in a moment. I'd also like to highlight the second point here. Yes, there's a boom in renewable power generation and yes, renewables are going to play a major role in a low carbon economy. And it is also true that fossil fuels are not going away anytime soon. This inevitable transition from fossil fuels to renewables will be much more evolution than revolution. The simple but inconvenient math around supply and demand of energy make this point very, very clear. The key point here is fossil fuels will have a long protracted sunset and will play a role right alongside renewables in the global energy landscape for the next 30 years or more. Now turning to slide 7, this is a demonstration of that highly uneven impact of climate change I was referring to. We've taken two prominent emerging market indices and parsed out high and low impact countries within them. So even within the category like large EMs, Indonesia and Brazil will be much more impacted in the next year, three years, five years than places like Malaysia and Russia. Next slide please. So how exactly are markets pricing in climate risk? Well, the short answer is very inconsistently. We've noted a few examples of where climate externalities are reflected in asset prices and also some examples of where they're not. But most importantly for investors, it's no longer a question of if markets will more fully price it in but what will be the catalyst for this re-pricing be? There are a slew of catalysts that will drive markets to pricing climate risk more and more. We identified five such catalysts in our paper and I'll speak to the three listed here. First, there's a data revolution underway in climate data and analytics over the last five years or so. Climate data is more accessible to investors. It's more granular and it's a better quality than ever. Now let's be clear. The data is far from perfect. There are substantial sizable gaps. Data lacks uniformity, standardized approaches. There's much room for improvement for sure, but the trend over the last five years is still very clear. Better data that's more accessible and more granular. The key point for investors around this is that by leveraging this data, they are better able to differentiate climate risks at a more granular level. So before, investors could parse out risks at a sector or industry level. Now they're able to drill deeper, get more granular and differentiate risks within a sector or an industry. The last two catalysts here are the collective nudges from governments and regulators as well as from consumers and investors. Companies around the world are responding to these influences with greater disclosure, more transparency, and other actions that allow markets to better consider in pricing climate externality. Next slide please. So climate change has already impacted the global macro and markets. It's driving a transition to a low carbon economy and investors are increasingly embracing this transition and view climate as a source of both investment risk and opportunity. According to [inaudible] survey of over 100 global CIOs, investors are already finding investment opportunities in areas like infrastructure and equities market. In our paper, we've taken a similar perspective in trying to identify some of the hidden risks and emerging opportunities in climate change. And slide 10 begins the section where we lay out these investment implications by asset class. So our research identifies investment risks and opportunities across fixed income, public and private equity markets and real asset. In the interest of time, I'll only cover some of these areas today. Turning to the equities for a moment here, well, the first point here draws upon the -- excuse me. The first point here draws upon the uneven impact of climate change. This divergence creates opportunities for active investors. Can you move to slide 11 please?
>> This one?
>> So really smart research done by our colleagues at QMA which is PGIM's quantitative equity shop details how within a category such as large emerging market countries, there will be divergent outcome. In fact, their research shows that Indian public equities could have more than 2% of their equity return shaved off annually by the physical risks from climate alone and higher expected volatility to boot. By comparison, China's equities are expected to lose only about one half of 1% annually with not much change in expected volatility. So this kind of uneven impact is really hard for purely passive index approaches to address and creates a number of opportunities for active investors. Can we move back to slide 10 please? I would like to touch on the third point here. So we already spoke about the data revolution, the new capability for investors to differentiate between firms and we've already spoken about the prolonged sunset for fossil fuel. Well, this combination of forces leads to some new possibilities for investors and the common ESG practice up to now is for investors to take an exclusionary approach to carbon-intensive industries, to, for example, banish fossil fuel drillers altogether from their portfolio. Well, the data revolution now allows for an alternate approach and now a growing number of investors are going beyond the standard investment playbook of brown villains and green heroes and they're finding attractive olive players. That is the greenest firms within brown industry. By embracing the data revolution, investors can really differentiate between fossil fuel firms. They can find energy companies that are really leaning into a greener future, ones that are looking to transition to this low carbon world. So among the oil majors today, you know, some European players like Total and Shell may fit this bill. These firms are less likely to be rendered obsolete than their peers. They're likely to outperform their peers over the long sunset as well. Also, by engaging with these climate-forward energy players, investors can encourage their green practices across the industry, talking about using cleaner fuels, ramping up renewables. By supporting these greener practices, investors can help reduce carbon emissions over this prolonged sunset. Investors can do quite a bit of good in this way. So the key point here is data-driven investors don't need to exclude all players in brown industry. Instead, they can choke their portfolios toward the greener firms and in doing so, they can capture opportunities to both do good and to do well. Can we jump ahead to slide number 12 please? I'd like to touch on one more asset class here, infrastructure, and I'll speak to the first two points here. To find the best opportunities in renewable power generation, investors really have to look beyond the saturated wind and solar power markets of Europe and North America and look at opportunities in Latin America and Asia. In Uruguay, in Chile for example, aging hydropower infrastructure needs to be replaced and upgraded to meet new energy demands and wind and solar will be a big part of that. In Asia, countries like China and India are just at the beginning of a lengthy transition to make their energy supply more green and there are opportunities there for investors as well. And the second infrastructure point here is an often overlooked opportunity we feel. So less predictable rainfall patterns in places like Australia and the Southwestern United States really drive a long-term need for more water infrastructure. I'm talking about desalination plants, water transport mechanisms and municipal scale water filtration plants. This ongoing need for water infrastructure can also provide investors with opportunities to do good and to do well. And I'll end my talk right here. I tried to give you a taste of our research. If you're looking for more, please do look it up online at pgim.com. Thank you very, very much for your time.
>> Very good. Thanks a lot for the presentation and those insights. That's fantastic. So we're going to head towards questions that's been sourced from the delegates. So the first one is, how does the rise of passive investment styles fit with ESG investing?
>> So, you know, the index approaches have really taken off over the last few years and quite frankly, climate change may be the kryptonite for passive investing. Let me give you two reasons for this. First, the impact of climate change as we have discussed is quite nonlinear and highly uneven so even within common equity groupings there's wide variation. I spoke about this earlier with regards to emerging markets. But the key point here is investors who are willing to deviate from the pure passive index approach, investors who are willing to tilt their allocations away from the markets and sectors with the highest vulnerability can easily outperform benchmarks.
>> Very good.
>> The second reason why climate change may be kryptonite for passive investing, leveraging, you know, this data revolution and, you know, nonfinancial data, what we call alternative data really allows investors to better differentiate where markets have a hard time. They can both manage risks better as well as find opportunities and this requires an active bottom-up analytical approach. Let me give you an example. You know, we often think of all properties in coastal areas as being high risk and indeed standard climate analysis usually drills down to the neighborhood or maybe the postal code level. However, by utilizing unconventional data, updated flood maps, satellite imagery, geolocation services for example, and leveraging more advanced climate analytics, real estate investors can be thoughtful and more granular in uncovering situations where the broader market sees only limited value. They're able to examine properties in high risk areas like Miami or Mumbai or Melbourne and find hidden gems. That is properties that are more resilient than their neighbors but yet are priced with the same high risk discount. So the bottom line here is the uneven nature of climate change and the difficulty in many asset markets have in pricing it inconsistently really, really are going to challenge passive index approaches. And this kind of risk, a risk with these kinds of characteristics really lends itself to granular, data-driven active analysis to address it effectively we feel.
>> Fantastic. And moving on, what steps is PGIM taking to implement ESG into its own investment process?
>> Sure. Well, you know, first let me say, you know, long-term sustainable growth from a company is very attractive to all active investors such as PGIM, whether they're considering opportunities in equity markets, debt markets, real estate, other alternative asset. And our analysts have been looking for these opportunities for decades. They've been incorporating, you know, all material factors including climate risk long before we even called them ESG. To answer your question directly, each of our business units tailors their approach to ESG to best suit their asset class in the markets that they operate in. For example, our fixed income group chose not to depend on ESG ratings from market data providers. They're bottom-up active investors and they prefer to use their own proprietary methodology rather than relying on some black box model of others. So instead they leverage all available data including alternative data like carbon emissions, heat and water stress metrics and come up with an independent, proprietary ESG rating for every bond across the fixed income universe. So talking about sovereign debt, municipal bonds, you know, state issued debt, all aspects of corporate debt, structured bonds as well. This proprietary ESG rating guides the investment decisions made by portfolio managers. One of the advantages of having our own proprietary model is it allows us to customize the ESG approach for clients depending on their priorities and objectives. So we're not sort of forcing a one-size-fits-all approach to ESG for all our clients and in this way, we're able to meet the needs of our clients today and as their objective and priorities evolve over time as well.
>> Fantastic. And just a final question, what do you think -- you know, do you think other regions will follow the same approach the EU has done in regards to regulating climate change?
>> So, the European Union has certainly opted for an approach to climate change that's heavy on government influence. European regulators have been very assertive in requiring disclosures by companies and initiating an emissions trading system across the EU to better transparently price carbon. But broadly speaking, government mandates may not be the only compelling influence for companies when it comes to climate. It's not the only motivation for companies in private industry in this area. Take for example the case of the United States. Certainly over the last four or five years, climate policy and regulation have not been very stringent, especially compared to places like Europe. There is no national emissions trading system in the United States and the disclosure requirements are far, far less yet we see more and more US companies upgrading their data disclosures. We see more and more large US firms committing to carbon neutrality programs really across all industries. So, you know, firms like Delta Airlines, Ford Motor Company, Coca-Cola, Amazon, Microsoft, clearly these companies are responding to other influences to make these changes. And these examples demonstrate to us that nudges from consumers and investors can be very, very effective, very powerful in compelling action from companies as well. And I would argue that most US companies are responding to those influences rather than government mandate. And it appears investors and consumers, when they band together, when they choose to take collective action really can compel a response from private companies.
>> Very good. That brings us to the end of the session. Shehriyar, many thanks for your valuable insights and the presentation, we really appreciate it.
>> Well, thank you very, very much Matthew.
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