Managing climate change risk as an investment risk
By Nick Liolis, CIO, TIAA General Account
How do you manage the climate change risk embedded in a large institutional investment portfolio? The General Account (GA) investment committee and I have been thinking about this long before we committed, in May, to the GA becoming net zero carbon by 2050.
Climate change can be a tricky subject. But with governments and regulators continuing to pursue their commitments to the Paris Agreement, we, as investors, need to stay ahead of the issue. We need to understand the market implications and be able to anticipate and respond so that we can continue to provide solid retirement income for our participants. It is part of our fiduciary duty, so the internal discussions were focused less on the why and more on the how.
Currently, climate change isn’t definitively priced in capital markets. We are dealing with a complex and relatively unknown set of risks without much historical precedent, which makes it difficult to model as we would with other risks. Add to that the idea that managing for climate change is adding an additional constraint on the portfolio, and our task of sourcing the best risk-adjusted returns to meet our long-term investment objectives becomes even more demanding. As a result, our discussions centered on how we can maintain flexibility in our approach to managing our financed carbon intensity.
Similar to our approach to asset allocation mentioned last quarter, our strategic, dynamic and tactical asset allocation process is built around allowing us to adapt and manage through different market environments over time. Setting a long-term carbon target, aligned with the current science and the global Paris Agreement, with flexible interim targets will allow us to do the same. As the world acts and reacts to climate change, we want to be able to create resilient portfolios that will be able to deliver risk-adjusted returns over many different scenarios, not a portfolio optimized for a specific set of circumstances.
Aligning the organization
For the GA’s investment committee, this is a huge financial projections exercise. It requires an enormous amount of data, much of which isn’t comparable across asset classes or in some cases doesn’t yet exist. Take sovereign bonds as an example. There are many different ways to measure the greenhouse gas emissions of a U.S. Treasury bond, and no consensus on the best way to attribute those emissions to the investor. Also, as governments and private entities begin to transition away from carbon, the physical risks associated with climate change begin to diminish. These complexities of quantifying climate risk are some of the reasons why this is so challenging. Ultimately a chief benefit of making a net zero carbon commitment is that it rallies the organization and directs resources to solving these problems. And as the quantity and quality of the data improves, markets can price climate risk more efficiently, allowing investors like us to make better-informed decisions.
The “net” of net zero is also an important part of this discussion. We realize that we can’t completely reduce all of our financed emissions to zero. So part of our task is to allocate capital to profitable enterprises that can provide negative emissions, such as carbon removal or sinks, to offset any remaining from the main reduction effort. This could involve strategies such as investing in agriculture, timber or bioenergy with carbon capture and storage technology. Additionally, we have to consider adaptation, which is protecting against the physical effects of climate risk, especially if we consider the possibility of the world failing to meet the Paris Agreement. It’s an unfortunate but possible scenario, and just one of the many that a resilient, long-term portfolio should be positioned for.
As investors, we share the challenge of managing a new dimension of known and unknown variables. For the GA, our solution is to challenge ourselves to stay ahead of the problem in order to properly meet our long-term investment goals in a rapidly changing investment environment.
As part of his participation in Nuveen’s Global Investment Committee, Nick Liolis offers his perspective as an institutional investor and asset allocator. Neither Nick nor any other member of the TIAA General Account team are involved in portfolio management decisions for any third-party Nuveen strategies.