The Journal Vol 4. Chapter 2
The Journal Vol 4. Chapter 2
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Avoiding long-term value destruction: a conversation

In June 2016, the Investment Institute brought together Ben Caldecott, the Director of the Sustainable Finance Programme at the University of Oxford's Smith School of Enterprise and the Environment, and Roger Urwin, Global Head of Investment Content at investment consultant Willis Towers Watson, to discuss the issue of stranded assets and how investors can defend their portfolios from the long-term value destruction that could arise from asset stranding.

Avoiding long term value destruction: a conversation

Avoiding long-term value destruction: a conversation

Ben Caldecott, the Director of the Sustainable Finance Programme at the University of Oxford's Smith School of Enterprise
Roger Urwin, Global Head of Investment Content at investment consultant Willis Towers Watson

Roger Urwin: Yes, and what the subject of sustainability and stranded assets brings to the discussion is a welcome opportunity to think more deeply about what is happening in an economy and in an environment that is changing profoundly. From that point of view, I think that stranded assets have landed at the right time to focus attention on how to better invest for the long term.

Ben Caldecott: That’s true. In the case of assets stranded for environmental reasons, the factors underlying this process don’t seem to be well understood by investors. Although the term has entered the lexicon and there’s been growing awareness of the issue as a result of the Paris Climate Change Agreement, unfortunately there’s a very big gap between awareness and actively including these factors in investment decision making and investment practice.

We’re on the cusp of new generation of analytics that can help asset owners and asset managers to address these issues and manage these risks. We think that the future is actually looking at the exposure of different assets, usually physical assets, to different measures of risk and opportunity and aggregating that exposure to a company level. New transformative methods of getting data have emerged recently, such as remote sensing from satellites or other sensors, big data and so on. There have also been developments in how analysis can be done – Artificial Intelligence (AI), for example, machine learning – that dramatically improve the availability of data and the type of analysis you can conduct. One of the challenges is making sure that that basic asset-level information is available, is trusted, consistent and credible. That’s a big gap at the moment.

At the Oxford Smith School we’re looking at how to make the next generation of data and analysis available to investors. We need to advance the ‘state of the art’. Current approaches, such as voluntary reporting and carbon footprinting do not actually provide very much information relevant to investment analysis. It is shockingly inadequate.

Roger Urwin: One of the things I agree with about this is that measurement is crucial. Measurement gives a subject respect. We didn’t have great measurement in this area before. Now we have entry-level information and it’s building constantly. There are optimistic signs that we will get important contributions to the subject coming from measurement.

I also wonder whether we haven’t necessarily got that far with this subject as investors. We have simplified investment down to a series of one-year or three-year steps and many of these factors seem to play out just a bit beyond investors’ term of interest? Asset managers can legitimately claim that the mandates they are normally given are framed in terms of three-year performance. For their part, I think they probably have more opportunities to frame their issues over much longer periods than they appreciate. But they also have to take these short-term stakeholder pressures seriously.

Ben Caldecott: A lot of this hinges on asset owners having the courage to create longer-term mandates and, unfortunately, I don't see that happening as much as it should.

Roger Urwin: Indeed, we’re not yet seeing large amounts of money committed on terms that make it absolutely clear that this is a 10-year mandate or similar. There’s an intense focus on measuring things in the near term. Even though I think long-term investment is recognised as a force for better returns, people aren’t going to give up on the habit of measuring long-term investment in a shorter-term context.

Investment consultants are in a challenging position in this area. The paradigm of most long-term investors is one that gets to long-term results via a series of short-term steps. Consequently, asset owners ask consultants for approaches that have been proved successful in the past as opposed to being consistent with a new future. But consultants and others have not helped enough in leading on something like this and breaking old habits.

Ben Caldecott: Yes, and I think all parts of the investment trade are now grappling with the challenges of managing these issues effectively. The data is sparse, the methodologies and frameworks for analysing these factors are immature and a lot of these factors are interdisciplinary. They find it very difficult to take a view on anything to do with the environment for those reasons. Overcoming that is going to be challenging.

Roger Urwin: Indeed, until we get a situation where investors can see risk slightly more expansively, beyond the capital-market opportunity set, and more in terms of some of these fundamental risks that lurk in the future, I think we still have the problem.

Ben Caldecott: How do we change that?

Roger Urwin: The key thing for me about changing it is that the leadership of these institutions needs to think more deeply about environmental and long-term issues, position their funds on this longer-term basis and benchmark themselves more actively with the best in the field.

But this requires a slightly different view of fiduciary duty – a forward-thinking view of that concept – and any asset owner who has thought deeply about the consequences for their portfolios from climate change and from stranded assets would recognise that they carry a bunch of lurking risks. Most of the pension funds that I know focus on where we have come from as opposed to where we’re going.

I have seen many good developments in the corporate sector with respect to shareholders being just a part of the whole mission. The concept of corporate social responsibility allows for the idea that corporations are doing something above and beyond share prices and corporate profits. But the equivalent in the pension fund space – performance with purpose – hasn’t really landed. I think it’s due to two things really. One is that pension funds are dealing with lower returns, which has created stresses in their financial equations, but also they haven’t been given safe harbours by regulation to interpret fiduciary responsibility with a dose of responsible investing in it. I think that’s a completely missed opportunity and I hope it’s corrected soon.

Asset owners should be speaking with the authority of their members, many of whom are in their 20s as opposed to their 70s. From that point of view, they should be mindful of the time horizons that they have responsibility over. Their mandate makes this subject so important.

Ben Caldecott: I do wonder whether one of the reasons why conversations with investors are harder than they could be, particularly in relation to stranded assets, is that a lot of investors switch off when you start talking about climate change. So being on a firmer footing with them would involve talking more practically about fiduciary duty, long-termism, extended horizons and the environmental factors that are real investment risks. There are always going to be investors that want to do something about climate change, who want to exclude things and do things differently because they have certain values, but they are in the minority.

Roger Urwin: So here’s an investment thesis: carbon, which is essentially a completely unpriced externality of today, will become a cost of tomorrow. It will become a priced element in the operating profit & loss statements of many organisations in many sectors and some sectors and some companies will be more affected than others. By positioning a portfolio to be low-carbon today, you’re making a statement that the market signals haven’t quite worked their way through into today’s prices. I think that it’s a plausible and sensible investment thesis.

Ben Caldecott: Maybe we can think about this from the point of view of climate change being, by definition, a systemic risk. So while it might result in some economic opportunities, it’s also going to cause a lot of economic damage and losses. The question is, does this translate into something that could affect financial stability? It’s plausible, but it’s an area that needs much more work. That’s why it’s a priority for the Bank of England, the Financial Stability Board and other regulators.

Roger Urwin: You’re absolutely right to switch slightly from stranded assets to climate change and resource scarcity to describe the systemic risks. They are real and material risks to pension fund future experience. There’s no question that these risks will limit future financial returns. Perhaps corporations ought to think more about the impact of stranded assets on their own situation. I think every board should be conscious of the potential impacts that are coming from these sources and they can always take expert advice to help them with that interpretation.

Ben Caldecott: But I also think that investors need to be realistic about the potential for companies to change and the challenges associated with change. For some companies – a pure-play coal miner, for example – you don’t really have that many options to change. A large utility, on the other hand, has a plethora of options. It’s important to bear that in mind because you can end up having a never-ending conversation with a company that just isn’t going to change. That’s not a very good allocation of scarce resources.

Roger Urwin: Ben, what do you think are the key points from this conversation?

Ben Caldecott: I think every scenario entails a bit of asset stranding, whether it is from physical climate change impacts or from regulatory and societal responses to those impacts. Investors need to think about how they grasp some of the opportunities that are going to be generated and manage those risks over time. To do that investors need to extend their investment horizons, clarify fiduciary duty and address some of the perverse incentives with new regulation.

Once those things start to resolve, you can have a more exciting conversation about the sort of changes in practice, and the new tools that will be demanded to address these issues. This is starting to happen slowly, but the challenge is doing it quickly enough that it has a material impact, particularly in terms of preventing the irreversible breach of key environmental thresholds.

This transcript has been edited for context, language and grammar.

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