New rules of engagement on climate change

Shareholders need to help companies develop a transition strategy to cut emissions, while environmental and social governance factors need to be a more prominent part of primary credit ratings, Aviva's Mirza Baig says

New rules of engagement on climate change
A polar bear stands on melting sea ice in Svalbard, Norway, in 2013. Climate change is a grave threat to these bears; new research published on July 20, 2020 predicts that these carnivores could disappear this century. They already face shrinking sea ice that cuts short the time bears have for hunting seals, while dwindling body weight undermines their survival in Arctic winters without food, scientists reported in Nature Climate Change. The study said if business-as-usual greenhouse gas emissions continue, it’s likely that all but a few polar bear populations will collapse by 2100. Photo: K. Miller / Polar Bears International handout / AFP

(ATF) In the last few years, the conversation on ESG – environmental, social and corporate governance – among investors of all types has advanced materially.

On the environment specifically, investors appreciate that climate change presents fundamental risks to the long-term viability of a business and their investments. Companies that do not adapt will not survive and risk undermining the case for investing in their business over the long term.

The outbreak of Covid-19 led to suggestions that climate change has been demoted down the list of investor priorities. On the contrary: Covid-19 has catalysed discussions rather than derailed them, as companies and investors realise the impacts of systemic risks and the importance of acting early and decisively, before it is too late. It is clear, however, that new strategies are needed to engage companies on ESG.

In years gone by, the challenge was to get companies to a point where they would make transformational commitments in line with the Paris Agreement; but such commitments tended to be very long term and focused on the adoption of 2050 net-zero goals, with 2030 and 2040 milestones along the way.

Investors are starting to learn that effective engagement on climate change requires more focus on capital allocation and evidencing of companies’ transition. This needs to be broken down into tangible near-term targets, metrics and proof points, so companies can demonstrate they are acting on their ambition now.

In 2019, BP, for example, faced an extensive shareholder proposal. After much discussion with investors, BP backed the proposal and investors gave it over 99% support at the AGM, providing a clear mandate from the market to act.

Extensive conversations with investors culminated in the landmark announcement in February that BP would become one of the first oil majors to commit to net zero for its own operations by 2050. After refusing to take responsibility for its customers’ emissions, it also U-turned to embrace ownership of its ‘Scope 3’ emissions impacts and committed to setting an array of life cycle emissions targets. This shows that such achievements can be managed with a genuine and concerted multi-stakeholder effort.

Shareholder voting

The power of shareholder voting is also important for pushing change, but often there is a false dichotomy between choosing to support the management or the climate. There are nuanced ways in which investors can evaluate company behaviour and use their votes to be a catalyst for change, when required.

For instance, investors could ask questions about whether a company has set or is looking to set a climate ambition, whether it has a credible roadmap to net zero, what changes from the company could demonstrate a willingness to change, as well as ask themselves about their own engagement experience with the company.

At this critical juncture, some might argue that it is better for investors to divest, but this is a somewhat blunt instrument. First, there is not the critical mass in the market for divestment to be a meaningful tool for change – there are always a queue of other investors ready to take your place should you decide to sell.

The other, and potentially more significant, issue is that while divestment sends a signal of dissatisfaction to a company, it does not allow for a clear communication of a desired future state and expected roadmap for change.

Develop a transition strategy

It is better to stay invested, stay engaged, and partner with companies as they develop a transition strategy, allowing investors to continue to influence the direction and the pace of travel.

This should not be solely up to shareholders. Creditors equally have an economic stake in the long-term sustainability of a business and can have influence too, particularly as more companies tap the bond market for future funding. At the point of issuance, companies need to make creditors comfortable with their financial health and prospects, and also need to keep creditors onside for servicing and refinancing that debt.

The conversation should also go beyond green covenants. Issuing any kind of debt involves providing assurances on the long-term viability of the business. Companies tied to the old economy, such as energy and utilities, that issue 10-year bonds with no clear pathway to transition, are coming to the market with a cloud over future cash flows, which will ultimately impact their credit rating and borrowing costs.

The lack of engagement by creditors has not been helped by the unclear inter-connectivity between the ESG/climate rating and the core credit rating of an entity from credit ratings agencies. These need to be more integrated, and ESG factors need to be a more prominent part of an issuer’s primary credit rating.

With climate change a potent threat, it is no longer an investor’s sole responsibility to generate the highest possible returns, but ensure returns are long term and sustainable.

If Covid-19 has taught us anything, it is that natural disasters can turn businesses upside down. Equity and fixed income investors alike have the power to influence and can push meaningful change on climate change through constructive and incisive dialogue.

Mirza Baig is the Global Head of Governance at Aviva Investors