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【Glocal 獨家訪談】EDHEC-Risk Institute Interview: Future of Sustainable Investing

The conference participants included over 50 academic scholars and 140 professionals from wealth management, banks, institutional invsetors and others. Following the conference, Professor Riccardo Rebonato PhD, Professor Gianfranco Gianfrate PhD and Professor Lionel Martellini PhD share their insights on sustainable investing and climate finance with The Glocal in the interview below.

 

Sustainable investing is an investing approach that considers Environmental, Social, and Governance (ESG) factors in portfolio selection and management. According to Global Sustainable Investment Alliance, global sustainable investing assets are estimated to be 30.7 trillion USD in 2018. However, lack of common framework, reliable ESG data and clear regulation impedes the growth of sustainable investment, despite its positive impact to the society. Governments and international organizations are tackling these problems to help institutional investors grow their sustainable portfolio. The EU, for example, published taxonomy technical report in June 2019 as a part of the Union’s effort in achieving 2050 carbon neutrality. Under friendly political atmosphere and strong social support, sustainable investing is slowly moving into the mainstream.

 

To understand sustainable investing better, The Glocal has invited researchers from EDHEC-Risk Institute, a leading academic think-tank in investment solutions for asset owners and asset manager. EDHEC-Risk Institute held its first annual Climate Finance Conference in Paris in December 2019. The conference participants included over 50 academic scholars and 140 professionals from wealth management, banks, institutional invsetors and others. Following the conference, Professor Riccardo Rebonato PhD, Professor Gianfranco Gianfrate PhD and Professor Lionel Martellini PhD share their insights on sustainable investing and climate finance with The Glocal in the interview below.

 

Q1: In past conferences related to climate finance, you have mentioned that climate change is a “negative externality” and an “economic growth problem”. What do you think the role of government is in correcting these market failures? More importantly, how do investors fit into this framework? Around the world, which side (the government or investors) leads the changes in climate financing?

 

Professor Lionel Martellini:

A healthy combination of mitigation measures, taken to reduce and curb greenhouse gas emissions, and adaptation measures, taken to reduce vulnerability to the effects of climate change, is needed as part of the world’s efforts to cope with climate change. Climate change is indeed a typical example of a negative externality problem. As eloquently put by William Nordhaus, “the problem is that that those who produce the emissions do not pay for that privilege, and those who are harmed are not compensated“ (W. Nordhaus, The Climate Casino, Yale University Press, 2013, page 17). The role of governments is essential in regulatory efforts towards the internalization of this negative externality, which is achieved by “putting a price to carbon”. When it comes to reducing emissions, this can best be done via carbon taxes and/or subsidies, and even more efficiently via the introduction of emission trading schemes (also known as cap & trade schemes).

 

It must be remembered, however, than in all scenarios consistent with a manageable temperature increase by the end of the century, sequestration and negative emission technologies (NETs) must play a key role: given the very long times of permanence of CO2 in the atmosphere, renewables by themselves are not sufficient to deliver a limited increase in temperature by 2100. The problem with NETs is that the established technologies are reversible, non-scalable and they aggressively compete for land usage. The more promising NETs options require a lot of research, which, for a variety of reasons, at the moment is not forthcoming from the private sector. A substantial government intervention, such as via subsidies, direct funding of research, etc, is therefore necessary.

 

In this context, private money from institutional and individual investors can also play a critically important role by decreasing cost of capital for climate-friendly initiatives, as well as increasing cost of capital for carbon-intensive activities. It is perhaps encouraging to see that in the regions where the leadership role in the fight against climate change is not satisfactorily occupied by the government (as is for example the case in the US under the current administration), large institutional investors are taking the lead through aggressive strategies aiming at reducing the carbon footprint of their equity portfolios via a combination of negative and positive screening as well as the use of suitable optimization methods. 

 

“The problem with NETs is that the established technologies are reversible, non-scalable and they aggressively compete for land usage. The more promising NETs options require a lot of research, which, for a variety of reasons, at the moment is not forthcoming from the private sector. A substantial government intervention (via subsidies, direct funding of research, etc) is therefore necessary.”

 

Q2: Lack of data, common framework and measurement inhibit the progress in sustainable investing. Given that there are multiple recognized institutions (such as PRI, World Bank… etc.) promoting sustainable investing, what do you think are the main challenges towards creating a “common language” in sustainable investing? What do you think are the necessary steps to tackle these challenges?

 

Professor Lionel Martellini:

The disclosure of reliable estimates for carbon footprint measures is obviously a key requirement for the development of any meaningful climate-aware investment strategy. Competing providers of such carbon footprint estimates are in relative agreement for scope 1 measures, which are the easiest to obtain since they are the most limited in scope. On the other hand, strong disagreements exist for scope 2 measures, for which two methodologies exist, namely location-based methods that consider average emission estimates for the electricity grids that provide power at the local level, versus market-based methods that considers contractual arrangements under which the company obtains power from specific sources. The situation is even worse for scope 3 measures, which includes emissions from the whole value chain of operations of the firm, either downstream, generated by product use by the customer, or upstream, generated by a firm’s supply chain. The adoption of a coherent framework for estimating carbon 3 emissions is perhaps the biggest challenge that the investment community is facing in terms of measuring and managing climate risk exposure, at least the transition part of climate risk.

It is hard to discuss about climate financing without mentioning green bonds. To qualify as green bond, the Climate Bond Standard Board has created specific framework to verify the bond’s effectiveness in funding environmentally friendly project, such as clean transportation and energy, protection of aquatic and terrestrial ecosystems, or sustainable water management. Governments have been promoting green bonds to investors by allowing tax exemption and providing clearer guidelines for issuers and investors alike. EU Green Bond Standard (EU-GBS), released in 2019, is an example where governments take initiatives in combatting “greenwashing” and supporting green bond market growth. According to S&P Market Intelligence, between 2013 and 2019, green bond issuance in Europe tops 240.65 billion USD, highest of all regions and accounting for 40% of global issuance. The market is poised to continue growing with EU-GBS’s comprehensive regulatory framework.

Q3: Europe is a leader in issuing “green bonds” worldwide. What do you think the rest of the world can learn from Europe in promoting financing climate actions?

 

Professor Gianfranco Gianfrate:

Europe is at the forefront of sustainable investments especially because of the deeply rooted sustainability culture of large part of the population. This is particularly evident in Scandinavia, the Netherlands, and the UK: institutional investors and banks in those countries have actually created the field of sustainable finance. The coexistence of European retail investors and professional investment firms that are genuinely concerned with sustainability has propelled the growth of “green bonds” as well. While sustainability culture cannot be exported easily, a key driver for the development of green bonds is also the stringency of climate policies such as carbon taxes and other mechanisms to price carbon emissions. As the transition to clean energy becomes more urgent and more countries implement strict climate regulations, the case for the investments in new renewable energy facilities will become more compelling. According to some estimates, up to $90 trillion financing will be needed to transform the energy production base of the planet in the next 10 years. Green bonds are likely to be the key financial tool to channel the required public and private funding towards renewables. Therefore, effective climate regulation can probably be the best way to foster the diffusion of green bonds globally.

 

Q4: With the exception of “green bonds”, a large part of the interests in “sustainable investing” seem to be on equity. Why is that the case?

 

Professor Gianfranco Gianfrate:

It is true that “sustainable investing” so far has mostly focused on equities, and it has started impacting the fixed income segment only recently. I believe this is for two reasons. First, bond investors are mostly concerned with downside risks, while equity investors are also looking for upside potential. ESG metrics have been employed as a possible source of extra-returns for shares but not for bond, therefore there has been a flux of funds and investment products advertising sustainability as a way to beat the market. Second, in the last two decades the major international institutional investors have developed an “active ownership” approach for their investments that encompasses exercising the voting rights attached to shares and directly engaging with the management and the board of investee companies to enhance their sustainability profile. Because only shares confer voting and “ownership” rights in companies, an investment culture has been forged according to which only by being an equity-holder you can be a “sustainable investor”. However, things are changing rapidly and the demand from both institutional and retail fixed income investors is growing steadily. It is likely that the interest will increase significantly not only for “green bonds” whose proceeds are destined specifically to sustainability projects, but also for funds that screen fixed income securities on the basis of ESG criteria.

Q5: How important is climate change to credit risks? How much climate-change-related-risks are borne by the financial system? What do you think about the possibility of a financial crisis induced by climate risks? How prepared are we for such a crisis, if it were to happen?

 

Professor Gianfranco Gianfrate:

Financial actors and regulators are more and more concerned with the potential impact of climate change on the stability of the financial markets and the banking system. It is no wonder that several central banks are evaluating to what extent climate change can pose a threat to markets and how they should intervene to prevent climate-related possible shocks to the financial system and the real economy. Green monetary policies would impact the banking system and, in turn, lending policies thus affecting credit risk and the way such risk is measured. Rating agencies are developing specific know-how and models to embed the exposure to climate risks in the assessment of creditworthiness of corporate and governmental issuers. For instance, S&P acquired Trucost, a company specialized in measuring corporate carbon footprint, while Moody’s acquired Four Twenty Seven, a firm focused on assessing the physical risks of climate change.

New estimates are shedding light on the broader indirect impact of climate change on the value of assets held by banks. Importantly, while direct exposures to the fossil fuel sector are small for most banks, the indirect exposures are large. In other words, there are climate change-related risks borne by the global financial system that are similar in magnitude to those that emerged in the financial crisis. The Task Force on Climate-related Financial Disclosures (TCFD) created by the Financial Stability Board (FSB) has recently advised global organizations to enhance their financial disclosures related to the potential effects of climate change. Still, transparency is only the first step and we are probably not fully prepared for a climate-related crisis. The risks may come from a sudden change in climate policies or from a major physical shock due to climate change. The latter would be the most threatening as they are the mostly difficult to predict and model.

 

“There are climate change-related risks borne by the global financial system that are similar in magnitude to those that emerged in the financial crisis… The risks may come from a sudden change in climate policies or from a major physical shock due to climate change. The latter would be the most threatening as they are the mostly difficult to predict and model.”

 

Aside from risks to the financial sector, climate change’s real life impact also post great risk to the economy. The presence of economic risks could be derived from many factors such as political dispute, epidemic, war, and climate change. However, the effects of climate change, unlike the other factors, are permanent. According to Munich Re, the world’s largest reinsurance firm, climate change has resulted an increase in difficulty to estimate the average annual loss from natural disasters. The increasing frequency of hurricane and other extreme weathers have also caused more expenditure on rebuilding infrastructure. Beside this expenditure, climate change has also directly affected many existing industries such as agriculture, fisheries, and forestry. While it is the threat is both significant and everlasting, the impact of climate change on global economy is still very difficult to measure quantitatively.

 

Q6: In one of the past conference, Professor Riccardo Rebonato delivered a provocative presentation about climate risk stress testing. You mentioned that population growth, economic growth, carbon intensity, technological breakthroughs are endogenous variables to the climate change problem. How can stress tests take this interdependence into account?

 

Professor Riccardo Rebonato:

The point I was making at the EDHEC Climate Finance Conference is that we must distinguish between variations on central scenarios, and less likely but still plausible events. Evidence from paleoclimate shows that in the past abrupt changes in the Earth’s average temperature have occasionally occurred over extremely short time spans (decades).  We do not fully understand why and how this happened, but, as far as we can reconstruct, increases in CO2 were “present at the scene of the crime”. Paleoclimatologists believe that positive feedback mechanisms were at play. When this happens all linear extrapolations go out of the window, and the possibility of more rapid and more severe changes in climate must be seriously contemplated – both from the perspective of adaptation and abatement.

 

Positive Feedback Mechanism (Source: Wikipedia Commons)

 

Q7: We seem to be facing a climate disruption unprecedented in recorded history. With little equivalent historical cases, how could one model the economic impact of climate-induced crisis?

 

Professor Riccardo Rebonato:

Economic theory handles well risk (the ‘known unknowns’), but poorly uncertainty (the ‘unknown unknowns’). However, the very fact that the degree of uncertainty is huge does have direct implications on the recommendations economic theory can offer as to the best course of action. In particular, the more uncertain we are, and the more severe the potential outcomes, the higher the ‘present value’ of future climate damage, and the stronger, therefore, the case for acting early and decisively.

 

“In particular, the more uncertain we are, and the more severe the potential outcomes, the higher the ‘present value’ of future climate damage, and the stronger, therefore, the case for acting early and decisively.”

 

Q8: How important is taking climate change into economic models today? What are the current approaches used by scholars, central bankers and other researchers, if there are any?

 

Professor Riccardo Rebonato:

As I said, dealing with the problem of climate change from an economic perspective is difficult, but not intractable. Unfortunately, many of the economic models that have informed public policy and debate so far (such as the debate about whether the ‘social discount factor’ in the Stern report is ‘correct’) are ‘entry-level’ models that were never intended to provide actionable results. This ‘misunderstanding’ has had very negative consequences, and very smart non-economists (including Nobel prize winners in physics) have come to the conclusion that “it is just a matter of preference”.

 

This is not the case: there are well-established economic models to handle in a far more satisfactory way the climate change problem – models that have been formulated by leading current economists on both sides of the Atlantic exactly to handle the case of uncertain outcomes and uncertain effectiveness of mitigation. Their conclusions, modulo some nuances, are consistent and compelling. We just have to listen to them.

 

Q9: In your opinion, how much of the problems regarding lack of funding for transformative technologies is political rather than technical (technological, economical… etc)?

 

Professor Riccardo Rebonato:

When it comes to solving a major practical challenge, problems are never purely technological, as the funding of their solution also comes to the fore. This is acutely true when it comes to tackling climate change, because to make a real difference the required commitment calls for a war-scale effort. This means that, exactly as it happens in war times, the diversion of resources from consumption to ‘fighting the war at hand’ will have to be large. Unlike traditional wars, however, the ‘tanks of the invading enemy’ are not immediately visible on CNN – and many groups have interest in claiming that there is no enemy whatsoever. They have actually been so effective in doing so, that up to 50% of Americans (and 70% of Republicans) believe that climate change is not caused by humans. Asking this 50% of sceptics and deniers to divert a substantial amount of resources from consumption (via taxation, subsidies, private investment) to research and to implement the required solution is a politically well-nigh impossible task. The current rise of populism and widespread distrust of ‘experts’ is part of the same narrative.

 

The more painful political choices have therefore been delayed, and apparently ‘painless’ solutions are touted as the ‘get-out-of-jail-card’. Nothing could be further from the truth. All experts agree that a viable solution must be made up by a combination of renewable and conventional energy sources, sequestration and negative emission technologies. Unfortunately, only some elements of this portfolio have been under the spotlight, other are almost unknown to the public at large, still other are ‘political untouchables’. As a result, the channelling of resources to various initiatives has been almost haphazard –the US spends more on beer on the 4th July than on fusion research in a year, it is difficult to believe that this resource allocation is in any way optimal.

 

Part of EDHEC Business School and established in 2001, EDHEC-Risk Institute has become the premier academic centre for industry-relevant financial research. In partnership with large financial institutions, its team of permanent professors, engineers, and support staff, and research associates and affiliate professors, implements eight research programmes and five company-partnered research projects focusing on asset allocation and risk management.  Additionally, it has developed an ambitious portfolio of research and educational initiatives in the domain of investment solutions for institutional and individual investors. As part of its “Make an Impact” signature, EDHEC-Risk plays a noted role in furthering applied financial research and systematically highlighting its practical uses.

 

 

Lionel Martellini, is Director of EDHEC-Risk Institute. He conducts research in a broad range of topics related to investment solutions for individual and institutional investors, equity and fixed-income portfolio construction, risk management and derivatives valuation. He was previously on the faculty of the University of Southern California and has held a visiting position at Princeton University. He sits on the editorial boards of various journals, including the Journal of Alternative Investments and the Journal of Portfolio Management. He holds a PhD in Finance from the Haas School of Business, University of California at Berkeley. Outside of his activities in finance, he recently completed a PhD in Relativistic Astrophysics (University Côte d’Azur) and has become a member of the LIGO/Virgo international collaboration for the observation of gravitational waves.

 

Gianfranco Gianfrate is Professor of Finance at EDHEC Business School and Sustainable Finance Lead Expert at EDHEC-Risk Institute . He writes and researches on topics related to innovation financing, corporate valuation, and climate change finance. Prior to joining EDHEC Business School, he held teaching and research positions at Erasmus University (Netherlands), Harvard University (USA), and Bocconi University (Italy). Gianfranco also has extensive experience in the financial industry, having worked, among others, for Deloitte Corporate Finance (Italy), Hermes Investment Management (UK), and iStarter (UK). Gianfranco holds a BA and a PhD in Business Administration from Bocconi University and a Master in Public Administration from Harvard University.

 

Riccardo Rebonato is Professor of Finance at EDHEC Business School. He was previously Global Head of Rates and FX Research at PIMCO. He also served as Head of Front Office Risk Management and Head of Clients Analytics, Global Head of Market Risk and Global Head of Quantitative Research at Royal Bank of Scotland (RBS). Prior joining RBS, he was Head of Complex IR Derivatives Trading and Head of Head of Derivatives Research at Barclays Capital. Riccardo Rebonato has served on the Board of ISDA (2002-2011), and has been on the Board of GARP since 2001. He was a visiting lecturer in Mathematical Finance at Oxford University (2001-2015). He is the author of several books, in particular having published extensively on interest rate modelling, risk management, and most notably books on SABR/LIBOR Market Model pricing of interest rate derivatives, as well as on the use of Bayesian nets for stress testing and asset allocation. He has published articles in international academic journals such as Quantitative Finance, the Journal of Derivatives and the Journal of Investment Management, and has made frequent presentations at academic and practitioner conferences. He holds a doctorate in Nuclear Engineering (Universita’ di Milano) and a PhD in Science of Materials (Condensed Matter Physics, Stony Brook University, NY).

 

(訪談由香港國際問題研究員團隊製作)

 

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