What is effective engagement?
Established relationships with issuers allow for candid two-way conversations over the life of an investment. We see three components to effective engagement on climate.
1. Understanding the company’s approach
Initial engagements allow the asset manager to develop a better understanding of the company’s strategy, from which the manager can identify those areas that need further consideration.
In terms of evaluating physical risk, it is not only essential to understand where a company’s assets are based, but whether and how the company is considering its susceptibility to such risks. As an example, we engaged with a Danish firm that operates offshore and onshore wind farms as we were concerned with the location of its wind turbines. Despite being designed to endure wind speeds of up to 156 mph, the turbines could still suffer from hurricane winds. Upon engaging, we were able to find the specific locations of these turbines, which, after further analysis, were not considered to be at risk. Even if the turbines were at risk, an asset manager would likely treat assets located in an area expecting growing hurricane risks differently, depending on whether they were insured or not. As such, engagements are vital for information gathering.
2. Emphasising areas of focus
Asset managers can provide perspectives to a company that may have otherwise been de-emphasised, bringing their research on competitors, peers, sectors and regions as well as what they are hearing from clients to the conversation. On the latter point, regulatory regimes on ESG issues are increasingly shaping investors’ investment agendas, and as a liaison point between asset owners and portfolio companies, asset managers can play a role in ensuring these areas are being considered. For example, UK pensions schemes are increasingly required to demonstrate management of climate risks in their portfolios — including alignment of their governance processes and disclosures to the Task Force on Climate-related Financial Disclosures (TCFD).
One approach to mitigating climate risks and improving alignment through engagements is to encourage companies to set decarbonisation targets and seek validation of those targets by the Science-Based Targets initiative. Owning companies that set robust targets and execute against them allows for better analysis of portfolio alignment relative to the client’s decarbonisation goals, as well as lower transition risk over time as assessed via scenario analysis tools. As exposure to transition risks and portfolio alignment are recommended metrics for financial institutions by the TCFD, engagements that encourage science-based targets (SBTs) and transparency about the outcomes of those engagements should allow UK pension schemes to demonstrate adoption of these best-practice recommendations.
As an example, we engaged with a global REIT, discussing the company’s lack of SBTs as well as its high weighted-average carbon intensity. We were concerned by its unwillingness to set SBTs, believing the company would prioritise revenue generation over carbon-emission reductions. Following our engagement, where we expressed our concern to management, the company has since put in place SBTs. In this instance, we were able to communicate the importance of setting SBTs in defining decarbonisation goals, which also reaffirmed our firm’s stance on reducing carbon emissions among assets owned, in line with our commitment to the Net Zero Asset Managers initiative.
Finally, this coordination allows for a deeper understanding and action that spans beyond the individual issuer. For example, during engagements, we often ask how an issuer plans to tackle Scope 3 emissions1. These are typically more difficult to address and reduce because they relate to indirect emissions, which are harder to capture. By engaging with a plethora of companies, we can facilitate knowledge sharing, using the insights gained from issuers that have a particularly innovative approach to addressing topics like Scope 3 emissions, to better support to those that are struggling. This allows for better outcomes across the portfolio.
3. Active monitoring and taking action
As seen with the case of the global REIT example, once the parties understand each other’s objectives, engagements can be used to steer each partner towards the common goal. It is crucial to highlight that divestment alone does not achieve the broader decarbonisation goal — only long-term engagement can help with this. To that end, it is important that engagements do not comprise a single conversation. Once the climate-change discussion is initiated, asset managers should continue to monitor and re-engage — and potentially take action. As one of the objectives of engagement is to obtain information, if, throughout the process, the manager learns that no meaningful progress is being made, they may decide against reinvesting maturities into that issuer and, at the extreme, to divest, even in a low-turnover approach. Similarly, if a company has set an SBT, the manager should continue engaging to ensure execution against its stated pathway. It is, of course, also important to understand each company’s unique circumstances, as this will influence the manager’s approach to further engagements.