Keith Guthrie, deputy chief investment officer at Cardano and a member of its Sustainability Steering Committee and Investment Committee, talks to DerivSource’s Lynn Strongin Dodds about frameworks that can be used for derivatives in meeting the net zero transition.
Q. Can you please tell me about the Institutional Investors Group on Climate Change (IIGCC) and the drivers behind the recent its recent Derivatives and Hedge Funds Discussion Paper IIGCC?
A. The IIGCC are a European membership body for investor collaboration on climate change and have over 350 members, mainly pension funds and asset managers, across 23 countries, with over EUR 51 trillion in assets under management. The IIGCC are at the forefront driving the energy transition and a more resilient future. Their aim is to help investors align their investment portfolios with a net zero target that was set out by the Paris Agreement in 2015. They work to support and help define the public policies, investment practices and corporate behaviours that address the long-term risks and opportunities associated with climate change. The Derivatives and Hedge Fund working group which I co-chaired was convened by the IIGCC to begin to answer the question on how to incorporate Derivatives and Hedge funds into the IIGCC’s Net Zero Investment Framework. It took input from many industry experts both asset owners, traditional asset managers and hedge fund managers.
Q. What do you hope to achieve?
A. To date, many of the frameworks have been built around a traditional long only investing universe. This is not surprising given that the majority of capital and assets are invested that way. Derivatives and long/short strategies adds an extra degree of complexity that has not been dealt with yet in these types of frameworks. Regulators have largely ignored both derivatives and hedge funds and the use of shorting as part of the thinking that goes into a sustainable portfolio. What we are trying to do is to develop a framework where we can measure emissions and create the right kind of pressures and incentives for companies to actually decarbonise.
The IIGCC Derivatives and Hedge Fund Working Group wants to develop a framework in terms of how to think about derivatives, to begin with credit and equity derivatives, in relation to net zero transition.
Q. What are some of the challenges?
A. One of the biggest challenges is asking the right questions. It is apparent that different investors have different objectives, but the first step is to be very clear about which questions you are trying to answer. Most asset managers tend to look at maximising financial risk and reward, but we also think they would benefit from doing the same with maximising influence and real economy impact. For example, on the risk side, emissions exposure can help determine portfolio sensitivity to changes in future carbon pricing. However, shareholders can also have an impact on the real economy by reducing emissions and influencing companies through voting, stewardship as well as collaborative engagement.
This concept of double materiality is still in its infancy, although the European Union and UK are further along on the path. Today, the vast majority of investors globally have not set themselves dual objectives. They mostly set a financial risk return objective but there are ways in which the two can reinforce each other. I think that if your economy is driven by more sustainable businesses, they will over time have lower risk and better financial returns. One way is through thinking about what investment activities have different tiers of influence
Q. Can you please explain further the three tiers of influence set out in the IIGCC discussion paper on this topic?
A. We look at three tiers of influence with the first one being what we describe as very high impact and direct influence. This could be for example, providing new capital to a business, either through debt or equity, or collaborative engagement with other investors on a particular issue. We think that those are highly impactful, direct ways of influencing businesses. The second tier is stewardship which is a baseline, and we expect all asset managers to do. If you own equities, it means voting, engaging with management around ESG issues as well as collaborative engagement through initiatives such as Climate Action 100 +.
The third tier is about impacting the outcomes for companies by influencing their cost of capital through the buying and selling their shares. The view is that if investors are on average buying shares, they are putting upward pressure on prices, pushing down the cost of capital for the company. If they are shorting or selling shares, then their prices will drop, and the cost of capital will increase. If this is done consistently over time, the buying is directed towards more sustainable companies which will in turn have a lower cost of capital and be more competitive. This is an indirect form of influence.
Q. How does derivatives fit into the picture?
A. Derivatives, unlike equities do not have voting rights nor can they be used for engagement. However, they do have an indirect influence because they can impact the pricing of the underlying equity through market arbitrage. For example, shorting a coal company would have the same negative impact as selling the shares. In general, derivatives can be used to either maximise climate influence or managing financial risk or both. One strategy is to go long assets held in physical form to actively engage and vote and go short companies that are high emitters that are unlikely to transition. We try to encourage users to think about how they can use derivatives in conjunction with the direct holdings to maximise their influence.
Q. What are some of the misconceptions?
A. It is important to understand it is not just about buying and selling companies. Risk management is well understood but investors need to also look at how they can maximise impact in the real world. Just buying longs will not do it because this could lead to a concentrated portfolio and too much risk. We want them to look at companies that may not be that sustainable but who they can engage with and influence change.
Also in a net zero context, it is important to understand that shorting will not take carbon out of the atmosphere in the same way as a long position will not actually put new carbon into the atmosphere. So shorts are not a carbon offset. It’s the underlying companies that you’re attempting to measure that are really having impact. For example, a portfolio with 100 tCO2e Long and 100 tCO2e short today has zero net carbon financial risk. In 10 years’, time, the same companies could have doubled their CO2 emission and the same portfolio would have 200tCO2 long and 200tCO2 short emissions. The carbon emissions could actually get worse but portfolio would still have zero carbon financial risk.
In the paper, we say that portfolios with low or zero net carbon financial risk must not be misrepresented as having low real economy emissions or as automatically being aligned with a net zero real economy by 2050. If they do, this is greenwashing.