How can we encourage institutional investors to make climate friendly decisions?

To meet net zero emissions all sectors of the global economy will need to embark on unparalleled transformation. The financial industry is a key player in this transition — with the potential to accelerate us towards that goal or impede the journey, depending on investment and divestment strategies.

However, fossil fuel projects continue to attract investment and increase atmospheric greenhouse gas emissions, which are higher now than they were in 2016 after the Paris climate accord.

More urgent than ever

To combat climate change, US$90 trillion is needed in sustainable investments by 2030. However markets aren’t moving fast enough. The Paris Climate Agreement calls out the role of the finance industry in boosting green innovation and low carbon industries. The question remains however, as to whether shifting to more sustainable investment is in the industry’s interest.

Investing for the climate makes financial sense

It’s becoming clearer that climate friendly investing is financially worthwhile. There are two reasons for this. One is to reduce exposure to financial risk as we move towards a low carbon economy. Fossil fuel extraction companies have declined in value over the last 10 years while some projects have been written off completely. On the other hand, green investments offer economic opportunities as the economy shifts gears — with indices of companies which factor in climate risk outperforming the market in recent times.

But institutional investors have been slow to respond

Institutional investors (i.e. banks, pension funds, fund managers) manage the majority of the world’s assets, and despite increasing interest in eco-friendly investing, have not responded fast enough. There is an urgent need to understand why — in order to establish effective ways to encourage more climate friendly investments sooner.

We asked institutional investors about their investment decisions

We collaborated with the interactive market insights company MarketMeter to investigate the values, attitudes and behaviours of 60 institutional investors, representing a group of ‘mainstream’ investment organisations and firms in Australia. We asked a series of questions about how they made investment decisions over the past 12 months.

We found that Institutional investors are not prioritizing climate risk

When we asked about the importance of 26 corporate priorities, climate risk ranked close to the bottom of those priorities (see chart below). Perhaps unsurprisingly, the top rated priorities were all more traditional benchmarks of financial performance e.g. earnings quality and execution of strategy.

Source: MarketMeter

The climate investment mindset is held back by behavioural patterns

We wanted to understand what was behind the low prioritisation of climate risk. Investors told us that a range of factors prevented (barriers) or encouraged them (levers for change) to consider climate risk in their investment decisions, presented in the table below.

Behavioural insights can help change investor behaviour

The climate crisis represents an existential risk, but also opens a number of economic opportunities for forward-looking and prudent investors. However financial professionals are not responding fast enough.

While there are wider systemic and market factors at play, our research highlights several behavioural barriers, as well as possible levers to catalyse change. Informed by these findings and the behavioural science literature, we make the following suggestions for where behavioural insights could help organisations and the wider financial system nudge financial professionals towards more sustainable investments:

Communicate dynamic social norms. Communicating that increasing numbers of people are adopting a behaviour, for example eating less meat, can motivate behaviour change. Climate finance may not yet be the mainstream, but we can draw attention to the fact that more and more investors factor in climate risk, and highlight that public interest in ethical investment is on the rise (as shown by Google Trends data) and that more and more governments are adopting strong net zero emissions goals.
Anchoring and defaults. We rely heavily on reference points when making decisions. Investors are no different, and commonly compare performance relative to financial benchmarks — broad measures of how the economy or certain sectors are performing. Climate benchmarks, such as the EU Climate Transition Benchmark should be promoted as the default comparison yardstick when reporting performance.
Loss aversion. We are more influenced by losses than we are equivalent gains. Highlighting the increasing financial risk of extreme weather events or stranded assets (i.e. fossil fuel projects abandoned when no longer profitable) is likely to influence institutional investors looking to insulate their clients or portfolios from heavy financial losses.

Find out more

We will be presenting this research as part of a wider report on barriers to climate finance entitled We Need A New Anchor, written in collaboration with non-profit ethical investment library and research centre Altiorem at the Responsible Investment Australasia RI Australia 2021 conference on May 7th 2021.

By Dr Alex Gyani, Director of Research and Methodology, APAC, Saul Wodak, Associate Advisor & Zoe Powell, Associate Advisor, BIT