Aaron Drew is an Associate of the NZIER and Chief Investment Officer of the Stewart Financial Group.
Next week in Auckland the eighth annual meeting of the International Forum of Sovereign Wealth Funds will take place, hosted by one of the top performing sovereign funds in the world, our own New Zealand Superannuation Fund (NZSF).
Its 30 member funds collectively have about US$5.5 trillion ($7.69 trillion) under management - a truly staggering figure - representing 80 per cent of assets managed by sovereign funds globally.
One of the key themes at the forum will be climate change. The days of assuming that climate change can be ignored as an investment issue has passed. As long-term stewards of their nations' wealth, sovereign funds are asking the question: How should we manage climate change risks?
Answering this question first involves identifying the sources of risk. Risks from the physical impacts on weather conditions, sea levels, and resources such as ground water supplies, fisheries and arable land is expected to magnify over this century.
Over the short to medium-term, the likely larger risks are the impact that climate change is having on spurring both technological innovation and policy measures to reduce greenhouse gas (GHG) emissions.
To take one example, the performance of companies that derive a significant share of their revenues from coal mining, or burning coal in the production of electricity, has been woeful over recent years.
Policy and technological innovation has led to the rise of competitive, cleaner alternative energy sources (in particular wind, solar and natural gas).
Importantly, we will intensify our efforts to actively seek new investment opportunities in the areas of alternative energy, energy efficiency and transformational infrastructure.
Markets have begun to factor into these companies' share prices the potential that their assets will be rendered obsolete, so called "stranded asset" risks. This risk is now seen as possible - although still unlikely - for the fossil fuel sector in general.
Having identified the sources of risk, the next question to address is how are they priced? Here the debate gets more contentious, and the answer one believes defines how the risks should be managed.
One influential, mainstream strand of opinion is that markets efficiently price all known risks. This means, for example, that there should be no investment benefit from excluding companies with very high GHG emissions in a global equity portfolio, or "tilting" portfolios towards companies with lower GHG profiles.
The impact could instead be to raise investment costs and reduce diversification. Ethical considerations aside, the management solution is simple - do nothing.
The alternative view point is that the investment impacts are unlikely to be fully factored into prices given they occur over a long-term period - much longer than the typical horizon of an equity analyst focused on the minutiae of a company's financial statements.
The boiling frog analogy is apt. If markets under-price GHG risks, then reducing exposure to the most at-risk assets, and increasing exposure to assets that could out-perform, is likely to improve a portfolio's long-term returns.
This view has been taken by the NZSF in its recently announced Climate Change Investment Strategy. In the words of the fund's chief executive, Adrian Orr:
"Some assets we invest in today may become uneconomic, made obsolete or face a dwindling market. Reducing the fund's exposure to these risks and to the physical impact of climate change is good for the portfolio, and consistent with our mandate to maximise returns without undue risk.
"Importantly, we will intensify our efforts to actively seek new investment opportunities in the areas of alternative energy, energy efficiency and transformational infrastructure."
Leading sovereign investors like the NZSF also have the clout to change individual company behaviours through their voting policies. But so too can retail investors make a difference, en masse, to the way their wealth is managed.
Fund managers, financial advisers and KiwiSaver providers are nothing if not responsive to the demands of their customers.