Cambridge Associates' climate head on moving from 'process' to 'pricing'

Climate risk is becoming harder and harder for private markets investors to ignore, and yet, even now, it may still be underpriced across many portfolios. Hello, and welcome to another episode of the new Private Markets podcast. I'm Charles Avery, senior reporter here at MPM, and joining me for this conversation is Simon Hallett, partner emeritus at Cambridge Associates. Simon spent 16 years leading Cambridge's European Foundation and Endowment practice, but five years ago took leadership of the firm's climate strategy, and now advises the full range of the firm's clients on integrating climate into their portfolios. That puts him in a good position to explain why private markets approach to climate risk is, as he puts it, "machroding in process, but not in pricing." Why the industry has gone so much better at measuring and reporting on climate exposure, but still struggles to let that analysis actually drive underwriting and investment decisions. We get into the structural reasons behind that gap from the absence of historical data to the non-linear compounding nature of climate damage, and what LPs and GPs can practically do about it even without perfect information. Now in case you're unaware, new private markets as an information service designed to help allocators and managers make better decisions when raising and deploying capital in sustainable private markets, you can read all our latest coverage at newprivatemarkets.com. Simon came by PEI Group's London office in August, and I hope you enjoy the conversation. Well thanks for joining us, Simon. Maybe to start with, it would be interesting to get a brief overview of when you look at your position and the foundation-down clients that you work with, how developed is their understanding of climate risk within their private markets, portfolios? Yeah, I guess in summary, it's a lot better than it was, say three years ago, but it's still evolving and it's still uneven. And if I had to put it in a single line, it's maturing in process, but not in pricing, which of course matters a lot to us as investors. Let me explain what I mean. On process, there's been real progress, and I'll talk, by the way, kind of broadly across, I won't be talking about particular kind of client groups, it's how we see the industry. On process, there's been real progress, so we've had industry initiatives like Initiative Climate International, ICI, ILLPERS, ESG Data Convergence Project, and what they've done is they've given us a common language and some other data expectations and to an extent improved climate diligence tools for the industry, and adding into that, data vendors become much more granular, you know, can buy location-based risk data that will tell you what a serious flood does to one specific building, which we never had before. So that's the sort of the input side, and from our side, we've rebuilt our own manager assessment framework that includes climate competence broken down into four components, governance, transparency, process, and outcomes, and that has risk assessment sort of running right through it. So collectively, we've got a somewhat richer picture, qualitative, as well as quantitative than we have three years ago. And so in terms of translating that into, you know, presumably most of your clients are accessing private markets through third-party managers, what does that look like in terms of that picture and what your clients are getting from them? You know, on the plus side, most GPs can now describe, for example, their approach to emissions measurement, you know, they can identify material sectors, material exposures, and they can articulate usually some level of climate governance, both the firm or portfolio company level. Stronger managers go further. They actually use climate data in engaging with management teams, in value creation discussions, particularly where you've got supply chain exposure or exit buyer expectations that are clearly relevant. So that's kind of encouraging to see. But the market's still very mixed, and here's the part that matters. The climate shows up still, much more strongly in reporting practices. It doesn't show up so much in underwriting and valuation or in investment committee decision rules. So we've got better process discipline, and we've got better comparability across managers, but we've got less evidence that climate analysis is actually driving portfolio construction or portfolio company selection in a hard-edged way. So stating it plainly, from what we can gather, private investors are still not thinking about this enough. Yeah, the managers who understand the issue best are sometimes the least exposed to it. The thematic clean tech managers, for example, are all over this topic. Real assets managers, they're becoming more aware, particularly in real estate and infrastructure, but they still tend to see it at the micro level, the asset by asset building by building, and maybe later we can come to why that's a problem. But it feels to me as though many private investors are still investing through the rear view mirror when it comes to climate change, and the danger obviously is that by the time the impacts are obvious and start being factored into valuation, it'll be too late. So that's a problem for GPs, it's a problem for LPs, it's a problem for society as a whole, because the clock's ticking on this. So there are structural reasons why we're in that position. And so when you think about those reasons, I mean, how far in terms of barriers preventing a more kind of proactive view of climate risk, are they technological? Are they about just sort of choices made at the investment level and prioritisation? How do you diagnose sort of the barriers preventing progress? Yeah, it's a combination of several things, but maybe the answer I should say, I don't think what's holding us back is laziness or ignorance in the industry. This is genuinely hard, and it's hard for reasons that are specific to climate. So I'll group what we see as the main ones into three. The first is the absence of history, where used as risk managers to maximising use of historic data to think about evidence-based probabilities, but climate change is taking us into a new world, and it's one we have to hypothesise about rather than look up. So the shape of its unfamiliar, in some ways it's not a risk, right, including climate danger, it's not risk, it's a certainty, and he doesn't an episodic cycle like a financial crisis or recession, it's cumulative, and it's self-reinforcing the chronic aspect of it that's often not picked up. And to practical purposes, it's irreversible. So how do we, what models do we use to think about that, what mental models, what's not really what finance is used to? It's quite different from modelling a recession of decades of data that you've already got, which is what we tend to spend a lot of time doing. So that's reason number one. Reason number two, and this is one I'd really like people to take away, is non-linearity, right? So as temperatures rise, you know, the range of outcomes rises with, you know, imagine that the bell curve shifting to the right and getting fatter. And that really matters because the immediate primary way we see the effects of climate change transmitting through to financial assets is through the damage that comes from extreme events. And as the probability curve shifts to the right and it gets wider, the frequency of those events, it doesn't just rise gently, it rises dramatically exponentially. There's a huge amount of convexity in climate risk. Now the market does understand convexity, but we need to apply it in this sense. And right now the market hasn't got great tools for pricing non-linearity in these long horizon risks and, or see, it's particularly pertinent where you're underwriting an investment that you might not be able to accept for seven, twelve years. And then you're thinking about what's going to be in the mind of the buyer to whom you exit. And part of the reason for all this is that two little works being done on translating the physical events that we talk about and that hit the news into financial damage. And again, the history is no guide there, partly because of the convexity, but also because there are lots of buffers between the physical world and investors, I mean, insurance, most obviously, but also lots of different aspects of the public sector, you know, the public sectors hit really hard by the negative impacts of climate change. Those buffers are finite, you know, they can be overwhelmed like a dam and the risk then comes over the top, or they can be eroded, like we're seeing an insurance market, we're seeing insurance gradually retreating from lots of asset areas. So once that happens, the investor suddenly carries the full cost, they've been seeing no lost data up to that point, suddenly they've got the whole risk on their book. And that's hard to predict and it's hugely material. Let's stop off an insurance for a second, because there's an industry that's actually quite good at these financial risk assessments, but they typically reprise annually, right? So they don't have a need or incentive really to do this multi-year modeling that would be really, really interesting for us as long as the rise investors, you know, there's no forward curve in climate damage and that's a huge missing price signal that gets to why I think we're under appreciating this risk. I've used lots of physical risk kind of metaphors to talk about this, but this isn't only a physical risk thing, transition risk has exactly the same shape. So if you think your asset that you're contemplating and might face competition from some emerging technology, that competition likely follows an S curve. So start slow, then rapid acceleration, so it's the nonlinearity again. So nonlinearity, that was the barrier too. The third one, it's kind of the biggest, but it's the quickest to describe. It's that all these like tail risk modeling, this helps us manage the micro risks, you know, does my factory get flooded, whatever. And it'll help you manage risk if those risks isolated and if they're independent. But they're not, right? the components of climate risk that they're anything but. they're correlated and they're self-reinforcing, they feed into each other up and down supply chains into an overall macro effect. And the model I've seen, including from the main commercial data vendors, suggests that the macro component of this risk is an order of magnitude larger than the bottom-up asset-specific risk that we actually spend a lot of time measuring and monitoring. And just coming back to the nonlinearity point, and that point around there being buffers between physical events and investors, I mean, if we think of, I mean, we start here in London at the end of a summer where we've had record temperatures. And we've seen, you know, I don't know about you, but I've been on trains that have been disrupted because of the heat and various weather events, causing damage to infrastructure and all those kinds of things. Have those kind of issues actually cropped up in portfolios as yet as something that manages a reporting or is it still at the point where those buffers that you were talking about between physical events and investors are still holding up? The events are kind of cropping up in commentary, but they're kind of isolated that people are not joining the dots. But I'll offer an example here of a manager that we talked to, who we pressed them fairly hard on the potential risk for a particular asset, to which their response was, it's a short, right? So that's how we deal with risk in that instance. Why, forward, you know, a couple of years, that assets got ridden down. I don't know, but supposing it's no longer insurable, which also means it's no longer collateral for leverage. Yeah, that dramatically changes the valuation case for that. So I think we're starting to see things like that appear. But people not anxious to kind of offer full transparency on those kind of things. Yes. And I mean, you mentioned earlier that there wasn't necessarily a consistency between the level of exposure that the managers strategy might have to these kind of risks and their level of attentiveness to it. And I suppose in one sense, something like clean tech, you can sort of see why they might be all over climate risk in a way that a normal with market fund might be. But I mean, beyond that, do you see factors which can give you an inclination to which kind of managers are taking this seriously? Is it geography? Is it team makeup? How do you think about it? Hmm, interesting. Beyond the sector they play in that would give them that natural information. Client base to a certain degree because managers respond to client demand, although it's quite hard to put a finger on that. I think what will drive change of behavior here is as we touched on the price signal. So there's a feedback loop between attention managers pay and what visibly costs visibly appear. So what's going to move the needle is exit values being materially affected by climate risk. And that might be episodic. It might be an experience that a manager has that changes their perspective on it. So it's happening in certain corners of real estate and infrastructure, but it's not happening in broader private markets. And if it starts to be repriced for climate risk. So here's a lot of metaphor that's kind of interesting. Compare the sort of systemic risks of climate to the AI disruption risk that we've applied to the SAS software sector. So people are all over that because it's really obvious now in real time. That's the similar kind of risk. So if managers start treating climate risk like they've treated that kind of disruption risk, it's get a good get into their underwriting immediately. Now, that's an example as well of how the incidence of your exposure drives your sensitivity to systemic risk. You know, software has sort of become a larger and larger portion of like buy at market in the last 10 years. So it that's appeared there. But it's pulled the attention away from the sort of building understanding of climate risk. So if anything, it's probably gone down the the attention space for the the median manager versus three years ago because other things are competing for their attention, which is kind of a shame because it hasn't gone away. It's still on that exponentially rising curve. I mean, thinking about that and making sort of switching focus to your clients, obviously, foundation and diamonds of I'm assuming varying sizes and capacities. I mean, how how consistent are your clients in firstly, I suppose, what they want from you in terms of the advisory provide and just generally in terms of where they are with integrating and thinking about climate risk. Yeah. So the process, right, is consistent. The way we're up with clients, we use the same framework for assessing climate risk at the manager level. You know, everybody gets that. That gives us a base of consistency. The attention, like we were talking about the managers, that varies and it's quite natural that it should vary. There's a few things that drive that. So the first might be mission, an endowment or a foundation where climate or the natural world's emission priority, the awareness and the interest and also the knowledge is often much higher. So the topic, it succeeds in that competition for brain space. So we might experience some like really detailed diligence questions on particular manager, live care, you know, forestry manager, the question might be why exact variety of trees are they planting there? It goes to that level of detail. The second parameter is really resource size. That's pool size and organization size as well. If you've got team of two, there's a limit to what you can work on and what gets onto the investment committee agenda. And that's again, that's an entirely legitimate sort of ranking of resources. And the third, I think, governance horizon, how long of view a board of trustees actually takes? So, you know, you've got spectrum, you've got the really specific physical risk underwriting of a particular asset, kind of questions that will come out of an environmental organization. The other end of the question, the conversation might still be debating how much this matters, what's the materiality to us at the super high level. So different stages of the conversation. But I'd say, you know, from practical experience across that whole spectrum, the questions on climate risk are increasingly coming from the very top. They're coming from the board level because they're the people with the longest time horizon and the broadest perspective. So that's cascading down. And sort of taking that analysis and thinking about what that means for manager selection, you know, what kind of exposure or rather among your clients, they're at the most sophisticated or prioritizing this the most highly. How does there the kind of exposure that they're looking for in their private markets will fairly differ from a manager that or from a client rather than this, you know, it's lower down on the on the agenda or they don't have the capacity to spend much time on it, etc. So I'm going to ask of this, asked on to this from the perspective of how we look at managers because that's they get ultimately goes back to the to to the client. So I mean, where it bites is as a fundamental test of underwriting rigor. So, you know, if a manager's failing to incorporate a climate risk that could reasonably lead to permanent impairment or loss of capital, always already experienced that in the prior fund that raises huge questions for us about their underwriting rigor generally, not just in climate. So this is how the mechanism works. So for many years, we've asked managers to share a range of ESG information with us, including climate risk. And that's fed into the due diligence. The manager assessment framework that I mentioned earlier, that formalises it. So the research and that has to score the manager on different range of climate topics. So that's part of every due diligence. There's a consistent climate assessment sitting in that report, but we do that on a materiality basis. So, you know, it's more relevant and expansive for some managers than others, for infrastructure, for real assets, expansive, elsewhere, it's lighter. So take growth equity, for example. You know, if firms investing at the intersection of technology in sort of foundational industries, so the capital heavy stuff, they'll have often more awareness. I'll hopefully a framework for risks like supply chain management. And we'd certainly expect them to do that. Firms investing further up the stack in the application layer, they'll often give you poorer and flimsy answers. But in reality, their reducing credit risk may genuinely lower, be lower. So we've got to be pragmatic in what we expect according to a reasonable assessment of the materiality. So what we're actually looking for, and I think this dovetails precisely with how clients think about manager investments, is what we're trying to identify are instances where managers got limited understanding of a climate risk that would reasonably be relevant and material to their strategy. So that's a fundamental input to a judgment on investment quality. So that, if you like, closes the loop, every client wants the highest quality judgments on, you know, the investments going into fun that they're going to potentially commit to. And this is a key indicator of that as well as the broad perspective on climate specifically. It comes back to what I said about convexity, really. The past is a poor guide. And this very much comes from our client base as well is where looking forward into a harsher world. Those are the kind of questions we get from investment committee members or board members and the questions that occur to us as well, what if, what if, what if. So we're trying to look forward into that harsher world. And we need to judge whether the manager's doing that too. As you say, there's no historical precedent for this. And therefore the quality of the data that you're able to put together will necessarily, I suppose, be harder. Well, firstly, harder to verify and therefore patchy. Is there a danger that, you know, the level of which you can plan according to this, so a lower quality data set means that you're sort of in a cache 22 position where you want to take it seriously and you want to integrate into your decision making. But the only way you can do that is using data that you're not entirely sure about and therefore you end up in a bit of a difficult situation. It's a really interesting question because I think there's an enormous danger in waiting for the right data before you act one or two, trying to optimize on the basis of analysis. So I guess the one thing we should take away from the convexity points and the difficulty of data is there's a whole stack of uncertainty here. We know the direction, we know with certainty that risks are going to increase, damage is going to increase in time. We don't know precisely where when or how and we're not going to know, right? That's that's it's important to really recognize this. So from a response point of view rather than trying to say we need better data so we can optimize a portfolio that's going to manage the risk down to a certain level. We accept that we're not going to get that data any time soon. So our job is to build a resilient portfolio and look for markers that are going to undermine that resilience which might be over concentration in certain asset areas, it might be leverage in the wrong places. We need to be asking the right questions and we need to be asking the right questions of investment managers and being assured that they're asking the right questions of portfolio companies when they're doing deal underwriting. So it's process and is it actually driving results? I think the as in the kind of the wider world of climate investing across total portfolios, the data can be a distraction. If we wait for more data it's going to be too late. We're making decisions now for investments that we're going to be stuck with for 10 or 12 years and we've got plenty of ideas and concepts and tools that we can use to make good judgments about that. We just need to understand the materiality. Exactly what the number is is not the point at this stage. And that was a final question and thinking again of the foundation or an endowment out there that a team of two trying to think about this and listening to this so far thinking it's extremely complicated and extremely difficult to do. And I suppose for any out there that have the misfortune of not being advised by Cambridge associates is there sort of two or three things that you would recommend that they do or two or three questions they ask of managers in it being kind of practical easy terms that can begin to get a handle on some of these some of these things. Yeah. I think the first thing is to just prod and poke the managers on individual decisions they take and try and get a sense of plausibly whether they incorporate climate in any honest and material way. A way of thinking about the answers here is the answer that's too glib and precise is likely to be an implausible one because the reality is as we were just talking with data we actually don't know. What you want to hear from your managers they take it seriously is that it's driving decisions that they make but they have humility about what they know and they accept that there's stuff that they don't know. I mean that's a good start awareness of if a manager can't describe to you where in their opportunity set or the kinds of things that are in historic portfolios where risk are greater risks are less you know that's you know if they say well actually it's not really material to our sector or well we just devoid investments whether it's going to be climate risk it's not plausible answer and there's a lot we can do without the data with just sheer common sense and expect thoughtful reasonable answers from investment managers. If I was setting up portfolio for the next 10 years and I knew I couldn't touch it and I had very little time the tension to do it I'd be thinking about how can I make this resilient rather than how can I pick the best portfolio for some idea of what the world's going to be and that's about thinking about diversification in lots of different ways possibly more diversification than you think is going to maximize returns you're thinking about leverage and concentration of risk and try to avoid those that'll do you a good lot of good. That's it for this episode of the new private markets podcast thanks for listening and if you enjoyed the conversation subscribe wherever you get your podcasts and head to newprivatemarkets.com for all the latest going on in sustainable private markets. We'll see you next time.