Perspectives : Philosophy | April 28, 2022

Our approach to climate risk

Climate change is a complex risk that presents physical, societal, and economic challenges to countries around the world. In this second of two Q&As, John Galloway, global head of Vanguard Investment Stewardship, discusses Vanguard's views on climate change and the role that effective stewardship will play throughout the energy transition to mitigate the financial threat to long-term investors.

What is Vanguard's view on climate risk?

Galloway: The impact of climate change on our environment and the wider socioeconomic ecosystem is one of the most complex problems facing the world today. Vanguard research, based on consensus scientific climate change scenarios, projects a negative impact on global GDP by 2050 in all scenarios. The projected net drag is about 2% to 4% in best cases and closer to 10% in worst cases.

Climate change poses a very real financial risk to virtually every long-term investor. It's hard to identify any Vanguard fund portfolio company that doesn't face some form of climate change risk, either a physical risk to its operations and its customer base or transition risk in terms of expected regulatory and market changes.

Our Investment Stewardship team represents Vanguard's internally managed equity funds, the majority of which are index funds. By design, index funds provide broadly diversified access to global markets, at low cost and for the long term. That broad market diversification also brings exposure to climate risk. That's why our Investment Stewardship program works every day to help safeguard long-term shareholder value.

How does Vanguard Investment Stewardship address climate risk?

Galloway: We are engaged owners on behalf of our funds. Through research and advocacy for strong corporate governance practices, direct engagements with company management teams and boards of directors, and proxy voting, we work to ensure that portfolio companies are taking the appropriate steps to address the risks that climate change poses to long-term investors.

We believe in the power of engagement. We have ongoing conversations with portfolio companies to share our expectations of them when it comes to addressing climate change risks on behalf of investors.

First, we expect company boards to demonstrate effective oversight of climate-related risks. That starts with a board that has the requisite skill, perspective, and independence to exercise appropriate climate risk oversight.

Second, we expect to see evidence that boards have robust strategies and mitigation measures in place to address climate risks.

And third, we expect boards and companies to explain their plans to remain resilient and successful in the face of changing regulatory and market conditions. This includes providing clear, comprehensive, and comparable climate risk disclosures, including any specific climate change transition targets and progress against those targets over time.

As with other material risks to long-term shareholder value, if a company does not demonstrate meaningful progress toward addressing risks associated with climate change, we may use proxy voting to support appropriately targeted shareholder proposals, or to vote against director nominees to demonstrate our concern.

Why doesn't Vanguard just divest from carbon-intensive companies?

Galloway: On behalf of our investors, Vanguard invests for the long term. By design, our index funds buy and hold companies for as long as they are in the benchmark index. So divestment is not an option for index funds that lack a mandate to avoid certain sectors or companies. In addition, from a real-economy perspective, there are significant limitations and downsides to divestment as an instrument of change.

This is where effective stewardship comes into play. By owning companies throughout their energy transition, and by focusing on the long term, we can encourage boards to oversee and manage climate risks, disclose progress, and deliver more long-term sustainable value.

How do you measure companies' progress on climate risk mitigation?

Galloway: Quantifying climate risk at the individual company level, and tracking progress in mitigating those risks, is a work in progress. The lack of mature, standardized measures is a real challenge. A number of industry and regulatory efforts aim to make progress on this front. We have hopes for these efforts, as we've seen progress across the fund portfolio companies in the five years since the Paris Agreement—which provides a common framework for reporting on climate efforts—took effect.¹ For example, we're seeing greater adoption of clear and consistent climate-risk reporting frameworks. More than 2,600 organizations now support the Task Force on Climate-related Financial Disclosures (TCFD) framework, including 83 of the world's 100 largest companies.²

And we see signs of other, more qualitative progress through our engagements. More boards are increasing their understanding of climate risk, either through board education or by adding directors with relevant skills and backgrounds. We also see more companies setting targets in the context of the Paris Agreement, as well as performing scenario analysis to assess future risk and opportunities arising from climate change.

Does Vanguard address climate risk on behalf of investors in other ways besides investment stewardship?

Galloway: Vanguard's efforts extend beyond engagements and proxy voting. We hold conversations with policymakers and are aligned with several climate-focused organizations and initiatives such as the Net Zero Asset Managers initiative (NZAM) and the Ceres Investor Network on Climate Risk and Sustainability.³ We have also been a longtime supporter of the TCFD framework created for disclosing climate-related risks and targets.

As an investment provider, we incorporate environmental, social, and governance considerations into most of our investment processes. Across the globe, Vanguard offers both passively managed ESG funds that screen out companies based on predetermined ESG screening criteria, including involvement in fossil fuels, and actively managed ESG funds that invest in companies that can deliver long-term value based in part on their stewardship and sustainability practices. And many managers of our active funds consider financially material ESG factors when selecting securities, regardless of an explicit sustainability target.

If Vanguard cares about climate change, why doesn't Vanguard support every climate-related shareholder proposal?

Galloway: We evaluate each shareholder proposal case by case to assess its long-term effect. Vanguard's sole agenda is executing our fiduciary duty to act in our investors' best interest by promoting and protecting long-term shareholder value. While advocates or proponents of a given shareholder proposal may believe it will help address climate change risks, our assessment is based solely on our assessment of whether the proposal is in the best interest of shareholders at the company in question. That's the important work executed by our Investment Stewardship team: staying true to Vanguard's fiduciary obligation to our clients and focusing on promoting and protecting long-term shareholder value through our assessment of the specific facts and circumstances of each company.

We recognize that our nuanced approach sometimes gets misunderstood or is inaccurately portrayed in the market. Some advocates and observers resort to "scoring" our voting record based on the false presumption that all shareholder proposals are equal. That approach fails to recognize our commitment to protecting our investors from risk, and the power of our active engagement and thoughtful voting.

We take our responsibility very seriously. Investors in our index funds have not asked us to pick winners and losers in the market, to dictate strategy to portfolio companies, or to pursue an agenda beyond our focus on long-term shareholder value.

¹ The Paris Agreement, an international treaty on climate change, was adopted in December 2015 and entered into force on November 4, 2016, after its ratification terms had been met.

² Source: Task Force on Climate-related Financial Disclosures (press release: Fourth TCFD Status Report Highlights Greatest Progress to Date on TCFD Adoption; report: 2021 Status Report).

³ The NZAM initiative is an international group of global asset managers committed to supporting the goal of net-zero greenhouse gas emissions by 2050 or sooner, in line with efforts to limit global warming to 1.5 degrees Celsius, and to supporting investing aligned with net-zero emissions, also by 2050 or sooner. The Ceres Investor Network on Climate Risk and Sustainability represents more than 200 institutional investors working to advance sustainable investment practices and accelerate the transition to a net-zero-emissions economy.


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