This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.
Most institutional investors today recognise the need to incorporate climate change into investment decisions. However, it is not a straightforward task and the gaps between realisation and action are persistent.
Some of the challenges to taking action have been widely debated and oft-cited, such as a lack of consistent signals from government policy makers on climate change; the need to upscale new technology; a lack of suitable investable opportunities; or a lack of data, models or suitable metrics.
These insights have propelled a number of new industry developments and regulatory reform efforts that focus on fulfilling ‘informational’ needs, such as best practice processes and new data, tools, and metrics in the hope that knowledge and information will propel investors to take action. Indeed, the FSB’s Task Force on Climate-related Financial Disclosures (TCFD) recommendations and the Network for Greening the Financial System efforts go to the heart of the lack of data and metrics and provide a useful framework for regulators, companies, and investors to move forward on their actions and disclosure in relation to climate change.
However, there are additional obstacles to investor action on climate change beyond those most commonly cited (which tend to be ‘informational’ barriers), and these relate specifically to investor behaviour itself. Our recent paper looked specifically at institutional investors and the prevalence of a range of cognitive biases, the psychological, social, and cultural underpinnings of these biases, as well as the role of power relations and how that may impede action at the organisational level.
Putting it another way, the assumption that if decision makers ‘have information, they will act’ is still predicated on the assumption of rationality, even when there is clear evidence that this is not the case.
Our paper argues, and finds evidence to suggest, that unless we more explicitly acknowledge the human dimension of investment decisions, the investment community will continue to perpetuate and participate in short-termism and fail to adequately manage systemic risks, such as climate change. It is for this reason that our study looked at institutional investors and their response to climate change as “humans” who have bounded rationality[i] and make decisions based on a range of influences, some of which are conscious and others unconscious or automatic.
Through a series of interviews with c-suite executives and an online survey completed by 90 respondents who are insiders to the institutional investment community with representation across different roles, functions, and regions, we identified the following 7 key findings or themes:
- Beliefs: There is general acknowledgment of climate change as a systemic risk, but in practice at the day-to-day level, there is a degree of separation from the issue in terms of what that means in practice.
- Specifically, we found evidence of myopia and cognitive dissonance.
- Perceived Difficulty (general): There is growing effort and momentum in some areas (such as engagement with companies on climate change), yet it is still “not really incorporated into investment analysis.”
- Evidence of narrow framing, loss aversion, and heuristics.
- Perceived Behavior of Peers: Most respondents do not think their peers are taking strong action on this issue, so they also feel a lack of motivation to act.
- Evidence of herding, loss aversion.
- Perceived Difficulty of Specific Actions: There is a degree of resistance to change existing frameworks; it takes time and energy and motivation to see it through, which may not be present at the individual level or across organizations.
- Evidence of anchoring, dominant heuristics, and rules of thumb.
- Perceived Challenges incorporating into Investment Decisions: Of the three dominant barriers that were identified by respondents, two of them relate to behavioral processes (lack of organizational buy-in and perceived complexity) and the third relates to information needs (lack of data).
- Evidence of status quo bias and cognitive dissonance.
- Perception of Risk of taking action: When it comes to taking action to try to change “the other” (external fund managers or companies) it is considered to be easier. When it comes to changing their own practices (i.e. valuation frameworks or asset allocation models) then that is considered to be much more difficult.
- Evidence of status quo bias and narrow framing.
- Perception of Risk of NOT taking action: Half the respondents believe that failure to act on climate change would not result in a less diversified portfolio.
- Evidence of overconfidence.
An additional theme that was pursued through the research was the role of power relations and how that may contribute to a slowing down of investor action on climate change. Specifically, we looked at the different functions within investment institutions and the different beliefs and behaviours that predominate between the more powerful and less powerful functions. In other words, do sustainability and climate change champions inside organizations exist at senior levels to sufficiently influence the outcomes of their organization?
Our paper discovered that that there is a difference between the more powerful and the less powerful agents inside an organization as defined in our research, and that the former (being predominantly CEOs, CIOs, head of investment strategy) is more likely to find it difficult to integrate climate change into valuations, to see how it fits into existing frameworks and investment practices, and to accept its compatibility with fiduciary duty.
This finding raises some important questions around the governance of climate change inside organizations and how those considerations need to be escalated such that the climate change champions have sufficient power and influence over the outcomes of their organization. Financial regulators could also utilize these insights as they review standards of governance specific to climate change responsibilities to address this behavioral gap.
In summation, our research findings have potential implications for institutional investor organizations in terms of how they evaluate and conduct their investment decision making processes, governance arrangements, the questioning of assumptions around existing beliefs and narratives –particularly with respect to how they are managing climate change impacts.
It also has potential implications for how regulators, industry groups, and associations communicate with investors, develop guidance material, conduct workshops, design surveys, present evidence, and establish new frameworks to support investor action on climate change.
Further research on the potential solutions to shift investor behaviour on climate change to achieve desired outcomes is needed, including challenging prevailing power relations and unwinding the dominant biases that prevail at the industry and organisational level. There is also a need to integrate the behavioural obstacles to climate change action into financial regulatory reform efforts, as well as through collaborative investor programmes and outreach efforts.
Dr. Danyelle Guyatt leads Climate Insight, a specialist consultancy and research firm that works with institutional investors who strive for best practice integration of climate change into investment processes. This post is adapted from her paper, “Institutional Investors and the Behaviourial Barriers to Taking Action on Climate Change,” available on SSRN.
[i] For example, see Simon, H. A. (1982). Models of bounded rationality. Cambridge, MA: MIT Press. Rationality is bounded because there are limits to our thinking capacity, available information, and time (Simon, 1982)