Climate change has become a global emergency, with individuals, corporations, charities and policymakers increasingly recognising the urgency of tackling carbon emissions. More and more investors believe that they have an important role to play in addressing the problem, with a growing amount of capital now invested within a climate change framework. This term implies some sort of awareness or restriction based on climate change metrics/concerns
Charities are increasingly looking to demonstrate that their portfolios reflect their values which has led to a greater emphasis over time on measuring their ESG (environmental, social and governance) impact. This feeds into the current interest in proactively investing using a climate change framework.
Organisations with a poor carbon footprint are increasingly paying the price. Recent analysis by Citi* estimates that borrowing costs for European integrated oil companies are 2% higher than for their US equivalents (where there is less concern on climate change), a huge difference at the current level of interest rates. Growing political attention, combined with the rapid fall in the cost of fossil fuel alternatives, shows investors cannot remain agnostic.
The potential impact goes well beyond oil exploration and production companies. Electricity, resource, chemical, manufacturing and transport sectors face significant disruption, plus a huge potential write down of previous investment and massive capital expenditure requirements to adapt, survive and take advantage of the opportunities. These changes are already happening and having a growing impact now – witness the car manufacturers’ investment in electric vehicles or the fall-off in demand for huge turbines at GE.
The Paris Agreement, which seeks to limit the global temperature rise this century to below 2 degrees Celsius and to drive efforts to limit the temperature increase even further to 1.5 degrees above pre-industrial levels, sets the global framework. This agreement has broad global support (even in the USA) and has set five key focus areas:
- Mitigation by reducing emissions
- Implementation of a transparency system to account for climate action
- Adaptation to climate impacts
- trengthening countries’ ability to recover from climate related impacts
- Providing support, including financial, for climate resilience
The UK and Continental Europe have led the charge. The European Union has committed to a 40% cut in greenhouse gas emissions by 2030 and to improve energy efficiency by 27%. In the UK, the 2008 Climate Change Act created the basis for tackling and responding to climate change. The Act provides the UK with a legal framework including a 2050 target for emissions reductions, five-yearly ‘carbon budgets’ (limits on emissions over a set time period which act as stepping stones towards the 2050 target), and the development of a climate change adaptation plan.
The Task Force on Climate Related Financial Disclosure (TCFD) and the Financial Stability Board now recognise climate change as a major systemic risk to investment which can alter the risk return profile of organisations exposed to fossil fuels.
Risk management and positive impact
The motivation of charity investors to invest through a climate change framework may be a desire to save the planet, but it also makes sound investment sense. The financial risk is a combination of several factors: if global warming is to be restricted to 2 degrees centigrade, many of the fossil fuel reserves can never be used and have no value – they will become ‘stranded assets’. This applies to infrastructure such as power stations, pipelines, chemical plants, cement and transport technology as well.
Increased legislation is another risk. This might include carbon taxes to make carbon producers pay for the societal costs of generating carbon dioxide, redirect demand and tilt the competitive landscape in favour of cleaner technologies. Another risk, already acknowledged, is that the sheer weight of money invested in this area changes valuations and the cost of capital for companies in many areas.
Managing risk is just one part: equally important is to identify the beneficiaries from these structural changes in areas such as energy efficiency or alternative energy technologies, plus changes in food consumption, animal feeds and alternatives to plastic.
From an investment point of view, climate change implies meaningful changes in portfolio construction, which may in turn influence portfolio performance under differing scenarios. This brings some challenges to traditional risk assessment frameworks. Excluding major sectors from a portfolio will have an impact in terms of returns timing, income generation, risk, cross-correlation, investment style and performance through the investment cycle relative to the main indices.
Another major challenge is to integrate conflicting objectives and achieve a balance. Tie this in with other social and governance objectives, plus all the usual factors in running a portfolio - extraordinary monetary policy, the rapid pace of technological disruption and geopolitical risk - and it is easy to be somewhat daunted. Good information and good communication between trustees and the investment managers making the decisions is key.
It is relatively straightforward to assess the long-term outcome of the Paris Accord if governments follow through on their commitments. How this plays out in the shorter term is harder to call. In the long-term, fossil fuels might be going the same way as the horse and cart, but this doesn’t mean that the oil sector is an immediate sell. In the dotcom bubble, markets correctly predicted that the internet would have a material impact on bricks and mortar retail, but it has taken until now for this to flow through.
More investors, particularly in the charity sector, are under pressure to explicitly sell some or all of their fossil fuel extraction holdings, to look beyond fossil fuel extraction to companies generating revenues from fossil fuels and, more broadly, to engage actively with their investments. In short, they are under pressure to integrate climate change risk across their entire investment process. This needs a high level of quality information as it relies on being able to identify fossil fuel reserves, fossil fuel related revenues, carbon emissions, intensity and efficiency, plus climate change leaders and laggards company by company and then collate it sector by sector and for each portfolio.
The starting point is always to establish the carbon footprint for each portfolio so that progress over time can be established. The information allows the portfolio to be compared to standard indices and helps identification of climate related risks. It also prioritises areas for future action and engagement and gives a framework for communication with other stakeholders and donors.
The quality of the data remains a major issue. Disclosure levels differ between companies, countries and regions. Definitions vary widely and much of the analysis is subjective. Some issues are black and white, but there are more grey areas that require discussion with trustees. Different screening services each have their own methodologies and so the same data can be interpreted differently, depending on the service used.
Developed world companies have much higher disclosure levels than emerging market companies so they naturally score better. European companies tend to score better than US companies because there is greater focus on these issues in Europe. The European Union is putting together a taxonomy of definitions and there are other initiatives on disclosure standards, but this will take time.
The evolution will continue. This is a rapidly developing area, with many learning as they go. Good communication with investment managers is key, while taking a steady step by step approach will ensure that all the stakeholders are comfortable and fully understand the implications of each step.
* The Changing Investment Climate – Navigating the uneven ESG playing field in the oil industry. Alastair R. Syme, Kate O’Sullivan, Oliver G. Connor, Prashant Rao. (Citi Research 27 June 2019)