This article was written on the fifth anniversary of the Paris Agreement. In 2015, the world committed to keep warming below 2°C, meaning decisive annual reductions in greenhouse gas (GHG) emissions. Instead we have had a 7% increase in GHG since 2015 and are on track for about 3°C warming with a high risk of irreversible tipping points.
The Climate Ambition Summit saw a flurry of new commitments from countries, companies and investors, most recently the Net Zero Asset Managers Initiative. Given what investors could have learnt, what strategy should they now focus on?
We conducted a three-day Twitter poll. We simplified the choice to portfolio decarbonisation, company decarbonisation, Task Force on Climate-related Financial Disclosures (TCFD) compliance or ‘other’. The sample was 120 but voting was anonymous.
Only 3% voted for the TCFD agenda. Given its profile and funding, surprising, further research is needed to explain this. Has TCFD been successful – meaning its work is now done? Or has its focus on reporting risk been inadequate for driving decarbonisation?
Portfolio and company decarbonisation came essentially neck and neck (46% and 40% respectively).
Portfolio decarbonisation is the process of reducing a portfolio’s carbon intensity. At its simplest, it involves buying stocks that are following a Paris-aligned pathway and selling those that are not. The theory of change underpinning this is that the aggregate buy/sell signal from investors focusing on portfolio decarbonisation triggers real world action.
There are two ways to decarbonise a portfolio. The easiest is to underweight or fully divest high-carbon stocks and replace with low or lower carbon assets. This divestment can be done using standard portfolio-optimisation techniques using GHG emission data – smart beta – or a more qualitative way focusing on climate laggard sectors (typically fossil fuel companies).
In both cases, ownership of the GHG emissions is transferred to other investors. Divestment advocates argue that if the divestment is quick and public, then it sends a political signal, which is true and is addressed below. In parallel, the fund would invest in lower-intensity companies or new clean-energy infrastructure or natural climate solutions contributing directly to reduced emissions.
If done well, portfolio decarbonisation can deliver competitive advantage. But adopting this strategy leaves investors vulnerable to criticism that they are profiting from the climate crisis or are ‘passing around’ the ownership of GHGs. The former has been acceptable: indeed, it is how green investing has been marketed – using the phrase ‘doing well by doing good’. Whether managers will be able to continue with business as usual as the climate crisis gathers pace, we doubt.
The other approach – company decarbonisation – involves persuading companies to implement a Paris-aligned decarbonisation pathway. The theory here is that the aggregate stewardship signal from investors – either directly or via lobbying regulators or legislators – causes real world decarbonisation.
If done well, other investors will benefit due to the potential for beta but also a free-rider effect. Adopting this strategy might leave investors vulnerable to criticism that they are trying to ‘save the world’.
To safeguard against this, investors have stuck to a backward-looking interpretation of fiduciary duty focused on defined portfolio risk adjusted returns and over a short time. Whether this can continue without investors losing their social licence to operate we also doubt.
In our experience, focusing on company decarbonisation is the harder approach. Why? The obstacles are at multiple levels.
First, traditional investment theory mitigates against ‘non-financial’ outcomes. These beliefs are shared across the investment chain. One ESG head at an investment management firm reported that a pension fund executive considered it overly prescriptive for the manager to ask companies to reduce emissions consistent with the Paris Agreement. Sticking with traditional investor/board/management roles and responsibilities seems more important than avoiding the climate crisis.
Second, company executives of laggard companies are not amenable to change. They may lack the skills for transformation and for some sectors – such as fossil fuels – the answers (de-growth and giving cash to investors) may clash with cultural norms.
Hence, activist-style stewardship strategies are needed and institutional investors are reluctant to go this far on matters which are not strictly about short-term finances.
Third, safeguarding beta is not well rewarded by asset allocators, and investment consultants do not recommend managers on this criterion.
As this discussion of the pros and cons highlight, neither portfolio nor company decarbonisation is the sole answer. Hence the tied vote makes sense, especially if we view these options using a Venn diagram (see figure). Our thanks to Tom Harrison for this suggestion for “climate mandated institutional activist investors”.
The focus on company decarbonisation is well suited to low impact (‘clean’) sectors that can thrive in a Paris-aligned world and also leader companies in high-impact (‘dirty’) sectors that can gain competitive advantage over (laggard) peers by going net zero by 2050. Companies in clean sectors should not need investors to be assertive; sustainability investors should be accountable for persuading these companies – which they have marketed as being sustainable and well run – for publishing and executing Paris-aligned transition plans. Here is where managers can contribute beyond generating alpha.
The focus on portfolio decarbonisation is suited to ‘dirty’ sectors that will struggle to align with Paris. There may also be laggard companies in low-impact sectors that fit. With the former, unless investors are willing to be forceful – by replacing board members or exposing corporate capture – they should sell and make this public. Index investors who refuse to change the benchmarks for their core funds should take responsibility for making these substantive corporate governance changes or they should not be classed climate-aware.
All investors should take responsibility for economic and systemic decarbonisation. At a minimum, this means explicitly prompting an effective carbon price ($100 per tonne). TCFD is not a panacea and will not drive decarbonisation, but it could play a role in driving resilience and adaptation.
This model needs further work. Not least, we face a biodiversity and a climate crisis in tandem and optimising our economies for one systemic risk, but ignoring another, is unwise. We think the model’s value is that it moves beyond the engagement versus divestment debate, and shows the additionality of niche and index investors in a regulatory environment that will impose more mandatory elements related to GHGs.
Raj Thamotheram is founder and senior adviser, Preventable Surprises, and Zsolt Lengyel is foundation secretary, Institute for European Energy and Climate Policy