After a year of devastating weather events across the globe – wildfires in the Arctic circle, droughts in subtropical Taiwan and deep freezes in dusty Texas – climate change is at the forefront of public attention. The cost of inaction is now greater than ever – the UN Environment Programme estimates that the global cost of adapting to climate impacts by $140-300 billion per year by 2030. This has put a huge amount of pressure on governments and organisations to put policies in place to tackle climate change.
Every year the United Nations has been bringing together representatives from across the world for a series of climate summits known as ‘Conference of the Parties’ (COPs). COP 26 is the next annual UN climate change conference which is being held in Glasgow at the end of this month. The conference aims to accelerate the transition to a low carbon future that keeps global temperature increases to 1.5 degrees above pre-industrial levels.
So – what are we looking for from COP 26? Following a damning, “code red” IPCC report highlighting global temperature increases are already at 1.1 degrees, a debate at the UN General Assembly that made strides on coal and climate finance and letters from the FCA telling managers to act and evidence their efforts, decarbonisation has to be urgently prioritised. Decarbonisation is the process of reducing the world’s carbon dioxide emissions such that, as implied by the IEA’s net zero by 2050 scenario, the global economy can be twice as large as today with 8% lower energy demand served 2/3 by renewables. This can be achieved through the transition to low-carbon power sources such as wind and solar instead of coal and gas as well as significant improvements in energy efficiency and behaviour changes. Decarbonisation is essential to meeting the global temperature standards set by the Paris Agreement and the UK government’s commitment to achieving net zero greenhouse gas emissions by 2050. The cost of emitting one tonne of carbon is the highest it’s ever been – €64/tCO2 at the time of writing – where before last year it had barely broken through €30/tCO2. Carbon emissions are on a trajectory to be a cost of business, not a by-product. As the price of carbon increases, the greater the incentive for companies to switch to cleaner forms of energy and reduce their carbon emissions across the value chain.
From our perspective as investors, the price of carbon ultimately needs to be factored into all asset prices as the cost goes beyond externality and becomes an internal cost of doing business. Success at COP 26 will be an important step in being able to assess a company’s environmental impact transparently and holistically. Importantly, it will help enforce standards for measurement. This is extremely important as sustainable investors because if you can measure something, you can begin to manage it.1
The price of Carbon has hit record highs in 2021
Navigating to a new world
How carbon-intensive businesses navigate the low carbon transition is a deeply strategic issue, both in the context of their products and services and how they operate. When looking at this in an investment context we need to consider the different scopes of carbon emissions, where they appear in the value chain, and what the implications of various low carbon transition pathways will be on a company’s revenues, costs, competitive positioning and ultimately their licence to operate.
When considering what a company will do, as investors we need to analyse corporate strategy. Making a commitment to net zero or alignment with the Paris Agreement is an important first step, but to really convince us we want to see more businesses providing detailed, credible, and irreversible plans on how they will achieve sustainable decarbonisation. These will need to be backed up with short, medium, and long-term science-based targets of both the emissions themselves as well as key strategic and capital allocation milestones. Without this, these commitments risk being empty promises, easily reversible by future boards and excos yet to be appointed. As sustainable capital allocators, we look to align our clients’ savings with delivering real world outcomes through a focus on how companies decarbonise their own operations in line with the Paris Agreement as well as how they can help others reduce their emissions.
What does this mean for sustainable investing? I believe there are two key outcomes that sustainable investors should look out for. Firstly, COP 26 will accelerate the urgency to address carbon capital at risk, and for us as stewards of our clients’ savings it is critical to allocate capital in line with the Paris Agreement, through a low-carbon portfolio that enables a 1.5°C climate scenario – we think this positions our clients at the forefront of this urgent transition.
Finally, we expect additional foundations to support climate related financial risk disclosures will become more standardised, and their quality will increase. In combination with the clearer policy direction that we can expect in the coming years, this should allow investors to be more confident in internalising the costs of climate change into their valuation models and seeing the direct effects of paying for carbon on a company’s cost base. The cost of capital for carbon intensive businesses should increase.
Fundamentally, we believe that investing in well-run companies with sustainable business models leads to better long-term returns for our clients and helps to facilitate the transition to a fairer world. COP 26 will push this into the public consciousness and help to accelerate the shift we have already been seeing over the last few years. As fund managers it is important that we help our clients to understand that capital allocation can play a crucial role in driving change for a better world, and how their savings deliver real world outcomes – to the planet, to people, and to profit.
The value of active minds: independent thinking
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