Decarbonisation: investors’ crucial role in achieving a global win-win

The US’s withdrawal from the Paris Agreement has once again brought climate change, and by implication its associated economic risks, to the fore.

Investors, businesses and governments are no longer able to turn a blind eye to carbon risks in the pursuit of fast profits, but can a low-carbon solution that suits all parties be found?

The risks posed by climate change are many. Besides the well-publicised environmental impact – rising sea levels, melting ice caps and the destruction of habitats – businesses will also feel the effects. For example, Russia’s estimated losses from a 2010 heat wave and drought stand at $15bn, mainly from the destruction of crops. This contributed to global price increases and export restrictions on wheat. Meanwhile, insured losses from a 2011 flood in Thailand were similarly valued at $15-20bn and the disrupted supply of hard disk drives, of which Thailand produces 40% of the global total, led to price increases worldwide for both the drives and the products dependent on them (PWC, 2013). Clearly the effects of climate change on the global supply chain are already being felt, but can the problem be fixed?

While it may not be possible to reverse the damage already caused, which has seen temperatures rise by close to 1.5?C since 1850, decarbonisation is key to limiting further harm.

Towards a global goal
November 4 2016 saw the ratification of The Paris Agreement: a landmark accord in which 195 signatories agreed to make a concerted effort to reduce emissions and to strive to keep further warming beneath a 1.5?C limit. This represented the most coordinated attempt so far to halt climate change, as every nation in the world was represented in the Agreement. However, on June 1 President Trump indicated his intention to withdraw the US from the Agreement. Withdrawal is a four-year process and so will not happen immediately, but the President has expressed his unwillingness to implement any aspect of the current pledge.

Calls for the US to remain in the Agreement were heard from nations around the world, and even the Pope expressed his hope that Trump would uphold the accord his predecessor signed. They are not the only voices publically appealing for the US to maintain its place in the Paris Agreement however; American business leaders from corporate giants such as Apple, Google, Disney and Starbucks have also lent their weight to the fight against climate change.

The support of corporations is crucial if governments are to meet carbon reduction targets; governments are unable to win the fight against climate change without the cooperation of businesses and investors. Both have a critical role to play in ensuring that temperatures don’t rise beyond 2?C – which is believed to be a turning point at which extreme weather and climate events are inevitable.

Investors’ role
As the owners of public and private companies, real estate and infrastructure assets, investors will play a crucial role in helping to address climate change. As politician and environmentalist Al Gore commented in a statement about the agreement:

“This universal and ambitious agreement sends a clear signal to governments, businesses, and investors everywhere… The consequences of this agreement go far beyond the actions of governments. They will be felt in banks, stock exchanges, boardrooms and research centres”.

Investors have more power to change the nature of a business than bystanders: if a significant impact is to be made on addressing climate change, a critical mass of investors must be mobilised to gradually decarbonise their portfolios. You may expect the energy and fossil-fuel industry to feel the effects of the Agreement most, but divestment from this area is not necessarily the best course of action. Rather, by supporting and influencing companies to move towards cleaner energy, investors have the power to drive change.

Moving towards decarbonisation
Arguably the most effective way of achieving decarbonisation is to increase investment in areas such as renewables and energy-efficiency technology, and by encouraging companies to reduce emissions throughout their value chains. It therefore stands to reason that the next generation of winners will be intrinsically linked with sustainable energy, green infrastructure and low-carbon services. For investors, this means adjusting quickly to the greener policy landscape and market to avoid becoming trapped with stranded assets.

The capital expenditure required to deliver the transition to a low-carbon economy is estimated at $4tn per annum by 2030. So, far from restricting business and investment, the implementation of the Paris Agreement will bring large-scale opportunities for investors across asset classes. However, taking advantage of the developing green market will require sound and informed judgements, as it is not always about buying best-in-class performers: it can be better to find a slow starter that has committed to change.

Of course, there are limitations to what investors alone can achieve. Supportive public policy, which allows reasonable returns on capital, is essential. While companies and investors can push emissions down through win-win strategies such as energy efficiency, achieving significant step-changes will require public-private cooperation. Varied timeframes may also be problematic, as policymakers, investors and companies all have different definitions of what long-term means. The transition to a low-carbon economy is estimated to require a 20-30 year timeframe. This is in contrast to most fund managers, who tend to work to a five-year plan. Overcoming this hurdle may present a barrier to forming a collective approach in combating emissions reductions.

Carbon mitigation activities
Reducing carbon emissions and achieving outcomes beyond performance isn’t always as straightforward as low-carbon companies. In fact, analysing a company’s carbon footprint is only one step in the process. A good example of the need to take a holistic view is illustrated by our decision to invest in a material manufacturer in India. The company was highlighted as a carbon-intensive firm, but our analyst understood that its products were helping car manufacturers reduce the weight of their vehicles and thus helping to lower carbon emissions. The negative impact of its own operations was therefore outweighed by the positive impact it contributed to.

Examples such as this make a strong case for stewardship and engagement. Working closely with companies enables a better understanding of the overall carbon performance of investee companies, and ensures that risks stemming from climate change and mitigation actions are fully embedded in a company’s strategy.

Active and collaborative engagement encourages companies to address the risks they face, and to communicate progress to shareholders. Portfolio managers and investors will react positively to improvements made, encouraging further action, and so a positive feedback loop is created.

Our approach – awareness, integration, engagement, advocacy
At Hermes, our commitment to our clients extends beyond delivering excellent performance. We believe we have a responsibility to understand the impact our activities will have on the world in which our beneficiaries live and work today, as well as the one in which they will retire tomorrow. This holistic approach drives our investment decisions – 89% of our AUM are engaged in carbon risk management activities.

Our four-strand approach to carbon risk management creates actionable goals, ensuring that all of the assets we manage consider carbon emissions:

• Awareness – portfolio managers understand the carbon risks in investments;
• Integration – green investment opportunities are identified, and divestment considered for assets with heavy emissions;
• Engagement – we work with public and private companies to mitigate carbon risk; and
• Advocacy – engaging with policymakers to encourage best practice in a low-carbon economy

Our philosophy of responsibility goes well beyond traditional investment orthodoxy. Instead, we look to highlight and constructively challenge areas where we believe the financial services industry is failing to improve its contribution to society. An inherent part of this improvement is increased transparency – deeper, more detailed and consistent disclosures are needed from companies to assess whether they are prepared for the transition to a low-carbon economy.

We are keen that companies disclose the results of a ‘stress test’ of the value and performance of each materially exposed asset or operation to a range of climate change scenarios. This means assessing whether asset values will hold up to the adjustment towards a lower-carbon economy.

To date there are no agreed or consistent approaches or models for stress testing companies for the climate change threat, which exposes both firms and investors to unnecessary risk. We have thus encouraged the Financial Stability Board Taskforce to support the provision of guidance for businesses on measuring these risks, with the aim of providing an early warning system for negative impacts resulting from carbon risks.

Time to challenge economic and financial models
Ultimately, to ignore carbon risk is to ignore valuation threats to portfolios. Short-term thinking will almost certainly be detrimental to firms over the medium-to-long term, as returns are likely to shrink if carbon risks are ignored in the pursuit of immediate profits. Similarly, some companies which do not pass short-term investment tests today are likely to deliver excellent long-term performance.

Market benchmarks tend to be short-term, however, so the fundamental question is how to revise these benchmarks to account for a wider range of risks and opportunities within longer timeframes. By challenging the current economic and financial models used by the investment industry, investors and companies can work together to ensure that the world does not breach the 2?C-or-lower climate change target.

Investor advocacy has a crucial part to play in achieving these objectives, but also in creating value for the future. Although the pace of technological innovation could affect the timing and magnitude of the transition to cleaner energy and processes, if investors take an active role in increasing pressure on companies to focus on the future, rather than on short-term gains, it creates a global win-win situation which safeguards the longevity of a firm’s value, while also assisting the movement towards a lower carbon economy.

Bruce Duguid – Director of Engagement – Hermes EOS