How do we align capital markets with the transition to a low-carbon economy?

  • 22 August 2019
  • Blog | Green Finance | Blog

INGRID HOLMES, HEAD OF POLICY AND ADVOCACY, HERMES INVESTMENT MANAGEMENT

Prior to the 2015 global agreement to cap a global temperature rise below 2°C and pursue efforts to limit increases to 1.5°C (the Paris Agreement on Climate Change), the Global Commission on the Economy and Climate was set up to examine and subsequently report on whether it would be possible to achieve lasting economic growth while also tackling the risks of climate change.  The report concluded with a resounding yes.  Moreover, the report stated that the capital for the necessary investments – estimated at $90 trillion – is available to meet the costs of this transition to a low-carbon economy. However, the report found several barriers to implementation. These include a lack of strong political leadership and a dearth of policies to accelerate the redeployment of capital into the energy, information communication technology, building and transport infrastructure, and land use change needed to avoid a climate catastrophe.


Four years later, the UK’s Committee on Climate Change 2019 ‘Net Zero’ report echoes and reinforces the same messages. The Committee forecasts that the UK could end its contribution to global warming within 30 years by setting and delivering an ambitious new target to reduce its greenhouse gas emissions to zero. However, the report also warns that to achieve this, market signals need to drastically and rapidly change – and policies will have to ramp up significantly to deliver the required transformation across all sectors of the economy. Lastly, the Committee stated that it is imperative to keep the public on side during this process of change, which requires the costs of the transition to be fairly distributed.


It is possible to achieve these goals. The reduction in cost of a number of key zero-carbon technologies means that achieving the ‘net-zero’ target is now possible within the economic cost estimated when Parliament passed the Climate Change Act in 2008. For example, latest cost data and prices emerging from auctions for renewable power contracts indicate that renewable generation can or will produce electricity at the same cost, or cheaper, than fossil fuel alternatives in most parts of the world.  In some countries, electric cars are already more cost effective than petrol or diesel alternatives; analysts expect this trend to grow across a number of markets over the next decade. ,  Furthermore, large corporates such as Danone and General Mills are adopting regenerative agriculture techniques that protect and enhance the environment, improve carbon storage, and cut the dependence of farmers on agrochemicals, many of which are derived from fossil fuels. Mass deployment of these technologies is the next step, underpinned by a sea change in consumer preferences – not least in what we choose to eat.


Despite these positive trends, the global economy is still far off from delivering the low-carbon vision promised by the Paris Agreement. Best estimates put us collectively on track (with current policies) for a 3°C increase in global temperatures.  Precautionary estimates from international climate experts state that, as a result, the 1.5°C barrier will be breached in as few as 11 years.  In short, we are in a climate crisis, and there is no time to wait for a predominantly market-led shift to a low-carbon economy.


It is clear that investors, corporates, governments and citizens need to commit to and significantly step up their efforts to address these issues in order to achieve global climate security. Nonetheless, the boundaries of responsibility are blurred and overlapping. A recent editorial by the Chairman of BP, Helge Lund, set the conundrum out neatly when he noted no company can drive the transition to a low-carbon economy on its own; success will require new levels of collaboration across industry, consumers, and governments, aided by technological improvements and well-designed government policies. 


Against this backdrop, however, plenty of asset owners and investment managers can and should play their part in the transition and accelerate the alignment of capital markets with a low-carbon economy.


The first step is to build their awareness of the climate change threat and opportunity – and integrate such considerations into how asset owners award mandates and investment managers design funds and investment processes. This will help adjust pricing signals to reflect climate change risk and opportunity. The market share of such socially responsible or Environmental, Social and Governance (ESG) approaches to investing, which incorporate such information on climate risk and opportunity, is significant and growing, with around 20% of EU AUM now managed in this way.  We are also seeing the growth of positive impact funds – capital looking not just to manage risk but also capitalise on the opportunity that comes from addressing climate change and other environmental and social issues. Brexit notwithstanding, this is something all EU-regulated investment firms will soon need to consider and disclose how they take such issues into account going forward. 


It is not only the investment decision making process that must adapt. Given how far away we still are from delivering a low-carbon world, arguably the biggest change asset owners, investment managers, and indeed capital market makers such as the investment banks can make is to engage with companies most exposed to the low-carbon transition. These engagements should look to address climate risks or opportunities and challenge companies to move further, and at a faster pace, through assertive stewardship. 


The Financial Reporting Council, one of the UK’s financial regulators, recognises the importance of investors playing a more purposeful and outcome-focused stewardship role: it is the driver behind the proposed revisions to the UK Stewardship Code. The new Code, which is due to be finalised in summer 2019, states “stewardship is the responsible allocation and management of capital across the institutional investment community to create sustainable value for beneficiaries, the economy and society. Stewardship activities include monitoring assets and service providers, engaging issuers and holding them to account on material issues, and publicly reporting on the outcomes of these activities.” 


The equal footing that the beneficiaries – the economy and society – are placed on within this definition is controversial for some who are arguably still entrenched in the 1970s Milton Friedman ‘Chicago School’ thinking: that there should be a clear separation between the goals of companies and the goals of individuals and government (i.e. public companies should focus on making money and leave ethical issues to individuals and governments).  Such thinking misses the changing academic consensus – which leading responsible investors internalised some time ago. Even at the Chicago School, the latest generation of academics are now arguing a shift toward maximising shareholder welfare is needed– and engagement and voting are a key means to achieve this. 


This is a critically important shift and is complemented by the stance taken in the Corporate Governance Code which states successful companies are led by effective, diverse and entrepreneurial boards “whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society”. This step change breathes new life into Section 172 of the UK Companies Act, which states that directors should promote the success of the company while considering the long-term impact of decisions; the interests of company employees; and relationships with suppliers and customers as well as the community and environment in which it operates. 


Investors are also beginning to demand that firms at the frontline of the low-carbon transition properly reflect climate risks in revenue forecasts, supported by proactive dialogue between audit firms, investors, and audit chairs of companies to ensure prudent assumptions are used.


These policy changes are imperative as they make it easier for capital market participants – companies, asset owners and investment managers alike – to have the challenging conversations needed about how business models, products and services must be adapted to help, not hinder, the delivery of a low-carbon economy.
The swiftest and most effective way to align capital markets with the transition to a low-carbon economy is to focus on transforming the underlying economy it finances. Amid the excitement of the growing green bond market – estimated in 2018 to be worth $167.3 billion (but still less than 0.2% of the global bond market) – and an emerging green loan market, the reality is that there is a huge amount more to be done to address the climate crisis, and that no single group can tackle it alone. 


The need for collaboration between investors, corporates, governments and individual citizens is urgent. If each wait to act, we will waste valuable time in mobilising the resources to tackle the immediate challenges we face. Furthermore, this could mean missing out on opportunities presented by the trailblazers that are innovating to solve such barriers presented by this climate crisis. Companies, asset owners and investment managers must act in collaboration and use their influence and expertise to drive companies to transition to a low-carbon economy urgently. They must also call for governments to create the market frameworks needed to accelerate the transition process. The need is great, the capital is available, and we can achieve lasting economic growth while also tackling the risks of climate change by seizing the opportunities presented by those providing capital solutions. So what are we waiting for? The time to act is now.

 

Read the Sustainable Finance Report here.