Investing in countering climate change

With Paris currently hosting the 21^st meeting of the United Nations’ Conference of the Parties (COP21), global governments are gathered to set a binding agreement that maps out the process for global greenhouse gas (GHG) emissions management from 2020 onwards. Much is at stake, from geopolitics to the costs of managing the biophysical impacts of a changing climate.

Nasa has shown that 97% of climate scientists agree that global-warming has very likely been caused by human activities. Yet, some members of the investment community still debate whether the continued burning of fossil fuels is safe for long-term, stable economic growth. We believe we should defer to the climate experts and assess the associated long-term risks and rewards in order to achieve an appropriate risk-adjusted return on capital.

Indeed, the physical implications of a changing climate are not lost on the financial services sector, and earlier this year Mercer revised their 2011 Climate Risk study, which found that investors need to view climate change impacts as a new return variable.

The issues that are important for investors to consider in respect of climate change include: intergovernmental negotiations; the long-term physical impacts; stranded assets; the emergence of new technologies and opportunities; current market responses; and, importantly, the timeframes over which these might occur. This is a brief exploration of how these issues may inform the macrothematic economic outlook, along with more sector- and stock-specific calls.

The lowdown on COP21

An important part of the COP21 negotiation process is the concept of ‘common but differentiated responsibilities’ (CDR), which acknowledges that developed countries are responsible for the bulk of historical emissions, and is used as the basis for developing countries taking action, conditional on financial and technological support from developed countries.

The Green Climate Fund is touted as the financial smoothing mechanism for CDR, with a proposed US$100 billion in finance to be made available annually by 2020. The problems are that, so far, only modest pledges have been made, and that the governance and distribution mechanisms are still nascent. However, the Fund will ultimately become an important component for driving the development of climate-resilient infrastructure in Africa.

Great expectations

In the run up to COP21, over 140 countries submitted their post-2020 emissions reduction plans in the form of Intended Nationally Determined Contributions (INDC). Initial analysis shows that collective efforts could save up to four gigatonnes (Gt) of greenhouse gas (GHG) emissions a year, but this falls short of what is required by science. OXFAM’s research indicates that with current reduction commitments, we are more likely on track for 3°C of warming.

A valid question remains: What can we expect from Paris and why is it important for investors? While expectations are high for a truly global binding agreement to emerge, the reality is that what we are likely to end up with is a loose piece of text that paves the way for more detailed negotiations.

What the Paris meeting has yielded, is some insight into how countries are planning to decarbonise their long-term growth plans. This is significant in that it shows that the tilt for capital allocation is moving away from carbon-intensive plans toward those facilitating a transition to a mixed-energy economy. In addition, it appears that businesses now understand that waiting for governments to define a legally binding agreement, and to agree on a global carbon price, is no longer viable.

Rather, leading businesses are working to understand the scale of the related risks and opportunities. This results in a more multifaceted approach, which, when set alongside the pace of technological change in the energy sector, changing social norms, and emergent political leadership, means that business leaders are now increasingly positioning their capital allocation initiatives towards a low-carbon economic outcomes.

Local climate action and insights

South Africa (SA) has committed to reducing emissions by 34% by 2020, and by 42% by 2025, conditional on the aforementioned assistance. It has pledged that emissions will peak, plateau and then decline (PPD) out to 2050. The PPD model is a rough guide to what SA’s carbon budget will potentially look like. Based on the current emissions profile and the energy build programme proposed in the Integrated Resource Plan (IRP), it is possible to assess the extent to which investments being made today fit within SA’s long-term carbon budget. This informs the debate around long-term asset stranding, and supports an analysis of whether the energy build programme is aligned with SA’s carbon reduction goals.

The Government has published a draft Carbon Tax Bill, and although its implementation date is uncertain, when promulgated, it will force companies to internalise the cost of GHG emissions, and thus create an incentive for mitigation action. Understanding the framework of the Bill and its price impacts will be important for investors in SA. Already some 80% of the World’s carbon emissions carry a price through carbon trade or tax schemes, and thinking that SA can continue to have no price for carbon in our economy is unrealistic. The sooner investment managers understand this, the better for their clients.

The Carbon Budget and stranded assets

At the 2010 COP16 meeting, 193 countries (including SA) agreed to aim to limit theconsequences of global warming by ensuring that the global average temperature rises to no more than 2°C above pre-industrial levels. This doesn’t sound like a lot, but the Earth’s biophysical system is equally as sensitive to a rising temperature as a human body is.

The temperature rise thus far is around 0.85 degrees, and progress towards the 2°C threshold can be tracked through measuring the increasing concentration of carbon dioxide (CO₂) in the atmosphere – measured in parts per million (PPM).

Using this data, it is possible to the calculate the amount of CO₂ that can still be emitted before we hit the 2°C threshold, popularly termed the Global Carbon Budget. Central to the negotiations is, of course, who gets which piece of this pie.

Through analysing the Budget, the World Resources Institute and Carbon Tracker both indicate that the untapped fossil fuel reserves reported as assets on the balance sheets of large resource companies exceed what science is telling us we can safely still burn. This creates the potential for a carbon bubble and a high occurrence of stranded assets in the World’s cumulative listed-equity portfolio, which has material implications for long-term asset pricing in the market.

Investment managers use carbon footprinting to understand their portfolio’s exposure to the potential for asset stranding, and to help them understand which companies and sectors carry the most carbon risks.

How does this translate?

The movement towards portfolio decarbonisation in developed markets is quite well advanced, but it is not so straightforward for developing markets. In SA, awareness among institutional investors is growing, as evidence points to the urgent need to mitigate risks in their equity portfolios. According to the African Development Bank the opportunity that emerges for investors in Africa lies in the real asset space where the annual infrastructure investment required is around US$95 billion per annum to 2050.

Jon Duncan is head of Responsible Investment at Old Mutual Investment Group

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