08 Oct 2020
08 Oct 2020
For all the environmental, social and governance (ESG) challenges companies face today, there is one which unites them all – a challenge dwarfing all others in its urgency.
‘E’ for the environment. ‘E’ for the elephant in the room. ‘E’ for the emergency we all now face – the failure of our fossil-fuel civilisation to address climate change.
The urgent threat of global warming demands a revolution in our energy systems. We are already late – but not too late. As asset managers and investors, we still have the power to change the world by helping to shift trillions of dollars towards climate-friendly investments. History may judge us harshly if we don’t.
Thankfully, help is at hand in the form of climate-aligned benchmarks, and the innovative new ETFs which use them.
By providing for the limiting of global warming to “well below 2°C above pre-industrial levels” and to “pursue efforts to limit the increase in temperatures to 1.5°C”, the 2015 Paris Agreement committed 195 countries to radical and meaningful change in their emissions and climate policies.
Achieving this will be challenging, but we can all be difference makers. When it comes to CO2 emissions, the devil is in the detail. How can you tell if your portfolio is on the right track?
Thanks to the work done by organisations such as the CDP (formerly the Carbon Disclosure Project), the Taskforce for Climate-Related Financial Disclosure (TCFD) and the Science-Based Targets (SBT) initiative, there is now a transparent framework for calculating, forecasting and disclosing data on companies' carbon emissions.
SBTs make the link between individual companies’ projected CO2 emissions and a projected average increase in temperature. Linking an investment portfolio to a specific temperature figure is an extremely simple measure for investors big and small to grasp.
Sadly, the figures don’t make for pleasant reading as they stand. Most major equity benchmarks currently imply temperature rises of around 4°C or more, which could be disastrous.1
The EU is in the process of updating its benchmark regulations, forcing index creators to disclose whether major existing benchmarks are aligned with the Paris Agreement’s warming scenario.
It’s also endorsing the creation of Climate Transition Benchmarks (CTB) and Paris-Aligned Benchmarks (PAB). These benchmarks will make it much simpler to create investment instruments which comply with the Agreement and start financing the transition to a world in which the average rise in temperature is limited to 1.5°C above preindustrial levels.
We believe these CTB and PAB labels will soon become as commonplace as organic labels for food products, and they’ll serve a similar purpose – an at-a-glance way of ensuring something is being done properly or is “clean”. The indirect effect will be to stigmatise “dirty” indices – practically all the major benchmarks still used by institutional investors.
The EU’s new benchmark regulations could bring about a genuine revolution – and lead to a world in which equity flows and company valuations are dependent on companies’ carbon footprints.
Publishing the temperature scenarios of the major benchmarks will affect almost everybody. Institutions and big-name brands, fund and wealth managers, private banks and advisory networks, could all become associated with a certain temperature scenario and a de facto position on climate change by clients, prospects and even the media. We could see a race to the bottom of the thermometer.
Amid such scrutiny, we’d expect institutions to start migrating their investments towards CTBs or PABs. Meanwhile, if the valuation of a company is being dictated by its carbon footprint, we’d expect its shareholders to pressure its management team to hasten their energy transition.
Thus, a virtuous circle is born, fuelled by forward-looking regulation and the court of public opinion.
For illustrative purposes only.
The trade of the decade
Today’s equity markets are pricing in an unrealistically and unsustainably low cost for energy and electricity because they are not taking the “real cost” of CO2 emissions into account. Nor are they factoring in the trillions of dollars needed to transform the world’s energy mix.
Some estimates currently suggest we must keep 80% of known fossil-fuel reserves underground or risk heating our planet far past the red lines drawn by scientists and governments.2
The equity markets however are still pricing some of those reserves in to oil producers’ stock prices. This could be the biggest hidden risk in your portfolios today, and it’s a risk you can’t hedge.
“Decarbonising” portfolios is not possible without reducing exposure to a potential fossil-fuel rebound. For us, that’s a portfolio risk worth taking. Accepting the challenge offers real potential for forward-thinkers with an eye on the bigger picture. We believe it will be the trade of the next decade, and beyond.
Of course, adjusting portfolios to such a degree is challenging. It will take years for such expertise to be widely shared – years we don’t have. Step forward the world’s indexing giants and their new indices.
We believe a quantitative, rules-based approach is the best way to employ the enormous (and ever growing) quantity of climate data now available. The world’s leading index companies, S&P and MSCI, have been building their climate expertise through corporate acquisitions, and are now sharing it in climate indices eligible for the EU’s CTB and PAB labels.
Of course, just building these indices isn’t enough to win the war. Investors must actually use them. Shifting money en masse to these indices is what will help us turn the tide.
‘Investment influencers’ and early adopters can play a key role here. It would only take a few sizeable, active and engaged asset owners to seed certain indices and ETFs, and thereby prompt many others without the time and resource to build their own climate-friendly portfolios to follow.
For illustrative purposes only.
We are on the cusp of a paradigm shift for listed markets of a scale comparable to the rise of the digital age. The sweeping changes to benchmark regulations could be the catalyst for a cleaner, greener future.
This is a once-in-a-lifetime opportunity for ETF providers to be champions of change and put the power in people’s hands at the click of a button.
Everyone can play a part in this revolution, from the world’s biggest asset owners to the individual investor planning for retirement in the comfort of his or her armchair. Just think: one person clicking that button and moving their savings into climate-action funds is far more impactful than that same person quitting flying or using public transport or becoming a vegan.3 What happens if millions of us do it?
Never think it’s too late. Never believe your contribution is too small. Never say never. We all have the power to change the world.
1Source: EU Technical Expert Group (TEG) on Sustainable Finance Interim Report on Climate Benchmarks, June 2019.
2Source: Bill McKibben, author and and leader of environmental group 350.org, https://350.org/why-we-need-to-keep-80-percent-of-fossil-fuels-in-the-ground/
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