Climate-aware investing means investing in new drivers of value and avoiding emerging risks. At State Street, we believe that a changing climate is forcing change by governments, companies and institutions, and these are reshaping investment markets.
The changing climate is changing how we live today and how we will live tomorrow. From fossil fuels to farming practices, some changes are subtle and others are dramatic, however we now see a focus on action over words, and a recognition that everybody has a role to play.
Corporations are center-stage in this call to action. Corporate reputations, legislation, capital pricing, and financial market regulation hang in the balance as investors shift their views of the world.
We believe the emerging risks and opportunities from climate change have propelled it to the forefront of environmental, social and governance (ESG) issues. Climate-aware investing no longer means simply taking a moral or ethical position on climate. It means taking a position on the financial impact of current and anticipated regulatory change. It means recognising the financial opportunities presented by emerging technologies that will help humans to adapt. It means weighting the financial risks associated with “business as usual”.
It is unequivocal that human influence has warmed the atmosphere, ocean and land. The planet’s average surface temperature is already around 1.1°C above pre-industrial temperatures (1850–1900)1
Concentrations of all the major long-lived greenhouse gases (GHG) in the atmosphere continue to increase, reaching the highest levels seen on Earth in at least two million years.2
Under the International Energy Agency’s (IEA) net zero roadmap, there is no need for investment in new fossil fuel supply, including oil and gas fields and coal mines or mine extensions.3
Evidence suggests that Australian investors are ready for these opportunities. A 2022 report on the views of Australian investors by the Responsible Investment Association Australasia (RIAA) found that over 80% of respondents believe their super fund or bank should commit to reducing greenhouse gas emissions, set targets for emissions reductions and pledge to achieve net zero by 2050. Renewable energy and energy efficiency was the number one environment or social theme for all age groups, from Gen Z through to Baby Boomers.4
Investors also appear less concerned that responsible investing will hurt financial performance, almost two thirds agree that responsible and ethical super funds or investments perform better in the long term.5
These survey results should encourage financial advisors to include ESG and Climate Change in their discussions with clients. In fact, the number one expectation that Australians have of financial advisers is to be knowledgeable about responsible investment, overtaking the prioritization of returns.6
Investors are now ready to make informed, long-term investment decisions that include consideration of climate and the transition to a low carbon economy.
Climate change is not a new issue, so why has it suddenly shifted from the fringes of political debate to the heart of international action?
Arguably, the catalyst was the 2015 Paris Agreement7, an international treaty on climate change that took force in 2016. The Agreement’s stated long-term aim is to stop the global average temperature from rising more than 2°C above pre-industrial levels, and limit that increase to 1.5°C. In December 2021, 197 states including the European Union were signatories to the Agreement.
While the Paris Agreement may have been signed in 2015, its foundations date back decades. Of special importance was the 1988 creation of the Intergovernmental Panel on Climate Change (IPCC). This United Nations body is responsible for assessing the scientific research on climate change and making recommendations for action to policymakers.
The Paris Agreement requires economic and social transformation and it relies on individual countries progressively increasing their climate ambition. Each country submits updated “Nationally Determined Contributions” (NDC) every 5 years that embody its efforts to reduce emissions and adapt to the impacts of climate change. Progress is assessed and debated at regular “Conference of the Parties”, the latest of which was held in Glasgow in early November 2021 (“COP26”). The pace of change can be seen in some of the COP26 outcomes:
Impressive as these commitments may seem, they are just that – commitments. Investors should expect to see more and more pressure for action in the years ahead.
“We can now say with credibility that we have kept 1.5 degrees alive. But, its pulse is weak and it will only survive if we keep our promises and translate commitments into rapid action.”
- Rt Hon Alok Sharma MP, COP26 President9
Nor is increasing climate ambition limited to United Nations (UN) conferences. The global response to the climate change threat is being led by:
Carbon pricing schemes now cover 23% of global emissions.10
Over 50% of the 1,600 largest public companies in the world disclose their climate-related risks and opportunities in line with the Task Force on Climate-related Financial Disclosures (TCFD).11
Financial Market Regulators
Increasing pressure on companies, banks and superannuation or pension funds to assess the risks they face from climate change.
Globally, over 1,000 climate change-related cases have been brought in the last six years compared with just over 800 filed between 1986 and 2014.12
Momentum for climate change action continues to build as the urgency of the problem becomes more widely acknowledged. It is crucial to understand that climate change action is altering investment fundamentals; global carbon pricing is starting to take form while capital allocations to low carbon technologies continue to expand. The consequences to investment markets will be profound; many professional investors are already including greenhouse gas emissions and climate adaptation strategies in their stock selection considerations.
The ground is shifting, and financial markets are already pricing assets on the basis of their ability to deliver sustainable profits in a global economy with ever less recourse to fossil fuels.
That the world needs to transition to a low carbon future to avoid catastrophic climate change is no longer in doubt. Here are some trends we suggest investors watch.
Achieving net zero GHG emissions has become a key goal in the effort to avert a climate crisis. Although the concept of net zero emissions was not part of the Paris Agreement, a detailed analysis by the IPCC on how the Agreement’s goals could be achieved sharply brought it into focus. That 2018 report, called Global Warming of 1.5°C,13 determined that if zero GHG emissions was achieved by 2050, then it might be possible (by the end of the current century) to meet the target of a 1.5°C rise compared to pre-industrial temperatures.
While over 90% of world GDP is covered by net zero commitments, a true global picture only emerges when you aggregate all the NDCs of individual countries. Research by Climate Action Tracker suggests full implementation of submitted and binding long-term targets and 2030 NDCs implies a temperature increase of 2.1%. However real world action based on current policies implies closer to a 2.7% increase.14
Despite the enthusiasm at COP26, the UN acknowledges that cuts to global GHG emissions are still far from where they need to be to preserve a live-able climate:
“The approved texts are a compromise. They reflect the interests, the conditions, the contradictions and the state of political will in the world today. They take important steps, but unfortunately the collective political will was not enough to overcome some deep contradictions.”
- UN Secretary-General António Guterres15
Investors should watch for a constant scaling up of ambition as envisioned in the 2015 Paris Agreement. There is pressure for countries to further strengthen their commitments. A number of countries (Australia included) are yet to increase their climate ambition from 2015.
Some commentators argue the net zero target is unhelpful, because plans to achieve it rely on unproven carbon capture technologies, carbon offsets and dubious carbon accounting, rather than on substantial reform to the global energy base.16 Nonetheless, signing zero carbon emissions into law represents a significant statement of intent that is likely to force innovation in carbon constraint as well as carbon capture.
In May 2021, the International Energy Agency (IEA), an associated body of the Organisation for Economic Co-operation and Development (OECD), produced a report outlining how global net zero GHG emissions could be achieved by 2050.17 Under its roadmap, there is no need for investment in new fossil fuel supply. Beyond projects already committed as of 2021, their roadmap assumes there are no new oil and gas fields approved for development, and no new coal mines or mine extensions are required. They also propose no further unabated coal plants be built – “unabated” means power plants without the technology to capture and store carbon dioxide. By 2035, there should be no sales of new internal combustion engine passenger cars, and by 2040 the global electricity sector should have reached net zero emissions.
Implication: The May 2021 IEA report will spur those countries that have already made the zero emissions pledge to double down on that commitment. It will encourage others to move from commitment to legislation and to set ambitious long-term strategies.
The Task Force on Climate-Related Financial Disclosures (TCFD) was created in 2015 by the Financial Stability Board (FSB) to develop consistent climate-related financial risk disclosures for use by companies, banks, and investors. Publication of the TCFD reporting recommendations in 2017 was groundbreaking.18 Companies are requested to assess risks and opportunities arising from climate change, and to disclose them clearly in a formal report.
The TCFD divides risks into two categories:
Physical risk has serious implications for the insurance industry and for the valuations of banks’ mortgages over real estate due to storms and floods. Floods and storms may also disrupt goods supply chains and storage facilities. Global food production is likely to be negatively impacted by stresses on agriculture and on sea life from rising temperatures. Mass movements of refugees can be expected, as currently marginal land becomes uninhabitable.
Physical risk rises as global temperatures rise.
Transition risk includes reputation and regulatory risks. Reputation-based transition risks are likely to rise as the global average temperature rises. For example:
Regulatory risk includes the risk that greenhouse gas emissions will be penalised by government regulation.
All industries are impacted by transition risk in their own way, however some are more directly impacted based on their industry and primary business models.
Consider Thermal Coal. The transition away from Thermal Coal as a source of heat energy (which entirely drove the Industrial Revolution), is now widely accepted as an inevitable and necessary means to decarbonise the global economy. Companies associated with thermal coal can be broken into two categories; thermal coal extractors and thermal coal power generators. Due to the Paris Accord commitments, companies that previously used thermal coal for power generation have a relatively clearer path to low carbon aligned business models. As power generation is only one aspect of a Utilities’ business, with transmission and distribution equally important, there is likely to be less disruption (and therefore less transition risk) for Utilities companies. In contrast, extractive companies face two additional transition challenges; the industry is less regulated (so the carbon ambition path is less clear), and the technical expertise and mineral resource location make these business models less flexible. Given the prevailing regulatory risk, we have seen many companies divest from their thermal coal interests in recent years, despite continued short term demand for imported thermal coal from emerging economies.
Although TCFD reporting is not yet mandatory anywhere, shareholders, fund managers and proxy advisors are stepping up pressure on companies to comply with TCFD guidelines. Indicative of the progress to date, more than 1,500 organisations have expressed support for the TCFD recommendations. Moreover, almost 60% of the world’s largest public companies have expressed their support for the TCFD and/or report in line with the recommendations.19
Implication: The quality of TCFD reports remains variable, with data capture and consistency still evolving. However, emerging best practice reporting is starting to provide investors and regulators with standardised, globally recognised disclosure.
Tackling climate change will be costly. The IEA report stresses that if the world takes seriously the imperative to achieve net zero carbon emissions by 2050, it will require at least US$5 trillion investment in clean energy by 2030. To put this into context, this level of investment equates to an extra 0.4 percentage point a year to annual global GDP growth.20
“For the world to achieve its objectives, we need a sustainable revolution on the scale of the Industrial revolution and at the pace of the digital transformation”
- Mark Carney, Net Zero Delivery Summit, 11 May 2022
There will invariably be winners and losers in the move towards a new economy and investors should construct portfolios that adapt to the world ahead, whilst also employing diversification as all sectors and companies will be impacted by these changes.
It takes time and money to innovate, develop and build pioneering products and infrastructure. But the cost of generating renewable energy has fallen so far that renewables now have economic potential without government subsidies, supported by falling battery costs.21
“… the levelised costs of electricity generation of low carbon generation technologies are falling and are increasingly below the costs of conventional fossil fuel generation.”
- IEA Projected Costs of Generating Electricity, 2020 Edition
To pick just few examples among many, battery storage will be a transformative element in renewable energy adoption. Belgium company Umicore, is a Materials company that specialises in recycling complex waste, recovering valuable metals from Lithium and Nickel batteries for the production of new rechargeable batteries. Vestas Wind Systems is a Danish company that designs, manufactures, installs, and services wind turbines for sustainable energy solutions. NIBE Group is a Swedish company who manufacturers heat pumps and other energy-efficient heating solutions. Even water utilities like American Water Works in the US or Severn Trent in UK will play an important role given climate change is already affecting water access for people around the world.
Putting a price on carbon emissions is widely recognised as a necessary step to drive change, and adoption of carbon pricing schemes is increasing from a low base. Efforts to date have been meagre; the World Bank estimates that governments raised only US$45 billion from carbon pricing schemes in 2019, rising to US$53 billion in 2020 and then US$84 billion in 2021.22 Carbon Taxes and Emissions Trading Schemes still only cover 23% of global greenhouse gas emissions and the median price is a low US$25/tonne.
If we make the assumption that 100% of global greenhouse gas emissions will eventually be subject to some form of carbon pricing, and that a carbon price of approximately US$75/tonne is needed in advanced economies by 2025 to meet the Paris Agreement commitments, the cost to global corporations could rise to be over US$1 trillion.23
This direct cost will be disproportionately borne by a relatively small group of companies that are responsible for a substantial amount of emissions. Greenhouse gas emissions are concentrated in power generation (25%), industrial uses (21%), agriculture (25%), transport (14%) and real estate (6%) sectors.24 However, these costs may also flow through supply chains to other, seemingly unrelated, goods and services. This is part of the financial backdrop for the development of low carbon technologies.
Implication: As the cost of carbon rises and prevalence of carbon pricing schemes widens, asset re-pricing will continue to occur. As renewable volumes rise, so costs fall, which then spurs more volumes. Falling fossil volumes mean lower utilisation rates, which increase costs and drive down volumes.25
A strengthening of disclosure requirements should make it easier to assess how companies are managing their emissions, as well as their resilience to carbon costs. Disclosure is key for investors seeking to measure and price climate-related risk.
An important moment for investors was the publication of the TCFD guidelines in 2017. The guidelines provide global financial regulators with a uniform framework for corporate and asset manager disclosures. The G7 has expressed support for mandatory climate-related financial disclosures based on the TCFD and that is reflected in support from regulators and supervisors, and ultimately in policy and regulation from governments. Countries with pending or implemented official TCFD-aligned reporting requirements include Brazil, the European Union, Hong Kong, Japan, New Zealand, Singapore, Switzerland and the UK.26
Standards setting organisations such as the International Financial Reporting Standards Board (IFRS) are also moving on climate. During COP26 in Glasgow, IFRS announced the establishment of the International Sustainability Standards Board (ISSB). The aim of the ISSB is to deliver sustainability-related disclosure standards for investors and other capital market participants, building on existing investor standards like TCFD.27 Organisations like IFRS are crucial because they can drive better corporate disclosure on climate-related issues even in the absence of government regulation.
“Finance Ministers and Central Bank Governors from over 40 jurisdictions in six continents officially welcomed the announcement of the ISSB and its work programme to develop a set of internationally consistent, high-quality and reliable standards for disclosure of sustainability-related information.”
- ISSB, May 18, 2022
Progress is also being made in Australia. The Australian Prudential Regulation Authority (APRA) released its Prudential Practice Guide 229 addressing climate change financial risks in November 2021.28 The guide, which is relevant to superannuation funds, insurers and banks, doesn’t try to impose new requirements in relation to climate risks. Rather, it supports APRA’s existing risk management and governance requirements; in effect risks and opportunities from climate change should sit alongside other risks being assessed and managed by a well run financial organization. Unsurprisingly, the APRA guidance reflects the established framework of the TCFD.
In a similar vein, the Australian Securities and Investments Commission (ASIC) has flagged climate-change disclosure for listed companies as a priority for 2022. Yet again, ASIC has acknowledged the quality of guidance provided by the TCFD and intends to work closely with the ISSB. ASIC has also flagged an interest in “greenwashing” for investment or superannuation products, where managers dramatically overstate the environmental or ethical features of a product.29
Implication: Regulatory pressure will force the disclosure of ever more information about climate risk. Capital markets will have more and more high quality information about sustainability when pricing securities. Small investors will need help to both understand and make good use of the information.
In preparation for what could be a widespread transition that is already well underway, we believe that advisory practices should consider the possible impact on client investment portfolios of climate change. Portfolio resiliency amid large scale disruptions to industry, financial markets and regulations will be critical.
ESG and climate investing is a journey not a destination. As there are many shades of “green”, the process of building ESG and climate portfolios can be initially confronting. Taking incremental steps might be easier than taking one giant leap. We have created a practical framework to guide advisers who wish to develop and implement an ESG and climate investment philosophy.
The risks and opportunities from climate change also provide an excellent chance for deeper engagement with clients. This adds a whole new dimension to client conversations about investment preferences and priorities. Practices that display an understanding of each client’s sense of purpose, and can better articulate how their advice helps fulfil that purpose, will thrive.
To quote the IEA;
"A transition of the scale and speed described by the net zero pathway cannot be achieved without sustained support and participation from citizens. The changes will affect multiple aspects of people’s lives – from transport, heating and cooking to urban planning and jobs."30
- ISSB, May 18, 2022
The scale of the challenge facing advisory firms is no different. The time to act is now.
1 Source: IPCC: Retrieved from https://www.ipcc.ch/report/ar6/wg1/
2 Source : CSIRO. State of the Climate 2020 Report. https://www.csiro.au/en/research/environmental-impacts/climate-change/state-of-the-climate
3 Source: International Energy Agency. Net Zero by 2050 Special Report.
4 Source: Responsible Investment Association Australasia. From Values to Riches 2022: Charting consumer demand for responsible investing in Australia.
5 Source: Responsible Investment Association Australasia. From Values to Riches 2022: Charting consumer demand for responsible investing in Australia.
6 Source: Responsible Investment Association Australasia. From Values to Riches 2022: Charting consumer demand for responsible investing in Australia.
7 Adopted at the 21st Conference of the Parties (COP21) of the United Nations Framework Convention on Climate Change on December 12, 2015. Retrieved from: https://unfccc.int/sites/default/files/english_paris_agreement.pdf
10 Source: World Bank Carbon Pricing Dashboard as of 30 May 2022
11 Task Force on Climate-related Financial Disclosures 2021 Status Report
12 Source: Setzer J and Higham C (2021) Global trends in climate change litigation: 2021 snapshot.
13 Source: IPCC, 2018: Global Warming of 1.5°C.An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty [Masson-Delmotte, V., P. Zhai, H.-O. Pörtner, D. Roberts, J. Skea, P.R. Shukla, A. Pirani, W. Moufouma-Okia, C. Péan, R. Pidcock, S. Connors, J.B.R. Matthews, Y. Chen, X. Zhou, M.I. Gomis, E. Lonnoy, T. Maycock, M. Tignor, and T. Waterfield (eds.)]. In Press.
14 Source: Climate Action tracker. See: https://climateactiontracker.org/global/cat-thermometer/
15 Source: United Nations. See: https://www.un.org/en/climatechange/cop26
16 Retrieved from: https://theconversation.com/climate-scientists-concept-of-net-zero-is-a-dangerous-trap-157368
17 Source: International Energy Agency. Net Zero by 2050 Special Report.
18 Source: TCFD. Recommendations of the Task Force on Climate Related Financial Disclosures Report. Published June 2017.
19 Source: TCFD. 2020 Status Report. Published October 2020.
20 Source: IPCC, 2018: Global Warming of 1.5°C.An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty [Masson-Delmotte, V., P. Zhai, H.-O. Pörtner, D. Roberts, J. Skea, P.R. Shukla, A. Pirani, W. Moufouma-Okia, C. Péan, R. Pidcock, S. Connors, J.B.R. Matthews, Y. Chen, X. Zhou, M.I. Gomis, E. Lonnoy, T. Maycock, M. Tignor, and T. Waterfield (eds.)]. In Press.
21 Source : Carbon Tracker. Retrieved from: https://carbontracker.org/reports/the-skys-the-limit-solar-wind/
22 Source: https://carbonpricingdashboard.worldbank.org/map_data
23 Source: Derived from World Bank Carbon Pricing Dashboard and IEA Net Zero by 2050
24 Source: SSGA, Carbon pricing: Where are we going? Retrieved from: https://www.ssga.com/au/en_gb/intermediary/mf/insights/carbon-pricing-where-are-we-going
25 Source: SSGA, Spiralling Disruption: The Feedback Loops of the Energy Transition
26 Source: Task Force on Climate-related Financial Disclosures 2021 Status Report
27 Source: IFRS - Path to global baseline: ISSB outlines actions required to deliver global baseline of sustainability disclosures
28 Source: APRA.
29 Source: ASIC. Speech by Chair Joe Longo at the AICD Australian Governance Summit, Thursday 3 March 2022.
30 Source: Net Zero by 2050 A Roadmap for the Global Energy Sector, IEA 2021
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The views expressed are the views of SSGA Australia through the period ended 31 May 2022, and are subject to change based on market and other conditions.
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