Capital markets have embraced the transition to a low-carbon economy. They are transforming themselves to ensure an orderly process, writes Paul Bryant
The only way we are going to make a real difference to the climate emergency is to simply stop investing in coal, oil and polluting industries altogether.” That was a client’s perspective conveyed to Chris Halliwell of Sanlam Wealth Planning. It is a view from one end of the spectrum – some investors take a more nuanced approach – but it’s not uncommon.
But a large and abrupt withdrawal of capital from carbon-intensive industries comes with risks for investors. Sanlam’s Chief Investment Officer, Phil Smeaton, highlights cost and inflationary pressures as vast amounts of ‘brown’ infrastructure gets replaced before the end of its useful life. Some assets are likely to become ‘stranded’ – for example, many coal mines will be redundant as coal gets replaced as a fuel source. Meanwhile, we will still need iron and steel in the future, so abandoning these industries and their supply chains makes little sense. They have to transform, not disappear.
Smeaton says capital markets are designed to deal with change. They continually deal with emerging and dying companies and industries. It’s the speed of change demanded by the climate emergency which is an abnormally complex challenge. But markets are adapting.
Calls for even faster change
The Paris Agreement of December 2015 – a legally binding treaty signed by 195 governments – marked a rapid acceleration in the transition to a low-carbon economy.
Reacting to a growing body of research, signatories committed to limit the increase in the global average temperature to ‘well below’ 2°C above pre-industrial levels (1861–1880 was used as the ‘pre-industrial’ base) and to try to limit the increase to 1.5°C. It was found that the risks of global-warming-induced events ramped up significantly if temperature rises approached or exceeded 2°C. These included the rapid degradation of ecosystems such as Arctic sea ice and coral reefs; extreme weather events such as heat waves and heavy precipitation; and climate ‘tipping points’ where abrupt regional climate shifts occurred.
Countries committed to submit their climate action plans or nationally determined contributions (NDCs) – mostly plans to reduce greenhouse gas emissions, the primary cause of global warming – in time for the United Nations Climate Change Conference to be held in Glasgow in November 2021 (COP 26).
But the plans submitted to date look inadequate. Reacting to an analysis of the NDCs submitted by 75 signatories by the end of 2020, UN Secretary-General António Guterres said: “Governments are nowhere close to the level of ambition needed to limit climate change to 1.5°C … the major emitters must step up with much more ambitious emissions reductions targets for 2030.”
While governments might be lacking in ambition, individual investors are not. Halliwell says he has seen a rapid increase in demand for sustainable investments, and he stresses that the demand spans the generations from GenZs all the way to Baby Boomers. “Clients have recognised that it’s probably the most powerful action they can take to influence change.”
Capital markets’ rapid response
It’s hard to argue that capital markets are not on the case. Between 2016 and 2020, the number of ‘sustainable’ investment funds in Europe grew from around 900 to 3,200, with more than 500 launching in 2020 alone. These attracted new capital of €233 billion in 2020, nearly double the €126 billion of 2019, and ten times higher than 2016.
The financial product landscape continues to adapt to deal with the transition to low-carbon. ‘Green bonds’ – which provide capital to projects with strong environmental credentials – have become a substantial market over the past five years. At the end of 2015, their cumulative value stood at US$104 billion, which grew ten times to US$1.05 trillion by the end of 2020. ‘Transition bonds’ meanwhile, is a market still in its infancy but with huge potential. These allow brown industries to raise capital with the goal of becoming greener.
We are also seeing more nuanced financial indices. While ‘green’ indices (such as ex-fossil fuel or low-carbon) have been around for years – the FTSE Environmental Markets Index Series was launched in 2008 – more recognition is now being given to the importance of a smooth transition. The FTSE TPI Climate Transition Index, launched in 2017, determines a company’s proportion of the index according to criteria such as how much green revenue it generates and its actual carbon emissions. Browner businesses are therefore incentivised to change as they will be assigned a higher weighting of the index as they proceed along their green journey.
Dealing with complexity
Markets are however having to grapple with the problem of consistency in assessing investments. As Smeaton says: “It’s not easy to work out a carbon footprint. Just because companies produce a number doesn’t mean it’s right or comparable to that produced by another company. And it becomes particularly complicated when you start measuring emissions and the like up the supply chain.”
This is also being addressed. When it comes to climate change, the Task Force on Climate-Related Financial Disclosures (TCFD) is the most prominent initiative. It has published (voluntary) climate-related financial disclosure recommendations which are “designed to help companies provide better information to support informed capital allocation”. These include disclosure recommendations around governance, strategy, risk management, and metrics and targets. As of September 2020 nearly 60% of the world’s 100 largest public companies support the TCFD, report in line with its recommendations, or both.
Regulation is also starting to play its part with the EU leading the way. Regulation requiring sustainability disclosures for financial products and for financial advisers to ascertain the sustainability preferences of investors is already in force. Additional regulation, such as a taxonomy (which establishes the criteria for determining whether an economic activity qualifies as environmentally sustainable) is in the pipeline (scheduled to apply from 1 January 2023).
Halliwell summarises how the above developments have impacted Sanlam’s offering to clients: “We have a much closer relationship. We now ask clients about their beliefs and how they want these to apply to their investment portfolio – from their views on nuclear energy to animal rights. Our portfolio managers can then marry clients’ ethical needs with their financial needs and design a portfolio bespoke to them.”
To find out more about sustainable investing, talk to your financial planner or portfolio manager.