COP26: Environmental risk

The COP26 summit has focused minds on climate-related investing. Commitments included not only more climate capital, but also more disclosure standards. such measures are vital if effective action is to be rewarded with returns, writes Peter Taberner.

The end of COP26 in Glasgow saw asset management firms reflecting once more on how to achieve net-zero carbon emissions while rewarding investors for their risk-taking.

This is a challenge discussed within the broader conversation of how capitalism can contribute to alleviating the effects of climate change.

At COP26, the thirst to mobilise capital to work towards transforming economies so they can function at a net-zero carbon-emissions level was clear.

One sign at the level of asset management and asset ownership was the Glasgow Financial Alliance for Net Zero (GFANZ), where over $130 trillion of private capital was committed to achieving the target of net-zero emissions by 2050. These were pledges that arrived from more than 450 firms across 45 different countries.

Ahead of the climate change summit, GFANZ counted more than 160 firms among its members, with assets worth a combined $70 trillion.

A GFANZ progress report released in November outlined four key objectives surrounding the mobilising of capital for net-zero investments.

Included in these objectives is an increase in capital flows into emerging markets and developing countries, enabling them to make environmental improvements. This key initiative is followed by support for the development of ambitious country platforms to accelerate action.

Engagement by GFANZ members over key initiatives to catalyse funding for those emerging markets and developing countries is a further objective, as is increasing the collaboration between the private financial sector and multilateral development banks.

GFANZ in its report would also encourage asset managers to engage in specialised lending towards lower-carbon projects, ones that are labelled Green and Transition Finance, and – in terms of managing the investment capital – suggested ways forward involve considering the emissions profiles of businesses and creating net-zero aligned savings and investment products.

Beyond GFANZ, fresh analysis recently commissioned by the UN High-Level Climate Action Champions found that 70% of the total investments needed to meet net-zero goals could be delivered by the private sector.

Other organisations – such as the Institutional Investors Group on Climate Change, a 360-member, Europe-based body – are also driving the investment community to achieve progress in net-zero investments by 2030.

Loss of appeal?
Fund managers looking to ensure reduced carbon emissions that will keep global temperature rises within the 1.5 Celsius target must deliver risk-adjusted returns. Yet as more investors look to own assets that are climate-change friendly, it is always possible that returns will fall and that net-zero investments will lose their appeal.

Dan Kemp, global chief investment officer at Morningstar Investment Management Europe, says companies that are better able to change to a sustainability model are a more attractive investment opportunity.

“These companies are likely to be trading at lower valuations and so investors can benefit from an improvement in the sustainability of the business, a more positive impact on the world and an improvement in the valuation,” he adds.

This is naturally a longer-term approach than simply buying companies with superior sustainability characteristics, but “investing is always a long-term pursuit”, Kemp says.

“The challenge for investors is to identify companies where the ability to transition is underappreciated and consequently the cost of capital is too high. In contrast, there is lower potential upside and higher potential downside where the probability of transition is overpriced and the cost of capital is too low.”

Balancing act
Energy and investment firms face a balancing act in what will be a delicate transitional phase of changing investment patterns, since the world remains heavily reliant on fossil fuels.

In the UK recently, the petrol supply crisis highlighted the panic that can set in if energy provision is disrupted. This can lead to huge economic uncertainty.

BP’s ‘Statistical Review of World Energy 2020’ found that in 2019, before the Covid-19 pandemic, the biggest increase in energy consumption was seen among renewables. At the same time, however, fossil fuels accounted for 84% of the world’s primary energy consumption.

COP26 delegates agreed that developing countries will receive more funding to switch to cleaner energy and that governments will phase out subsidies to fossil fuels.

The most controversial move was to ‘phase down’ rather than phase out coal after interventions from India and China.

Mark Lacey, portfolio manager of the Schroder ISF Global Energy Transition fund, says the recent supply shocks and rising electricity prices will accelerate the pace of divestment in coal, and of investment in key energy transition markets such as wind, solar and batteries. But he also says that sentiment towards selected energy companies is improving, including in the oil and gas sector.

“The heavily discounted and once-disliked conventional energy companies are starting to be very much part of the energy transition solution – not part of the problem,” says Lacey.

Major integrated oil companies, which continue to be important suppliers into the oil market, are seeing their capital allocation changing, he adds.

“These companies have significantly reduced capital expenditure over the last few years as both oil and gas prices had weakened significantly. They have now focused on reducing their debts, maintaining dividend payments to investors and redirecting capital towards renewable power capacity, hydrogen and energy transition infrastructure. They are in no rush to spend more on oil or gas projects.”

Alix Foulonneau, a sustainable investment analyst at UBS Asset Management, says that although tools exist to model climate change risks at the portfolio level, a “fundamental bottom-up research approach” by asset managers is also important. That’s because it leads investors to examine a company’s climate change preparedness in the context of its sector, assets, capital allocation strategy, technologies and operations.

“For example, an energy transportation company could be trading at a discount because investors have overlooked its potential to be a key player in the transition due to the energy-agnostic characteristics of its assets, or the reconversion potential of its sites,” she adds.

“That granularity is not captured by ESG data providers or regulators’ green taxonomies, which gives active investors like us the opportunity to identify alpha potential.”

Incoming standards
Investment in the energy transition and how to monitor it is a challenge in itself. Another development during COP26 was designed to help.

The IFRS Foundation announced the creation of an International Sustainability Standards Board, responsible for developing standards around sustainability disclosures to help financial markets.

The data necessary for ESG investing – much of it from disclosures – is a difficult area for fund managers and interested observers alike.

“Our approach depends on market position and type,” says UBS’s Foulonneau. “For industrial companies, we look for technologies with positive environmental impact, and efficient processes and energy supply.

“For food retailers, we seek transparency in procurement, including commitments on deforestation and biodiversity, efforts to supply plant-based alternatives, and meaningful waste reduction.”

She adds: “We monitor so much more than a percentage reduction in greenhouse gas emission targets and needless to say, a vague commitment to net zero by 2050 is not enough.”

The creation of standards is something the Taskforce on Climate-related Financial Disclosures (TFCD) has been working on for some time, having released a set of recommendations four years ago. These recommendations, recently updated, included advocating the creation of specific organisations on disclosures that should be included in financial filings, to make net-zero-related decisions.

Guidance will also be provided for all sectors on climate-change-friendly disclosures, alongside supplemental guidance for certain sectors.

The TFCD supports using metrics on climate-related risks, which are typically associated with water, energy, land use and waste management.

With the world looking on, and as the framework for climate-change-friendly investments takes shape, fund managers and the financial community at large must grab the opportunities available.

© 2021 funds europe



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