Andrew Parry, head of sustainable investment at Newton Investment Management, looks at the challenges presented by climate change, the importance of COP26, and why governments need to pull their weight to tackle the climate crisis.
Climate change is the biggest challenge of the world we live in today and will likely have wide-ranging, complex and uncertain consequences over the remainder of our lives on Earth.
Whilst a decade ago the impact of climate change was much less discussed, today it is taking prominence globally due to a range of drivers, including changing political imperatives, underscored by the stark warnings in the recent IPCC 6th Assessment Report amongst others.
The global pandemic caused a stir amongst societies worldwide, signalling to governments and corporates that severe change was needed to ‘build back greener’ or else risk never reversing, or even stalling, the trajectory of climate change. Now, as we enter the period of tentative economic recovery and COP26 nears, it is clear there is a long road ahead to meet net-zero objectives, especially after the latest report from the IPCC which provided strong evidence that change must happen now. It thus essential that governments align their action to their rhetoric, and then supported by the financial services industry.
The landscape has shifted for the financial community; but governments still lag behind
To truly understand the progress and challenges faced today, and the significance of events like COP26 on climate change goals, it’s important to first contextualise the milestones of the past decade, as well as the failures.
The biggest development we have seen over the past five years was the financial industry finding its voice on climate change issues. To illustrate this, simply look at the differences in AGM outcomes of the world’s biggest emitters. Five years ago, it was widely known what the impact of oil and gas production had on climate change, yet five or six years ago, these firms remained largely uncriticised due to the fact they had stable dividends and strong business models. Fast forward to 2021, these same companies are being widely challenged by the financial community as sustainability is placed at the top of shareholder discussions.
Financial markets have truly amplified the concerns on the severity of climate change, with investment firms publicly voting against unaligned business practices and implementing stringent engagement policies. In tandem, many investors have become activists in their own right, by not only encouraging financial firms to challenge companies, but also expecting to see aggressive activation of change.
While this is extremely positive, the financial community can only influence these goals to a certain extent. We are now reaching an inflexion point where integrated efforts are needed, and that stems from central governments, to corporates, associations, investors and the general public. Looking solely at government initiatives, the Paris Climate agreement was the first big step in a united, international agreement to solve climate change. Yet despite this coming into play in 2015, global emissions still rose year-on-year (apart from 2020 due to the pandemic). To build upon the momentum of the financial community efforts, governments truly need to match their rhetoric with strategic action.
Incentives and disincentives: The role of governments
Government action is still the missing cog in the machine in terms of tackling climate change. We’ve seen some bold commitments in recent times, but the action to back them has largely lacked. To effectively reverse or stall the effects of climate change and meet net-zero targets, systemic change is required. This means government-enabled incentives and disincentives need to be mandated.
In the absence of such incentives or disincentives, someone, somewhere will always be looking for an opportunity for quick financial gain, which is what we are seeing today.
Whilst public firms have made strides in divestment, private companies have been quick to pick up the scraps. Today, we aren’t seeing coal assets shutting down plants, but instead, selling them to private firms who are exploiting assets for pure financial gain. This dilemma can be coined as a ‘free rider principle’, meaning there are no incentives for good behaviour and no punishments for bad behaviour.
Another important consideration for governments centres around how they plan to balance the need for economic recovery and climate change. This dilemma is hard for the financial sector to ignore. The pandemic added another layer of complexity as low-interest rates and unprecedented monetary stimulus packages have adversely impacted climate change goals by encouraging consumption as a means of economic recovery.
One potential solution to this dilemma which we could see play out in the years to come is using individual climate change action as a means of geopolitical economic policy competition.
Climate risk modelling – focus on the curve
With an issue so complex and adaptive, data quality has fallen short, leaving risk for errors and adverse challenges such as greenwashing risk. So how do industry players factor in these risks into their climate change models?
For investors, it’s important to consider the shape of the future energy transition curve in terms of historical context. 20 years ago, even the most aggressive forecasts could not have foreseen the influence of technology or how it has truly penetrated businesses and lives today. Technology growth was forecasted to be concave, meaning a rapid flow of opportunities over the short-term, which as we all know, was not the case. The impact advances in technology had happened over a longer time period than anticipated, but ultimately more significant than even the optimists anticipated. This led to a convex curve of accelerating growth, meaning tech companies in the early stage of the transition disappointed significantly before ultimately coming good and in dramatic fashion.
There is potential for the same effect to happen to the green assets transition curve if governments fail to set the right incentives. As countries work towards their net-zero goals, immediate action is required. If we see a flurry of action in 2040 following limited efforts in the years before, the transition curve will be too convex, and back-end loaded. This will lead to the expectations built into the valuation of green assets being thwarted, but more worrying, could lead to fossil fuel demand being extended for longer than sound scientific logic demands.
Governments need to focus on pushing the curve to becoming front-end loaded and convex or risk further disasters down the line.
The significance of COP26
Now is the time for governments to align their actions to their rhetoric, and COP26 represents a global forum to do exactly that. The ideal outcome of COP26 is to see policing initiatives that are binding, ultimately bringing teeth to net-zero commitments. Without systemic change and the introduction of mandated incentives and disincentives, the efforts of the financial community can only go so far. Engagement and aggressive voting policies will remain crucial, but without the alignment to sovereign policies, we risk failing to meet climate change goals – and the effects will be irreversible.
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