Many pundits today argue that the climate crisis presents investors with unprecedented uncertainty and urgency, and that this requires unprecedented – i.e. new and innovative – action. They are saying investors should reinvent themselves in light of climate change.
However I believe that now, more than ever, investors should play their ‘traditional’ roles: holding corporate management to account, allocating and reallocating capital, and dispassionately assessing and managing risks and opportunities; and also by engineering investment solutions, ideally in cooperation with governments.
In doing so they can make a far greater contribution to the energy transition than by jumping onto the ESG bandwagon, which – while with the best of intentions – has become obsessed with what I call “labelling” – measuring, disclosing and classifying things; while forgetting to think about “enabling”.
We must ask ourselves continuously what our objectives are, what problems we are trying to solve, and then come up with ways to actually enable solutions, and evaluate where there is a genuine role for investors.
A concept that has become popular in ESG and policy circles is that measures and measurements alike have to be “science-based”; the best example of this is the “Science Based Targets” initiative. While well-intentioned, I believe this has set us on the wrong path.
That’s not because I don’t believe in science; on the contrary. But it is because we are not correctly defining “science” when it comes to climate change.
When people talk about the need to be science-based in the context of climate change, they’re referring mostly to climate scientists. As a starting point this makes sense.
Climate scientists study weather conditions, averaged over a period of time, and can tell us how carbon and other emissions impact those weather conditions, including the global temperature. They have models that tell us how much fossil fuel we can burn and still keep temperatures below two, or maybe even below one and a half degrees celsius, as agreed in the Paris agreement.
Incidentally, the word “climate” comes from the Greek word “klima”, which means “slope”; the ancient Greeks thought that the climate had to do with the “slope”, or axis, of the earth.
Climate scientists seem quite united in their opinion that what is needed in order to solve climate change is a significant reduction in greenhouse gas emissions. These emissions come mostly from the burning of fossil fuels: coal, oil and gas.
However, climate scientists can tell us little about how to make the technologies needed to shift away from this. Therefore, I’m a proponent of expanding the circle of scientists for the definition of “science-based”.
To answer the question about technologies, we need another set of scientists: engineers – the people who invent, design and test machines and technologies. The word engineer comes from the Latin “ingenium”, or “cleverness”, and these clever people are the ones who came up with solar panels and windmills, and are looking at the possibility of modernizing nuclear technologies, and refining and scaling up hydrogen technologies.
Also, they’ve been looking at technologies that can pull emissions from the air, or avoid them going up in the first place: carbon capture and storage (or CCS), and direct air capture (DAC). However, the clever people can show us how to make the machines work, but can tell us little about the prices or incentives that are needed for large scale investment and deployment of these technologies.
For this, we need a third science: the dismal, or some would even say “miserable” science: economists.
And economy is another term we’ve borrowed from the classic languages: it comes from the Greek word for house, or household: “oiko”. Economists study the behavior of enterprises and markets, and can tell us how to measure and influence supply and demand in our global household.
And economists have measured the supply of energy: they will tell us that most of the global economy runs on fossil fuels: more than 80% of the world’s energy use comes from coal, oil and gas. The remainder comes from a hybrid category of “renewables” of which wind and solar are only about 5%; the rest is nuclear, hydro and bio-fuels (basically, burning wood). The most carbon intensive sectors are transportation, power (or electricity), industry, real estate, and agriculture.
In addition, economists are measuring, and projecting, the demand for energy – all that energy supply is not produced out of a simple desire of companies to produce, it is made because there are willing buyers on the other side. Willing to buy and willing to pay. And those buyers – people sometimes forget – are you, me, and everybody else on this planet.
Also, economists tell us demand for energy is rising, and will likely continue to rise, with growing populations and large segments of populations rising out of poverty and moving towards the middle class, especially in Asia. In short, while every economic problem is a problem of both supply and demand, when it comes to climate change people often forget the demand side of the problem and focus only on the supply side. The naming and shaming of oil companies, through divestment strategies or through the recent Shell verdict from a Dutch court, may give a certain degree of satisfaction to climate activists but will do little to change supply, as long as there are no measures to change demand, or substitutes, such as new technologies, that can deliver the supply.
So, back to economists: they are the people who can tell us which levers need to be pulled to influence supply and demand – pricing, taxes, laws, regulations, subsidies – but they are not well-positioned to tell us how those levers are pulled, and more importantly: how likely it is that those levers are pulled.
And this brings us to the fourth science: political scientists. Again based on a Greek word: “polis”: city, or state. Political scientists study systems of governance and power, and can tell us how governments work, and how governments pull levers and twiddle knobs – also referred to as carrots and sticks – to change the general framework that we all operate in. The toolbox they have for this, simply said, is laws, regulations, taxes and subsidies.
So, in a nutshell, the climate problem is this: the people who measure the slope of the earth are telling us we need to reduce emissions to save the planet, and are telling us we’re not doing it fast enough.
The clever people are telling us they are working on technologies that will allow us to generate energy in ways that don’t involve fossil fuels, but also that this is a lengthy process and there are barriers to speeding it up.
The dismal scientists who look at the household budget are calculating what prices and other incentives are needed to influence the supply and demand for energy in ways that those new technologies can replace fossil fuels. But they cannot set those prices or incentives.
And the folks who study the “city managers”, or governments, are telling us how likely it is they will make the laws, regulations, taxes and subsidies that will actually determine those prices and incentives, and will set the whole process in motion to meet the goals the climatologists have recommended.
In other words, corporations and investors who want to be “science-based”, and think about climate change holistically, will need to inform themselves, as much as possible, about what all these 4 sciences are telling us.
So where does this leave corporations? This is perhaps an overly simplistic view of the world, but they are stuck in a system they can barely influence, even if acting collectively.
Of course corporations can (and should!) reduce the emissions they control directly – scope 1 and 2 in ESG jargon – but can do little to influence global supply. They can try, as the Dutch court recently instructed Shell to do, but this is likely to lead to the most polluting activities simply changing hands, or any reduction in Shell’s production being eagerly matched by a competitor increasing it.
A clear example of labelling versus enabling: Shell has been labelled part of the problem, but the Dutch court has not thought about how this enables solutions to the problem, or might even make the problem worse.
Corporations, after all, can do little to influence demand – they cannot persuade 9 billion people to forgo trips to Paris, or air-conditioning, or the importing of avocados from Mexico. Also they cannot create laws, regulations, taxes or subsidies, that would force people to do this; as a society we’ve decided that governments should be those carrot and stick wielders-in-chief. Corporations can invest in new technologies, but will only do so once this can be done in a way that covers the cost of capital, and unfortunately most nascent technologies require government interventions such as subsidies to get to that stage.
Harald Walkate is ESG Advisor to a number of organizations including Dutch Founders Fund and was formerly Head of ESG for Natixis Investment Managers and Aegon Asset Management.
This is an edited version of the keynote speech given at the Cambridge Risk Summit 2021: Transitioning to Net Zero – Managing the Risks