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Alongside its headline-grabbing temperature objective, the Paris Agreement sets a goal of “making all financial flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.” In response, many investors are now seeking ‘Paris Alignment’, which is generally interpreted as a reduction of the carbon footprint of their portfolios in line with a Net Zero or similar target.
But this is likely to be a sub-optimal approach, particularly given the eye-watering levels of capital that will be required to transform companies in hard-to-abate industries. Worse, it may run counter to investors’ fiduciary duties to their stakeholders, for example pension fund beneficiaries.
A more rational response is for investors to pursue Paris Resilience, by optimising the (financial) robustness of their portfolios in the context of a range of plausible scenarios for how society will react to the onerous challenge of climate change.
At the start of the 2020s, investors are under pressure not only to produce stellar investment returns, but also to direct capital towards creating a positive impact – for example, through better environmental or social outcomes, to improve corporate governance or to strengthen diversity & inclusion. Some believe that investors should take a meaningful share of society’s burden of mitigating climate change, while others argue that, unless investors prioritise the management of the risks and opportunities arising from climate change, they are likely to deliver sub-optimal financial returns.
How should investors navigate these confusing and potentially conflicting demands?
Let’s start with the broader context. The process of investment management comprises three steps. First, investors establish with their stakeholders Investment Beliefs; for example, their approach to risk or their willingness to outsource to specialist managers (Strictly speaking, it is asset owners who set investment beliefs, which may shape their relationships with the managers they appoint). Second, they seek investment opportunities in line with their target returns; and third, they manage risk, usually taking account of their tolerance for losses or volatility.
In my view, if they assess all external pressures on them in the context of these three steps, investors can respond in the confidence that they’re fulfilling their fiduciary duty to their stakeholders.
From Paris Alignment to Paris Resilience
There’s no doubt that investors should look more closely at the emerging or rapidly evolving risks and opportunities linked to climate change. However, while investors who divest entirely from oil producers as a result of recommendations arising from their risk analysis are acting appropriately, those who divest because they want to put pressure on such companies to change their business models, or alternatively make a contribution to society’s burden of mitigating climate change, will need to check they’re acting in accordance with their own Investment Beliefs.
Investors seeking to manage climate change risk in the context of Paris Alignment should avoid three pitfalls and instead focus on establishing Paris Resilience.
First, a flawed theory of change. Society will address climate change efficiently and rapidly, not by a predetermined allocation of CO2 emissions reduction – for example “each company aims for Net Zero”, which may simply transfer responsibility for emissions to other actors or entail inefficient levels of capital expenditure on new, unproven technologies – but through effective public policy, particularly to shape private sector markets for low- or zero-carbon goods and services. Such policies may include the phasing out of certain products, carbon taxes or regulations that specify rules for new markets such as power trading.
Investors should look instead at the potential market dislocations arising from these policies and assess their impact and the likelihood that they will materialise. In particular, they should expect significant ‘creative destruction’, with new products and services replacing those sectors for which a migration to low carbon is difficult or capital intensive and for which ‘sunset’ is the best direction!
Second, incorrect metrics. Climate change risk for companies is manifest in potential impacts on their balance sheets and cashflow. Their current or future carbon footprint is a poor proxy, particularly as it takes no account of the company’s pricing power (e.g. its ability to pass on higher energy costs to its customers). Instead, investors should look at the likely impact of market dislocations on companies’ financial statements – for example, the impact of future carbon prices on corporate cashflow across a range of (ideally standardised) scenarios.
And third, sub-optimal analysis and response. The potential for cost reduction of ‘low carbon’ technologies and processes is only half the story. Investors should focus instead on the return on invested capital of proposed business initiatives. New industries based on ‘substitute’ products, such as cellulosic materials to replace plastics, are likely to offer much better ROIC than squeezing the last slug of emissions out of hard-to-abate sectors.
Crucially, investors should then check whether these dislocations are reflected in today’s asset prices before they determine how to modify their portfolios. Once armed with these insights, investors may choose to check how the companies whose shares they own are responding to the new landscape of risk and opportunity.
Investors with sufficient resources may choose to take the further step of contributing to efforts to persuade policy makers to accelerate the shaping of rules and regulations required to underpin new markets, for example for carbon credits for CO2 absorption.
By avoiding these pitfalls and focusing on raising the Paris Resilience of their portfolios, investors can deploy (with enhancement) their proven investment management tools and avoid the potential confusion and resistance they’ll likely encounter if their practices stray from their Investment Beliefs.
Over time, it’s likely that they will both end up with better investment outcomes and support the efficient redirection of capital that is essential if we’re going to transition to a more sustainable, low-carbon economy, and meet the Paris Agreement’s goals.
Ian Simm is the Founder and Chief Executive of Impax Asset Management Group