Markets and Insights #8: A scorching summer – What if your investments were the solution?
The latest report from the IPCC, the Intergovernmental Panel on Climate Change, has gone almost unnoticed because of the geopolitical news. Yet its core message is alarming: it is crucial to act now to respond to the climate emergency, including the financial sector.
Previous reports have focused on assessing the impact of human activity on the environment. Having concluded with a very high probability that human activity is the main cause of global warming, the latest publication proposes with solutions.
One of the main recommendations is a more rapid redirection of global financial flows towards climate change mitigation and adaptation solutions. To date, the investment gaps to reach the Paris Agreement trajectories and succeed in slowing global warming are immense. According to the IPCC, investments in green electricity need to be multiplied by 2 to 5, in energy efficiency by 2 to 10, in transport by 7 to 8 and in sustainable agriculture, including silviculture, by 10 to 29.
This reorientation of financial flows concerns all players in the finance sector. For banks, it means integrating climate risks into the assessment of financing risks, and for asset management and investment companies, it means understanding and integrating the impact of investments on global warming into portfolio management. In this way, along with governments, asset managers are moving towards "net zero". The Net Zero Asset Manager initiative, created in December 2020, already has more than 236 signatories representing more than USD 57 trillion in assets under management. With this initiative, signatories commit to aligning their portfolios with the Paris agreements and to supporting investments for net zero emissions by 2050.
Thanks to data science and physical flow modelling, it is now possible to estimate the global warming trajectory of an investment portfolio, or in other words, the 'temperature' of the portfolio. Scientists are now able to estimate the greenhouse gas emissions 'budget' we can still emit to limit global warming to 1.5°C. Overall, the World needs to reduce its emissions by 7.6% per year. As not all sectors have the same immediate reduction capacity, scientists have also estimated the share of this budget attributable to each sector annually, depending on the potential for decarbonisation of their industrial processes and the technological progress expected. Alignment champions already exist, but heavy industries for example, as well as the oil sector, still have a long way to go in the transition. This sectoral analysis can then be combined with a more detailed analysis at company level: the efforts already made and their commitments towards net zero. It is thus possible to estimate the global warming trajectory of each company.
By obtaining a trajectory for each company in the portfolio and knowing the invested share of that company, it is possible to estimate the global warming trajectory of a portfolio of listed assets.
Due to the many existing methodologies, which are sometimes complex and not so transparent, as well as multiple data providers, the results can be highly heterogeneous and incomparable for the same portfolio. The report "The Alignment Cookbook" by the Louis Bachelier Institute published in 2020 highlights these disparities by studying the different methodologies of 12 data providers. For example, the implied temperature increase for the same portfolio can vary from 1.5°C (and therefore be aligned with the Paris Agreement trajectory) to more than 3.5°C (and therefore no longer aligned with the Paris Agreement). These differences can be even greater in terms of the underlying actions.
More than calculating the implied temperature of a portfolio, these tools have an educational role and can help investors realise their role in the fight against global warming. For example, if a portfolio follows a global warming trajectory well beyond 2 degrees, an investor can make the radical choice of divesting from the stocks or sectors that emit the most greenhouse gases. They can also make the sometimes more constructive and effective choice of engaging in dialogue with the companies concerned to encourage them to reduce their emissions.
This notion of engaged dialogue is now an integral part of the investment process. Investors engage and expect companies to engage in dialogue. Increasingly, companies have dedicated environmental specialists within their investor relations teams. This dialogue works and encourages companies to improve transparency on emissions and other environmental data. Often, it also helps to push for more ambitious targets. This dialogue is even more necessary as the majority of European equity indices are currently estimated to be well above a 2.5°C rise.
The fight against global warming can only be carried out with the participation of all stakeholders, with the financial sector having a major role to play. As the saying goes: "Small streams make big rivers...", it is through small individual efforts that the collective will be put in place.