How climate change mitigation is turning investment assumptions on their head

COP26 may have underlined the world’s determination to act decisively on climate change but turning intent into impact will affect different businesses in different ways. Support for organisations playing a part in limiting global warming is set to accelerate dramatically; the sanctions for those seen as doing harm will multiply at a similar pace.

There is no alternative. The only way for governments to hit their net zero targets on greenhouse gas emissions — and deliver on the pledge first agreed upon six years ago in Paris to keep global warming “well below 2C” — is to take full advantage of the regulatory and policy instruments at their disposal. “Deep down, we all know what is necessary to change the world,” says Neil Goddin, co-manager of the Positive Future Fund at asset management firm Artemis. “It is going to require us to build something different, not more of the same with a bit of a tweak.”

Driving transformation

In practice, there are three areas where this is likely to play out. First, we will see more governments introduce carbon pricing in one form or another — either through carbon taxes or the introduction of emission allowances markets. Next, we will see carrot as well as stick in the form of subsidies for low-carbon technologies and solutions. And finally, we must expect more legislation, from new emissions standards to outright bans on certain activities.

Each of these policy responses has profound implications for a broad range of industries — positive impacts in some cases, but highly detrimental effects in others. “The combined national policies already signal that a massive capital reallocation is going to be required,” says Guillaume Emin, Senior Sustainable Investment Manager at FTSE Russell, an LSEG business. “For investors, that tectonic shift presents both risks and opportunities.”

For those industries and businesses able to play an active role in climate change mitigation, the outlook is increasingly rosy. The Intergovernmental Panel on Climate Change (IPCC) — the United Nations body responsible for assessing the science related to climate change — warns that a marked adjustment in investment choices in favour of green economy businesses is now necessary¹.

Indeed, the IPCC estimates that the additional energy-related investment required between 2016 and 2050 to reach the more ambitious target of limiting global warming to just 1.5C could be as much as $830bn a year. That represents a huge boost for companies involved in segments such as batteries, renewable energy equipment, public transportation solutions, recycling services, buildings’ renovation materials and efficiency management goods and services.

At the other extreme, pure-play fossil fuel businesses face significant threats. “In a 1.5C trajectory, the stranding of fossil fuels assets would be a distinct possibility,” says Emin.

Factoring climate change risk into investment decisions

Investors are taking note. The rapid growth of investment strategies with an environmental, social and governance (ESG) tilt in recent years partly reflects individual investors’ increased desire to align their savings with their values — to do good at the same time as doing well. But it is also dawning on many that holdings in businesses on the wrong side of the climate change agenda could be in for a rough ride.

As a result, even investors not following an explicit ESG mandate are questioning their exposure to such stocks. Research from PwC² shows institutional investors now expect ESG and non-ESG products to converge; in 2022, 77 per cent expect to stop buying the latter.

David Osfield, manager of the EdenTree Responsible and Sustainable Global Equity Fund, believes that even his peers in non-ESG funds will have to start paying attention to sustainability factors when selecting stocks.

“Utilising sustainable data, from an idea origination perspective, is critical in identifying companies to build a sustainable portfolio, as well as understanding the material risks that can drive the engagement agenda,” says Osfield. “Rather than seeing this as a trade-off against financial data, a significant proportion of our non-consensus forecasts come from reflecting these sustainable insights in our models.”

They may be “non-consensus” for now, but as other investors begin to make greater use of sustainability data in their portfolio analysis, their models will shift. In the energy sector, for example, full decarbonisation of production requires a complete rethink of current assumptions. The same is true of decarbonisation of transport. In agriculture, it is not simply that dietary shifts and food waste will transform consumer spending patterns, but also that farmers will need to manage land differently; in India, for example, agriculture accounts for 20 per cent of greenhouse gas emissions.

The list goes on. And while these shifts can be managed in combination so that the overall impact is reasonable, that will not apply at individual stock level, warns FTSE Russell’s Emin. “If well-calibrated, all these instruments result in fewer greenhouse gas emissions and lower associated economic damages,” he says. “But they can all impact asset valuations and have implications for investors, although in different ways.”