Is it time for investors to wake up to climate change?
07 Feb 2019
There’s little doubt that climate change is a hugely challenging problem to solve. It’s been made more challenging by our collective failure to properly understand the connections between the economy and the environment. Even now that the realisation has dawned, there is a contradiction between our desire to maintain our current way of life and our willingness to accept that significant changes (and, very possibly, considerable sacrifices) will be necessary.
It is clear that society needs to break its addiction to fossil fuels and the carbon emissions they create. The recent report from the Intergovernmental Panel on Climate Change suggests we have just 12 years to effect the changes that will put us on the right track. The potential implications for financial markets are huge and it is crucial that institutional investors consider these issues and the associated risks in framing their investment policy.
Divest, engage or exploit?
Research from the Global Sustainable Investment Alliance records the amount of capital committed to responsible investment strategies in 2016 was around $23bn. This figure had grown 25% over the previous two years and it is almost certain that the amount has continued to grow since then. This figure does, however, encompass a range of different responsible investment approaches, including strategies which integrate the consideration of environmental factors (usually in conjunction with social and governance issues), strategies focused on engagement and exclusion-based approaches.
Therein lies one of the inherent contradictions that makes climate change so problematic: how should investors respond to climate change risk? Should institutional investors shun companies with significant fossil fuel reserves or large carbon footprints and bias portfolios towards “greener” alternatives; should they use their ability as asset owners to engage with company management to effect changes in behaviour or should they use ESG analysis to identify and exploit market mis-pricing? That all of these approaches are still found suggests there is no right answer, at least from a pure investment perspective.
Divestment may be regarded as a simple approach, but is it really effective? It certainly reduces exposure to companies that may suffer financial losses as a consequence of the transition to a low carbon economy, yet it is a very blunt instrument. In its most basic form, it focuses only on those companies with fossil fuel exposures, ignoring those other industries with large carbon footprints. It may be appropriate for some companies where the business model is in irreversible decline. Can a fossil fuel company become something different? Is it not more likely to fail rather than change?
But what of those companies that may improve behaviour or even evolve to form a part of the solution? Is engagement the solution here? Do shareholders have the power to change companies? Engagement is an approach which takes time, requires patience and persistence. It can be successful, as the recent announcement from Shell to align management incentives to carbon emissions demonstrates. Yet, the success of engagement cannot be guaranteed and, to those seeking action more quickly, it may be seen as a cop-out - a delegation of responsibility.
There are a number of alternatives which lie between divestment and engagement. But these are not necessarily the extremes. Where does price come into the debate? Is it even the job of institutional investors to secure a better future for the planet; do they need to do more than understand the risks and exploit market mis-pricing in order to secure a better future for their clients’ investments?
Whatever the personal views of their stakeholders, institutional investors can no longer ignore the issues as recent regulatory progress has set a timeframe for them to begin their discussions. And that’s just the start. Institutional investors can no longer avoid the question: what should we do? How can we best act in the best interests of our stakeholders, both to deliver the financial returns, but also to recognise that these returns rely on the health of our one home?
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