investment insights
Five priorities for COP26: an investor’s perspective
Lombard Odier Private Bank
Key takeaways:
- Investors need clearer action plans to meet the Paris Agreement goals, including interim emissions targets, policy guidance and industry strategies
- Efforts must focus on the energy sector, including removing fossil fuel subsidies and providing price incentives for new technologies. More accurate carbon pricing and trading mechanisms are also key.
- Common sustainable investment frameworks would help deploy USD120 trillion of private capital towards the net zero transition
- A focus on nature, including accurate pricing of natural resources and developing natural climate solutions to help offset greenhouse gas emissions, would also be welcome.
Our role as investors is to understand and manage climate transition risks, and capture the opportunities. COP26, the international climate conference that runs from 31 October to 12 November, represents a unique chance to bring together public and private sector participants to accelerate progress towards the Paris Agreement goals. Below we outline five priority areas for action.
1. Investors need more clarity on net zero
If the global temperature rise is to be limited to 1.5°C, greenhouse gas emissions must halve by 2030 and reach net zero by 2050. Six years after the Paris Agreement, we estimate close to 80% of the global economy is now covered by net zero targets of various kinds. Yet investors lack clarity on the strategy and action plans – including interim targets, policy guidance and industry strategies – to get there. Progress is needed at COP26. Current emissions trends are not aligned with government pledges, and the path of the real economy is far from 1.5°C. This makes it hard to allocate capital at scale with a net-zero mind-set. Governments, industry, regulators and investors must work together to ensure a gradual adaptation and asset repricing, if we are to avoid shocks that could threaten financial stability. In physical climate risks, like flooding and wildfires, alone, there is an estimated USD 227 billion shortfall in insurance cover1. Mexico’s use of public and private capital to insure a coral reef from storm damage is an encouraging response here. For their part, industries must commit to set science-based targets, which should be backed by decisive policy and regulation. This in turn will help investors make informed decisions on which companies to support. The auto industry is a good example. Today, the economics of electric vehicles (EVs) are driving the industry’s transition, but government subsidies and mooted bans on petrol car sales have also proved an important spur. In Norway, they have helped drive EVs to 54% of car sales in 2020.
2. A focus on energy and removing fossil fuel subsidies
Nowhere is the net zero transition need more acute than in the energy sector. Renewables must supply 90% of global energy by 2050, estimates the International Energy Agency2. Yet today fossil fuels supply 84%3. Progress is being made – more than a third of global electricity now comes from renewable sources – but changing the dynamics of transport and heating is harder (see chart). Removing fossil fuel subsidies and providing price incentives for new technologies are urgent priorities at COP26. Recent energy price spikes may drive investments in alternatives, but they also demonstrate how destabilising the shift away from fossil fuels could be. In Europe, plans to extend carbon taxes on petrol and heating have met strong opposition from those worried about widening fuel poverty. The energy shift must shield society’s most vulnerable, since subsidies often support those on the lowest incomes. Here, public-private partnerships can help finance and de-risk long-term investments, including in green infrastructure, clean hydrogen and energy storage. In the UK, carbon contracts for difference helped develop the renewable energy sector. Meanwhile, central bank stress tests should reveal institutions with high fossil fuel exposure and risk concentration, with credit ratings agencies supporting the transparency. Crucially, investors must fund companies in transitioning industries, not just those in sectors that are already low carbon. Encouragingly, company valuations increasingly reflect their climate credentials. Eight years ago, ExxonMobil was the world’s most valuable company. By September 2021, it had fallen to 35th, while renewable energy firm NextEraEnergy already briefly surpassed it in 2020.
3. Better carbon pricing mechanisms
COP26 should advocate a fair carbon price, as a crucial mechanism to advance decarbonisation. Today, the IMF estimates that 80% of global emissions are unpriced. National and regional carbon trading mechanisms provide only patchy coverage. China only began carbon trading for selected industries in July 2021, with a carbon price equivalent to around EUR 6.5 per tonne. Prices must be nearer EUR 100 per tonne to begin to meet the Paris Agreement goals, notes the World Bank, and in most scenarios would continue to rise as remaining emissions fall and become more difficult to mitigate. Europe’s Emissions Trading System, one of the world’s most advanced, still gives away a large number of allowances, notably in aviation. National carbon taxes on imports can help with ‘carbon leakage’, or pushing carbon-intensive activities offshore, but remain unpopular. In June, the IMF proposed an alternative: an international carbon price floor for a select number of large emitters, with variable rates for ‘advanced,’ ‘high’ and ‘low’ income countries4. Higher carbon prices should help incentivise technological innovation, such as the hydrogen economy, and the push towards low-carbon activities. Revenues from carbon trading could be redistributed to help households with energy price increases, and finance climate risk mitigation.
4. Common investment frameworks, to mobilise private capital
Signatories to the UN Principles of Responsible Investment represent a hefty USD 120 trillion in capital. Yet there is no single framework for how to invest sustainably, nor to define sustainable financial products. Regulators are trying to standardise the field, via the EU Taxonomy and SFDR (Sustainable Finance Disclosure Regulation) in Europe, but these have limits. Current investment approaches vary from exclusions, to ESG (environmental, social and government) criteria, and wider sustainability measures. At Lombard Odier, we view ESG metrics as a point of departure for assessing companies’ historical business practices. In addition, we focus on forward-looking measures that look at business models and assess ‘climate value impact’ (CVI), or the physical, transition and liability risks that companies face as the climate transition unfolds. Our guiding principle in allocating capital is climate-related financial exposure, not a focus on low carbon companies. Our Implied Temperature Rise (ITR) metrics assess whether companies’ decarbonisation strategies are sufficient to maintain global carbon budgets within the limits needed to meet the Paris Agreement goals. We thus seek to invest not only in green solution providers, and companies that are more insulated from the transition, but also in companies in high-emitting, climate-relevant industries that are on credible paths to decarbonise. We call these firms ‘ice cubes’: they have positive CVI, and will be instrumental in cooling the economy. We seek to avoid ‘burning logs,’ or high emitting firms with no plans to change: these have negative CVI. This approach builds further on recommendations from the Taskforce on Climate-Related Financial Disclosures5 (TCFD’s) Portfolio Alignment Team that emphasise metrics of portfolio alignment including ITRs. At COP26, we would welcome efforts to adopt these recommendations globally, and to encourage investment firms to work with climate experts to develop and stress-test their models, as we do in-house and via our partnership with Oxford University. Greater standardisation would also help address issues of industry ‘greenwashing.’ With huge inflows into ESG funds, and investors increasingly questioning underlying methodologies, an erosion of trust represents a big risk – not just for the sector, but also for the climate transition. Transparency and common standards, such as those that the TCFD is seeking to provide, are the obvious solution.
5. A focus on nature
Climate change – the focus of COP26 – is just one of nine, science-based planetary functions that define humanity’s ‘safe operating environment6’. We would welcome greater ambition to define clearer road maps, industry targets and investment pathways to address these, including deforestation, biodiversity and ocean acidification. In biodiversity alone, 68% of animal populations have vanished in the past 50 years7, with nature loss increasing the transmission of animal borne diseases like Covid-19 and threatening the new drug discovery pipeline (which is mostly derived from nature). COP26 could be an opportunity to discuss how to impose a fair price on using natural resources, and also to further the development of natural climate solutions. These nature-based solutions, including agriculture and forestry, are the most powerful way of capturing the remaining CO2 we will still emit in a net-zero world. Exploring ways to develop these as investment solutions - e.g by selling carbon credits to those looking to offset emissions and using forest as a carbon sink – are an important priority for policymakers, industry and investors alike.
1 Source: http://cpnet/files/live/sites/sitecp/files/CP UK Market/Marketing/Our Global UK Approach_2021.pdf
2 https://www.iea.org/reports/net-zero-by-2050
3 Source: BP Statistical Review 2020
4 IMF Staff Climate Note: https://www.imf.org/en/Publications/staff-climate-notes/Issues/2021/06/15/Proposal-for-an-International-Carbon-Price-Floor-Among-Large-Emitters-460468
5 TCFD: https://www.tcfdhub.org/resource/measuring-portfolio-alignment-assessing-the-position-of-companies-and-portfolios-on-the-path-to-net-zero/
6 Stockholm Resilience Centre: https://www.stockholmresilience.org/research/planetary-boundaries/the-nine-planetary-boundaries.html
7 WWF and Zoological Society of London, https://www.zsl.org/sites/default/files/LPR 2020 Full report.pdf
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