Asset management’s pivotal role in transition to low carbon economy
As the COP26 UN climate change conference draws closer, the crucial role of asset management firms in tackling the climate emergency appears indisputable. Yet the challenges they face and the support they require from governments and regulatory authorities are also clearly emerging.
The climate crisis is one of the greatest systemic risks the world is facing and is “unequivocally” due to human activities, according to the UN, with the burning of fossil fuels being the largest source of greenhouse gas emissions.
The recent report by the UN Intergovernmental Panel on Climate Change (IPCC) was a “code red for humanity”, according to UN secretary-general Antonio Guterres. It highlighted that even under the most optimistic pathway, which assumes achieving net zero carbon emissions around 2050 before turning negative – as humanity starts capturing huge amounts of carbon dioxide out of the air, using technology that has yet to be proved at large scale – the world will hit 1.5°C warming above pre-industrial levels in the next 20 years. This would then decline to an approximately 1.4°C temperature rise by the end of the century.
While this amount of warming would increase the frequency and severity of extreme weather such as heatwaves, flooding and droughts, and result in a sea level rise of up to two feet, more severe climate impacts would be avoided. At the same time, the world is expected to be both richer and more equal by the end of the 21st century, and societies will have an easier time adapting to the changed climate than they might have with less global co-operation and resource sharing.
Yet, under nations’ current actions plans, based on all the existing 2030 climate pledges that have been formally submitted by the 191 parties to the Paris accord, our planet is expected to warm by 2.7°C by the end of the century, which is well above the 2°C and preferably the 1.5°C long term goal of the Paris Agreement. This represents the middle of the five possible climate scenarios outlined by the IPCC report and is the future the world is on track for, if humanity fails to adopt more aggressive emissions reductions measures.
COP26, which represents the 26th meeting of the Conference of Parties, to be held in November in Glasgow, Scotland, provides a key opportunity to take stock of progress, but also bolster commitments alongside a clear plan of action for how targets will be met in the short, medium and long terms.
Critical role
While substantial change is needed across economies, governments and societies, the private sector, led by the asset management industry, has a big part to play in financing the transition to a low carbon economy. Asset managers can direct capital towards low carbon products, services and technologies to accelerate the transition to net zero. They can design innovative financial products, while also encouraging clients to invest in a climate friendly way. Importantly, as shareholders, they can use corporate engagement to encourage companies or investees to adopt ambitious climate strategies.
“As long-term investors, we play a pivotal role, not only in decarbonising investment products on behalf of our clients, but also in shaping the real economy transition by engaging with and holding businesses accountable on their net zero transition plans,” says Michelle Scrimgeour, chief executive officer, Legal & General Investment Management.
Through its Climate Impact Pledge engagement programme, the UK’s largest asset management firm “systematically” holds companies in 15 climate-critical sectors accountable, through votes and potential divestment, if they are falling behind in their climate ambitions and disclosures. This has allowed the firm to “affect real change and help steer companies towards better practices, including reducing carbon emissions,” states Ms Scrimgeour, who is also co-chair of the UK Government’s COP26 business leaders group.
This year’s Net Zero 2050 Roadmap of the International Energy Agency calls for investments in clean energy to triple by 2030, and the support of asset managers is “essential” if this goal is to be achieved, says Florent Deixonne, head of sustainable and responsible investments at Lyxor Asset Management.
Today, almost half of all global assets under management, $43tn of the $100tn total, are geared towards the net zero emission goal to be reached by 2050 or sooner, via the Net New Zero Asset Managers initiative. Launched in December 2020 by an international group of asset managers, the initiative now numbers 128 signatories.
But asset managers have to tackle various challenges to meet this goal. In particular, any engagement to net zero should come with “a transparent, consistent, and detailed climate action plan, including intermediary decarbonisation targets,” explains Mr Deixonne. This requires “operational capacities to monitor engagements and follow up the execution of a strategy,” as well as a “strong knowledge of climate challenges within internal teams to lead the climate transition and manage activities accordingly”.
To reduce carbon emissions, significant transformation is needed across the energy, food, transportation and infrastructure systems, explains Maia Becker, director, corporate governance and responsible investment at RBC Global Asset Management. This will require investment in both ‘green’ opportunities, such as renewable electricity, energy efficiency, green buildings, as well as ‘transition’ opportunities. The latter include energy companies in the process of decarbonising, producers of critical minerals for batteries and solar panels, low-carbon technologies for hard to abate sectors like steel and cement.
Companies changing from ‘brown’ to ‘green’ are “the most important lever in the fight against climate change,” believes Henrik Pontzen, head of ESG at Frankfurt-based Union Investment. Ignoring ‘brown’ companies and not guiding them on their way to becoming ‘green’ will hamper climate transition, he warns.
But asset owners and asset managers should stop “hiding in investments with a low carbon footprint,” warns Mathias Fawer, ESG analyst at Swiss firm Vontobel.
“This is rather short-sighted and is based on static metrics and often narrow assumptions. A low carbon footprint does not reflect the company’s ability to contribute to the climate transition,” he explains.
For instance, tech companies like the American FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks or the Chinese equivalent BATX (Baidu, Alibaba, Tencent and Xiaomi) have a low carbon footprint relative to their revenues or market capitalisation, but their businesses do little to reduce society’s climate footprint.
The emphasis must be on companies that enable the transition towards a net zero economy, by generating for instance cleaner energy through their products and services, or reduce energy needs of buildings and improve efficiency in industry processes. “The focus on solution providers is far more important and requires a holistic impact assessment,” explains Mr Fawer.
Joining forces
But asset managers do not have the ability to achieve the ecological transition by themselves. All stakeholders in the global economy must join forces, enhance their ambitions and adopt new policies, regulations and incentives.
“No single party can stop climate change, so collective action is required. Multi-stakeholder efforts need to be scaled up and co-ordinated to reinforce efforts,” says My-Linh Ngo, head of ESG investment and portfolio manager at active fixed income specialist BlueBay Asset Management.
The COP26 climate talks, delayed by one year due to the pandemic, are the “best chance for governments to inspire and enable global collaboration efforts with ambitious binding commitments,” she says.
“Asset managers play an important role in helping facilitate the transition to net zero, but we cannot act alone,” says Ashley Hamilton Claxton, head of responsible investment at Royal London Asset Management. “We need clear and consistent regulation from governments to set out a road map for financing the transition.”
Governments need to put forward policy frameworks and mechanisms that support investments in low-carbon activities, says Natacha Guerdat, investment manager and managing director at Asteria Investment Managers, the impact investing affiliate of Reyl Group.
Firstly, this is through committing to a determined action plan through their Nationally Determined Contributions. Secondly, it is key for governments to support a carbon market mechanism which allows for accurate carbon pricing. A global carbon price ensures carbon emissions can be properly accounted for by companies and investors.
Collaboration and joined up regulation at a global level is also paramount. “Climate change is a global problem, which can only be addressed on a global or at least regional scale. Additional regulation in individual countries can be counterproductive because it can cause confusion and competitive disadvantages for companies and asset managers,” says Union Investment’s Mr Pontzen. “We expect planning reliability and stringent regulatory frameworks from governments and policy-makers.”
Policy-makers also need to provide clear frameworks around corporate disclosures, says Emily Steinbarth, senior quantitative research analyst at Russell Investments.
“Existing frameworks should be leveraged to avoid the continued proliferation of misaligned frameworks as this is driving reporting fatigue and inconsistencies in reported data,” she says. The first step to driving this transition via capital markets is through more reliable and comparable data sets, while regulations should be logically sequenced. “Policies that are not sequenced appropriately, and that require investors to report on data that is not available, undercut data reliability and usability.”
Reliable data is vital as asset managers are increasingly engaging with companies to set ‘science-based’ climate related targets, and improve disclosures related to the management of climate-related risks.
“As climate-related financial data is further incorporated into asset prices, climate risks will more meaningfully affect valuations,” adds Ms Steinbarth.
Just transition
It is also important to ensure policies support a ‘just transition’, and develop a climate-neutral economy, ensuring no one is left behind. Ultimately, climate change is a socio-economic problem as much as it is an environmental one.
Challenges remain in driving a just transition quickly enough to avoid the impacts of climate change, points out Ms Steinbarth. The question is how to make alternative fuels cost attractive without disproportionately passing costs of carbon onto those segments of the population least able to afford it.
Governments have a responsibility to establish “a minimum safety net” and build social resilience or adaptiveness to stop people being stranded by the low carbon transition, adds BlueBay’s Ms Ngo. They also need to ensure the resulting prosperity is shared.
Governments need to scale up their carbon ambitions quickly to avoid a disruptive and disorderly transition, “as this is in no one’s interest, least of all the investment community, as it leaves us exposed to significant risks,” warns Ms Ngo. “The finance community needs certainty on the direction of policy so we can plan and invest accordingly.”
Governments also need to work with the investment community to develop innovative climate finance solutions, as public finance alone cannot fund the needed transition, she adds. In particular, funding needs to be directed to emerging markets which are the most vulnerable, to help them mitigate impacts and build resilience.
The Covid-19 crisis has affected many economies and has slowed the development of ecological solutions and investments in energy transition. But ironically, it has also shown how policies can be enacted overnight when faced with an existential threat. “The development of a Covid vaccine in such a short period of time is illustrative of what can be achieved when different parties partner and collaborate to develop solutions,’ adds Ms Ngo. “That same focus and mindset needs to be applied to the climate challenge.”
