ESG Investing: The Climate Change Challenge

In the last 10 years, the world has experienced unprecedented natural disasters like floods, draughts, heat waves, wildfires, melting polar ice caps of the Artic and Antarctic and subsequent rising ocean levels. The threat of climate change has affected global weather patterns and brought significant economic loss to many.

The Paris Agreement

Climate change is a global emergency that goes beyond national borders and consequently requires international cooperation and coordinated solutions at all levels. To tackle climate change and its negative impacts, world leaders, at the COP21 UN Climate Change Conference (2015) in Paris, agreed to commit all countries to reduce their greenhouse gas (GHG) emissions and work together to adapt to the impacts of climate change, and calls on countries to strengthen their commitments over time. The Paris Agreement provides a pathway for developed nations to assist developing nations in their climate mitigation and adaptation efforts while creating a framework for the transparent monitoring and reporting of countries' climate goals. The Agreement also marks the beginning of a shift towards a net-zero emissions world, whereby, the world leaders have agreed to keep global warming to no more than 1.5°Celcius above pre-industrial levels. In the COP26 Glasgow Climate Pact

Conference (2021), global leaders reaffirmed their commitments towards reduction of harmful GHG emissions by 45% by 2030, and to reach net-zero by 2050 (UN Climate Action, 2022).

Transition to a Net-Zero World

Transitioning to a net-zero world is one of the greatest challenges we have ever faced. It calls for nothing less than a complete transformation of how we produce, consume, and move about. The energy sector is the source of around three-quarters of GHG emissions today and holds the key to averting the worst effects of climate change. Replacing polluting coal, gas and oil-fired power with energy from renewable sources, such as wind or solar, would dramatically reduce GHG emissions. Many coal mines are being closed as the price of coal becomes increasingly more expensive compared with renewable energy sources. Replacing the costliest 500 gigawatts of coal capacity with solar and wind would cut annual costs by up to US$23 billion per year and yield a stimulus worth US$940 billion, or around 1% of global GDP (UN Climate Action, 2022).

ESG Investing: Financing Climate Action

Financial resources and sound investments are needed to address climate change, to both reduce emissions, promote adaptation to the impacts that are already occurring, and to build resilience. The benefits that flow from these investments, however, dramatically outweigh any upfront costs. Studies and reports conducted before the COVID-19 Pandemic showed that investments in climate action would go far to build a sustainable economy. According to data from the World Bank (2019), the world will need to make significant investment in infrastructure over the next 15 years - around US$90 trillion by 2030. Moreover, the size of required investments is expected to increase as the world transitions towards a low carbon economy. A McKinsey & Co study estimated that a total investment of US$275 trillion in physical assets are needed to achieve net-zero by 2050 (2022). However, these investments can be recouped. Transitioning to a green economy can unlock.

new economic opportunities and create new jobs. Sectors expected to benefit from ESG investments include those related to renewable energy, clean tech, green real estate, sustainable forestry, agriculture, education and healthcare.

What type of climate-related risks need to be considered?

Investors approaching climate risk for the first time typically run an “investment carbon footprint” analysis that compares a portfolio's carbon intensity against a benchmark. It serves as a portfolio heat map in any asset class, with the aim of understanding the climate-relevant sectors and companies. An investment footprint is only a start and should be complemented by a bottom-up risk analysis that covers more specific information, for instance, evaluating indirect GHG (Scope 3) emissions and avoided emissions, fossil reserves analysis, utility generation mix, forward-looking indicators on companies' climate strategy and 2oCelsius scenario compliance checks (CFA Institute, 2017).

Investors face different dimensions and levels of climate change risk, namely, asset level risk and direct investor risk. The asset level risks to be considered include:

• Climate change effects on the global economy and physical risk for individual assets, for example, extreme weather events impacting a company's production facility. The insurance industry is dealing with such risks in the context of insuring disasters.
• Carbon pricing risk for underlying assets, such as, installations that become subject to carbon pricing, either national/ international taxes or cap & trade systems. The European Union Emissions Trading Scheme (EU ETS), for instance, is the largest cap & trade system, covering over 11,000 factories in 31 countries. The profits and losses (and therefore stock and bond prices) of companies will be impacted by such systems once carbon prices increase. Therefore, it becomes a concern for investors.
• Regulatory risk for assets of certain sectors or operating in specific geographies could hit investment valuations. For example, air pollution in China frequently leads to factory closures or city-wide bans on large vehicles.
• Litigation against high-carbon emitters and investors: Natural catastrophes linked to climate change pose a threat to companies with the largest climate impact, as they could be made liable for such damage.

When evaluating climate related investments, investors also need to take into consideration the direct investor risks, such as:

• Stranded assets and carbon bubble risk: Portfolio holdings can be potentially overvalued due to stranded assets. The world is transitioning to a low carbon economy. Consequently, companies that either own or are dependent on fossil fuel reserves, like coal and oil, will be impacted as these reserves can no longer be burned and might lose some or all of their economic value. 
• Investment risk: Research has shown that climate-harming companies have a tendency to financial underperformance. In 2015, 14 major funds with US$1 trillion under management were found to have missed US$22 billion in returns by investing in companies that harm the climate (CFA Institute, 2017).
• Regulatory risk for investors posed by financial market regulation related to climate change: Regulators can demand climate-compliant investments or close in on profits generated through climate-harming investments. Since 2016, France is asking its investors to explain whether their strategies are in line with French climate targets. California is demanding similar transparency from 1,200 insurance companies. Other jurisdiction regulators are expected to follow suit.
• Technology risk/innovation disruption: Focus on climate change promotes interest and investment in alternative and less carbon-intense technologies. These can disrupt the business models of climate-harming industries that miss the respective innovative developments in technology.
• Reputational risk for investors associated with financing climate-related projects: Eco-activists have been vocal in the media on “divestment” campaigns, calling out investors that have particularly climate-harming assets in their portfolio.
   

What's next for ESG Investing?

The growing demand from stakeholders to incorporate ESG criteria into investment decision-making process as well as a company's strategy, culture and operations has brought sustainability to the forefront of mainstream business management. Integration of ESG issues ensures a company remains competitive and relevant in a low carbon economy. ESG is a powerful tool to identify potential opportunities and risks. This is important as it will channel capital allocations and resources to more sustainable projects that has the most impact to society. Furthermore, climate action requires the joint efforts of governments and the private sector to finance projects and programs to combat or mitigate the threat of climate change. Therefore, ESG investing plays a crucial role in driving the financial markets evolution for a better tomorrow.

 

References

McKinsey & Co, “The net-zero transitions: What it would cost, what it could bring”, 2022

CFA Institute, Handbook on Sustainable Investments, 2017

UN Climate Action, 2022