Net Zero: Getting Back to Basics

Evidence of the direct link between the human burning of fossil fuels and climate change is all around us, yet despite the increasingly unequivocal science there is a long way to go in the fight to limit the impact of rising temperatures and increasingly frequent volatile weather events on our planet.

It has been 27 years since countries and global organizations first met at the United Nations (UN) Climate Change Conference, or COP for short, to collectively discuss how to bring about carbon-emission reductions. In simple terms, in order for the world to stop warming, we need to achieve a balance between the volume of greenhouse gases added to the atmosphere and those taken out, i.e. the volume added should be no more than the volume taken away – this is net zero.

In recent years, there has been plenty of talk, but a relative dearth of meaningful action. Despite 196 countries agreeing at COP21 in Paris in 2015 to limit temperature rises to well below 2 degrees Celsius above pre-industrial levels, and preferably to limit the increase to 1.5 degrees Celsius,¹ global carbon emissions have continued to rise, up 6.4% in 2021 to a new record above the pre-pandemic peak.²

In November 2022 at COP27, there was again much talk but still a relative dearth of concrete detail over how the world would attain the holy grail of net-zero carbon emissions. What is clear though is that if we are to collectively hit the net-zero target, it will require an extraordinary and global effort by governments, companies and individuals, and asset managers will have a crucial role to play.

Real-World Decarbonization

Unsurprisingly, there are different methodologies and approaches for seeking to achieve net-zero carbon emissions among asset managers.

Some have advocated a linear year-on-year reduction in the carbon intensity of portfolios, aiming to reduce annual emissions by, say, 7% per annum over the next decade. One way these targets could be achieved is by disinvesting from certain sectors and companies, and favoring capital-light business models rather than engaging to help difficult sectors or regions with their transition. However, there is a danger that such targets could be artificially attained with relatively little effort and negligible meaningful progress towards net-zero emissions.

For this reason, there is a widespread belief that decarbonization must take place in the real world, rather than through portfolio reallocation decisions. With this approach, there can be a focus on regional and corporate transition plans which result in real-world decarbonization that addresses the climate-change jeopardy faced by all stakeholders. Active managers can establish a focused and effective engagement program to ensure that companies’ plans are credible, not just scientifically robust. Engagements with high-emitting companies can be prioritized, as they will be the ones whose transition to net zero will be most difficult (but of most significance in achieving the net-zero goal).

There are also myriad new investment opportunities aligned with delivering a successful energy transition.

Equity Stewardship

Equity investors have a number of tools at their disposal to hold companies to account on climate-related issues. Shareholders’ opportunity to vote on the re-election of directors is an important tool in their ability to reflect concerns with a company’s oversight or progress on the management of key risks, including climate risk.

Climate considerations at general shareholder meetings can take different forms, including management-proposed resolutions on climate-transition plans (also known as ‘say-on-climate’ votes), shareholder resolutions with a climate-specific focus, and campaigns seeking to hold board members to account for lack of sufficient management of climate risks, or lack of ambitious and robust transition planning.

One-on-one meetings with company representatives can also increase investors’ understanding of the company’s approach to climate risk management and provide opportunities to push for more robust and ambitious actions where necessary.

The Role of Fixed Income

The role fixed-income markets have in funding the journey towards the net-zero transition is crucial, as the majority of funding required is expected to come from debt rather than via equity.

Fixed income already plays a major part in the re-engineering of the financial system and the role it has to play in funding the transition is becoming increasingly important. It is not just about government action; the private sector is key to the mobilization of mainstream capital, and it is reliant on credible frameworks and regulations being put in place.

There are now more ways in which fixed-income investors are better able to direct capital towards improving outcomes. Some are through labelled bonds, where proceeds are directed to specific projects or where a failure to meet certain targets results in the penalty of higher interest costs. But a growing appreciation of ESG (environmental, social and governance) analysis means standard (or vanilla) bonds, which make up by far the largest part of the bond market today, are an important tool too.

Even though they do not get to vote, bondholders can engage, and have the ability to deny capital to issuers. Not only is the initial funding required, but the debt needs to be refinanced over time.

Conclusion

We are facing some very stark realities: fossil-fuel substitution with cleaner counterparts needs to happen more quickly. Energy security and affordability have to be balanced with climate considerations.

Asset managers have a key role to play in helping to ensure capital is directed towards the net-zero transition. However, because climate change is a systemic risk, it is also crucial to understand that asset managers alone cannot solve the issue. Progress is dependent on the right regulation being put in place, the right technology, and asset managers becoming better aligned. Industry bodies and trade associations must be on side too, and advocacy efforts are also key – engagement can sometimes be more impactful when multiple investors collaborate.

While there is a huge amount of jargon used by asset managers, broader business and governments seeking to quantify how to achieve net zero, at a fundamental level climate change represents a series of risks and opportunities for businesses that will need to be managed.

Burying heads in the sand and using the past as an indicator of the future is not only likely to cause serious damage to our planet, but could also result in permanent destruction of capital and missing out on the opportunities as new industries emerge.

¹ What is the Paris Agreement?, United Nations Framework Convention on Climate Change (unfccc.int), accessed December 2022
² Greenhouse Emissions Rise to Record, Erasing Drop During Pandemic, IMF blog, June 30, 2022