In the second of our series looking at the medium-term structural shifts that global investment assets will be exposed to, we focus on climate and natural resource disruption, and the risks and opportunities these can create for the global economy and investors in the decades ahead.
As we discussed in part one, Special Report: Are China and the US decoupling?, long-term investing can often take for granted the continuity of prevailing global systems, yet there is broad scientific consensus that our climate is changing at a pace that outstrips anything we have previously seen before.
Climate and environmental change risk is a variable that can impact almost every investable asset. However, within this piece we have decided to look at a number of key themes that we believe will prescribe investor thinking going forward.
This report discusses:
- How policy is a driving force for change
- The response from the world’s largest economy and the Biden White House
- The increasing reality of stranded assets
- How environmental, social and governance (ESG) concerns are informing capital allocations
- How bond markets are evolving to capture green opportunities
- What this means for your investments at Nutmeg
Background: climate disruption
A shifting climate on Earth is not new. NASA states that “in the past 650,000 years alone, there have been seven cycles of glacial advance and retreat, with the abrupt end of the last ice age about 11,700 years ago”. But climate change as we refer to it today – the warming of the world’s surface temperature – is significant because of the direct impact made by humans and resultant speed of the warming.
The Intergovernmental Panel on Climate Change (IPCC) reports that “human influence on the climate system is clear, and recent anthropogenic emissions of greenhouse gases are the highest in history”.
One statistic on the impact of human behaviour on our environment is difficult to ignore: air pollution is among the biggest killers of human beings globally, killing an estimated seven million individuals worldwide each year according to the World Health Organisation.
Many policy development frameworks seek to recognise the extent to which our climate and ecosystem is changing due to human behaviour, and if these changes are tolerable and sustainable if human societies want to continue to develop and thrive. One such approach is the Planetary Boundaries Framework, first developed in 2009 by a group of internationally renowned scientists at the Stockholm Resilience Centre, part of the University of Stockholm.
These scientists identified nine processes that regulate the stability and resilience of the Earth’s ecosystems, proposing quantitative boundaries within which humanity can thrive, but beyond which the risks of large scale or irreversible change increase. Rather than focusing on one aspect of system change, the framework seeks a holistic view: seeking to quantify and estimate safe limits of change and behaviour across a range of planetary functions.
Source: Stockholm Resilience Centre
Of the nine planetary boundaries, four were believed to have been crossed by 2015: climate change, loss of biosphere integrity, land use change and altered biogeochemical cycles (phosphorus and nitrogen). Climate change and biosphere integrity are described as ‘core boundaries’, each of which has the potential on its own to drive the ‘Earth System’ into a new state should they be substantially and persistently transgressed.
So, the need for action is clear: human behaviours are materially changing our ecosystem and pressuring its capacity to absorb these changes. At the same time the global population continues to grow and trends such as urbanisation accelerate.
The policy emphasis is now simply too large for investors to ignore
Global policy makers have long warned that financial market participants are yet to fully comprehend the impact of climate risks. Yet it is not just the physical climate risks that investors need to be concerned about. Policy responses to the climate crisis are accelerating globally and expected to further accelerate in the coming decade, raising the prospect of disruption at the macroeconomic, regional and sector level.
The 2016 Paris Agreement was a landmark legally binding international treaty that united close to 200 governments across the globe in the fight against climate change. The foundations for such an agreement were laid over two decades earlier with the adoption of the UN Framework Convention on Climate Change at the 1992 Rio Earth Summit, which came into force in 1994. The main aim of the convention is the “stabilisation of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system.”
The Paris Agreement commits governments to action on climate change, seeking to limit global warming to ‘below 2, preferably below 1.5 degrees Celsius, compared to pre-industrial levels’. It requires countries to detail the actions they will take to reduce their greenhouse gas emissions every five years and provides a framework for countries to work together in sharing financial and technical capabilities. The long-term nature of the climate goals has encouraged policy makers and businesses to move beyond rhetoric and into real action.
In the UK, we can see this in the government’s pledge to be carbon-neutral by 2050, and to slash emissions by 78% by 2035. In the EU, The European Green Deal has set a similar goal, while a more general shift to low-carbon technologies and processes is beginning to gather pace in industries where the policy agenda is rapidly moving. For example, the recognition that policy is rapidly driving us towards a lower-carbon based transport system is one of the reasons for the emergence of electric vehicles as a key growth sector over the previous 18 months.
In a similar vein, government and corporate policy is aligning to reform other sectors such as single use plastics. In November 2019, Malaysia released a roadmap to eliminate single-use plastics from the country by 2030. The action plan includes improving recycling infrastructure, investing in eco-friendly alternatives to plastic with incentives for manufacturers, pollution levies and greater control on waste imports. Mirroring this, Coca Cola have committed to start using PET bottles made only from recycled plastic in Sweden, in a step towards reducing annual virgin plastic use by 3,500 tonnes. This represents the first stage of the company’s plan to use PET bottles made from 50% recycled plastic in Western Europe by 2023.
The accelerating policy emphasis is beginning to advance evolutions elsewhere within the broader economy. This is a positive sign, and one that points towards a reinvention of the global economy to prioritise sustainability activity. At COP 26, to be held in Glasgow in November 2021, Paris signatories will be asked to submit new long-term goals at the conclusion of the first five–year cycle, with ambitions high for accelerating action on tackling climate change and targeting a net zero by the middle of the century. This includes accelerating the phase out of coal, speeding the switch to non-combustion engine technologies, alongside the mobilisation of climate finance.
But it is not simply policymakers that are demanding change. As we have covered in our literature on socially responsible investing (SRI), investors are also demanding more from some of the largest US investment institutions – college endowments, for example, have come under pressure to divest from fossil fuels. Private equity investors who have long ignored the environmental and social elements of environmental, social and governance (ESG) are now dedicating significant resources to this topic.
BlackRock, the world’s largest asset manager, has moved to prioritise sustainability and to step back from investments in carbon intensive industry and energy production. Stakeholder pressure from organisations and individuals is increasing, as underlying investors demand to know how their money is being managed and how this aligns with their values.
How the US can lead a clean energy revolution
Fossil fuels have dominated the energy mix of the world’s largest economy for the past one hundred years, and while American carbon emissions have been falling from their peak in 2000, the world’s largest economy is still heavily dependent on sources of energy that contribute significantly to greenhouse gas emissions. In recent years, the United States has fallen behind its European and, in some cases, emerging market peers when it comes to energy sustainability: it now ranks 32nd in the World Economic Forum energy transition index, behind countries such as Colombia and Chile.
The US has achieved energy independence in the past decade, but the finite nature of fossil fuels raises questions of energy security for the world’s second largest energy consumer. The US has been slower to adopt renewables within its energy mix as a substitute for coal, instead relying on natural gas to replace oil-based products. Put simply, if left unaddressed a lack of progression on energy transition risks becoming an inhibitor to long-term economic performance.
How to change
President Biden made climate considerations a key pillar of his pre-election policy commitments, outlining an ambitious and progressive plan to define a US climate strategy. Core to his approach was the recognition of climate change as an existential threat, and the positioning of climate policy not just as environmental policy, but also as a mechanism for economic stability and growth in the decades ahead. A recognition that without investment and innovation, the US economy risks becoming fundamentally disadvantaged by falling behind global peers in a key area of technological innovation, and one potentially core to its future prosperity.
Having been sworn in as US President, Biden’s administration immediately enacted a number of executive orders aimed at tackling the climate crisis, including returning the US to the Paris Agreement. As part of the ‘Build Back Better’ plan, the Biden administration hopes to reinvent the US energy sector with a view to becoming the world leader in clean energy technology. The challenge is huge, but the plan should not be underestimated: like the UK and the EU, Biden is promising US net-zero emissions by 2050 and to electrify America’s transportation sector, installing a vast network of new car charging points, upgrading the grid and deploying utility-scale battery storage across the US.
At a Leaders Summit on Climate organised by the Biden administration in April 2021, Biden announced that we are in “a decisive decade” for tackling climate change, before pledging to cut US carbon emissions by 50-52% below 2005 levels by 2030; adding that there were moral and economic imperatives to immediately act on climate change. Though such ambitious policies are not always realised, Biden’s Democrats currently control both legislative houses and, as mentioned, the stakeholders for such policy extends far beyond politics.
However, as it looks to re-establish a position of leadership in the global climate fight, the US administration will be forced into making tough decisions regarding the existing US energy infrastructure and its existing growth trajectory. Only 11% of US energy consumption currently comes from renewable sources and the shale revolution that enabled US energy independence in the past decade has brought with it significant investment and high-quality job creation in communities across the United States, as well as tax revenues. Expectations of bold decision making are high: hundreds of climate action groups have called for Biden to repeal the 2015 policy on fossil fuel exports that has set the US on course to become the world’s second largest exporter of natural gas within ten years.
A true clean energy revolution would need to be radical and uncompromising in its approach, and an existing energy infrastructure that is incompatible with climate goals looks set for material dislocation in the coming decades.
‘Stranded assets’ are becoming a reality and not just in the energy sector
‘Stranded assets’ is a term coined by the Carbon Tracker Initiative that is broadly understood to mean the loss of the ability of an asset to generate an economic return prior to the end of its economic life because of a change associated with the transition to a lower carbon economy.
This is most easily visualised through ‘physical stranding’ – where access to, or the viability of, an economic asset is removed through physical change, such as flooding. For example, the future viability of coastal distribution facilities for export heavy industries due to rising sea levels.
But there are also regulatory (where economic life is affected by legislation or policy change) and economic (where relative costs or market prices decrease economic life) drivers. The fossil fuels and connected energy supply chain industries, for example, are particularly vulnerable to regulatory and economic stranding. It is widely acknowledged that given climate policies adopted to date and the global move towards net zero carbon emissions, that current fossil fuel reserves are unlikely to ever be exhausted. In fact, the Financial Times reports that should the Paris Agreement upper boundary of 2°C warming be met, 59% of fossil fuel reserves would be stranded.
Clearly, stranded assets matter because their current worth informs investors’ company and securities valuations. The effect of stranded assets is felt not just by the companies that own the assets but by the financial ecosystem they sit within – from the banks who lend to them, to the suppliers who extend credit and the service providers who rely on their business. They affect all manner of economic variables, from the costs and viability of insurance to the costs of borrowing money. Recognising and assessing the risk of stranded assets and the interconnectedness of these risks across industry business models will be a key cause of concern for investors in the decades ahead.
How the hidden weight of money from ESG capital allocation has an effect
As the transition to a lower carbon economy becomes a major macroeconomic theme in the coming decade, investors need to be aware of the potential for dislocations due to vast reallocations of capital within financial markets. This can lead to both extended valuations in beneficiaries and ‘value traps’ in unloved sectors and stocks.
The weight of money argument for ESG is significant. According to the Global Sustainable Investment Alliance, global sustainable investing assets in the five major markets of Europe, the US, Canada, Japan and Australia/New Zealand, stood at $30.7 trillion at the start of 2018, a 34% increase in two years. In Europe, total assets committed to sustainable and responsible investment strategies grew by 11% from 2016 to 2018 to reach €12.3 trillion – twelve times the total European ETF market at the end of 2018.
The rise of index investing in the ESG arena, and the reliance of global investors on a few data sources for ESG analysis risks a concentration in capital allocation in certain companies and sectors. A grouping we at Nutmeg have termed the ‘Lonely Planet Effect’, referring to the idea that just as a restaurant recommendation in a guidebook leads to a steady stream of tourists arriving for dinner, it could also lead to absence of independent thinking. Likewise, investors risk becoming over reliant on core ESG data sets and ratings, which lead them to the same conclusions, and which could in turn lead to crowding effects.
The effect of these capital allocation trends should not be underestimated. There is evidence to suggest that their impact is already being felt by corporations. A 2018 KPMG study found that over a third (36%) of the C-suite and board members surveyed, indicated that investor pressure had increased the company’s focus on ESG. A 2019 Harvard Business Review article found that ESG was ‘almost universally top of mind’ when interviewing 70 senior executives at 43 global institutional investment firms.
Alongside policy drivers, the potential for a further, dominant shift of capital towards ESG focused strategies is clear: US investors have been slow to adopt ESG investment principles, lagging behind global peers. At the end of 2018, total assets committed by US investors to sustainable and responsible investment strategies were broadly the same size as Europe’s commitment, at circa $12 trillion, despite the significantly larger size of the US capital markets. Compare this to the assets under management (AUM) of Principles for Responsible Investment (PRI) signatories by the end of 2018 (circa $82 trillion) and the gap is stark. In fact, 18 of the world’s largest 25 asset managers are headquartered in the United States, and with an estimated 34% of investment assets being held by the top ten asset managers globally, a shift in strategy from even one or two of these institutions will lead to significant capital reallocation.
Green bonds and the sovereign dilemma
Environmental risk is a growing investor consideration beyond equity ownership. The market for climate aware or ‘green’ fixed income assets (bonds) is growing rapidly as participants recognise the need to factor climate risks into their lending activities.
Green, or ‘climate’, bonds, are debt securities issued to finance (or re-finance) projects and initiatives that explicitly focus on climate objectives. While there are many different types of these bonds, they typically carry the same credit rating as other non-green bonds issued by the same entity, yet the proceeds are earmarked only for use in environmental projects. These types of bonds were pioneered by organisations such as the World Bank and the European Investment Bank, though they are now widely issued by corporate, municipal and, to a lesser extent, sovereign entities. The market for green bonds is now estimated to be worth over $1 trillion. The expectations of significant growth in this sector are largely due to the increased prominence of climate concerns in the public policy of the new US administration and the potential for significant green issuance from the newly established EU recovery fund.
Though entities must monitor and report on how the proceeds are used, there are tangible benefits for issuers. Critically, while these bonds typically share the same credit (for default risk) profile of non-green bonds from the same issuer, demand for green bonds means that investors are often happy to pay a small premium to hold them. The climate bonds initiative notes that demand for green bonds has led to higher levels of oversubscription compared to their non-green equivalents. This is incentivising further issuance to the market because green bonds come with a lower cost of capital and borrowing cost for issuers, while they also lower the cost of environmentally focused initiatives.
However, while the number of green fixed income securities has grown rapidly, the market for green sovereign (government) securities has been slower to evolve. Poland issued the first sovereign green bond in 2016, yet large developed market sovereign issuers have been slow to follow – beaten to issuing their first green securities by nations such as Fiji, Indonesia and Nigeria.
That looks set to rapidly change: Germany issued its first green government bond in September 2020, Italy raised €8.5 billion in March 2021 with its debut green bond issuance and the UK government raised £10bn from its first ‘Green Gilt’ sale in September 2021 – with demand far overwhelming supply.
The multiple governments under pressure to realise their commitments to the Paris Agreement may see Germany’s experience with green sovereign debt as a test case for the benefits of prioritising green expenditure: The Climate Bond Initiative notes that as of the end of 2020, green bonds had maintained a lower yield and exhibited lower volatility than their non-green counterparts.
Despite increasing green issuance, wider ESG considerations remain a challenge for sovereign debt investors. Credit profiles and currency risk differ markedly between sovereign states, while the diversification effects of debt holdings and investor preferences for safe-haven assets such as US treasuries, can often outweigh relative ESG considerations. However, this current balance looks set to evolve over the coming decade as policy initiatives and market dynamics make climate considerations unavoidable.
Conclusion: How do we expect this to influence investment thinking?
Given what has been discussed so far, it is clear that the risks and opportunities arising from climate change not only have the potential to change the risk reward dynamics of individual and wider asset classes, but also to re-shape broader economic systems in the coming decades. Climate risk, therefore, has rapidly moved in recent years from a periphery consideration in investors’ minds, to one that is front and centre in long-term investment frameworks.
Yet financial markets are still only beginning to account for climate variables. Investor frameworks for the assessment of climate risks in portfolios are developing rapidly, shifting from measuring carbon footprints towards measuring transition alignment. Yet known and unknown risks remain: the move toward a low carbon or net zero economy will be neither smooth or predictable, nor is there a simple ‘silver bullet’ solution available today.
Factors such as the speed at which new and more accurate data becomes available to investors, shifts in policy or the adoption of new technology, are not linear but will be long-term in nature. Investors will therefore have to contend with an evolving landscape for climate risks in the coming decade, that is punctuated by periods of rapid structural change.
Measuring, identifying and actioning climate related risks in investment portfolios is no straightforward task, with the scale and complexity of underlying dynamics challenging for even the largest global investors.
Take, for example, a future carbon taxation, as proposed by the International Monetary Fund (IMF) in 2019. This tax would have significant impact on sovereign and corporate economic competitiveness, global supply chains, and consumer behaviour. This could bring about change in global economic systems of a scale and speed never witnessed before. In 2020, Refinitiv noted that a carbon tax at the IMF’s proposed $75 a tonne level would result in additional operating costs of close to $4 trillion – equivalent to 4% of global GDP.
Yet investors today can take positive actions to recognise long-term climate risks.
At Nutmeg, we are committed to recognising the importance of environmental, social and governance (ESG) factors in the delivery of sustainable long-term returns for our clients – we see this as core to our responsibility to act in clients’ best interests. In taking on that responsibility, we look to apply best practice when it comes to the integration of ESG factors within our investment portfolios and the reduction of carbon risks.
Our in-house investment strategy recognises the ongoing transition towards a lower carbon economy and will continue to evolve – as our recent changes to our fixed allocation portfolios show.
We use funds across our investment styles that employ screens for fossil fuel connected sectors and prioritise companies with low carbon emissions, alongside those that lead their peers when it comes to socially responsible practices in their wider operations. Where appropriate, we will also introduce investment strategies that are focused on climate aligned sectors of growth, such as clean energy companies.
This allows us to lower the carbon intensity of our investment portfolios (by an average 9.3% as at February 2021), while retaining global geographic and sector diversification we seek as investors. By doing so, we recognise and tilt portfolios away from the long-term risks associated with the transition to a lower carbon economy.
For those investors who want an explicitly responsible approach, our socially responsible portfolios now have more than three years track record in delivering not just greater alignment with environmental, social and governance norms, but also returns since their inception that have been in excess of the average UK wealth manage.
Since September 2018, we’ve also offered a range of portfolio metrics to help our clients better understand the environmental alignment of their portfolios – no matter how they choose to invest. We use insights from an industry leading data provider to assess how companies within our portfolios are exposed to, and manage, environmental risks; including their exposure to carbon intensive activities and their approach to responsible water practices. You can find these in the portfolio dashboard of your Nutmeg account.
Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.