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Climate change is an unstoppable force for change in society. It’s also an unstoppable force for change in investment – and one we believe every investor should pay attention to.

Bottom line: At Nutmeg, we believe environmental, social and governance (ESG) factors cannot be ignored in investment portfolios.

Issues such as climate change will continue to change the way society and our economies operate in the years to come, while there is widespread evidence that incorporating ESG criteria in investment decision making can improve investor outcomes.

The subject is not one we can comprehensively cover in one blog post, but in the spirit of brevity we’ve reduced our rationale for a lower carbon focus to five points.

The low carbon transition has already started

Our mix of energy consumption as a society is changing – radically so. Coal use may have peaked more than five years ago. Analysts expect demand will fall post 2025 and be almost entirely phased out of electricity production by 2040.

In oil demand, pockets of isolated growth will remain in aviation and shipping, as well as for petrochemicals, but demand as a whole is expected to peak by 2022 and plateau until around 2030. Experts expect it will rapidly decline after that, particularly as electric vehicles grow in popularity and we approach a tipping point on alternative fuel sources and energy efficiency.

It’s not surprising, then, that at the same time renewables generation is set to accelerate, International Energy Agency data shows that global energy-related carbon dioxide emissions stopped growing in 2019.

Clearly, the clean energy transition is well underway.

Carbon pricing is an inevitable game changer

Currently, almost all carbon costs are ‘externalised’. By that we mean the costs of dealing with carbon production are not directly borne by those who create it.

Airlines, for example, create emissions by flying yet the effects – and costs – of those emissions are externalised to wider society. This is despite studies to say that pollution is a leading cause of death globally – more lethal even than smoking, malaria and general violence. Carbon pricing mechanisms seek to internalise the societal cost of carbon emissions.

In 2019, the IMF issued a report on the case for introducing a carbon tax, believing this could effectively disincentivise the use of fossil fuels while accelerating the shift to alternative energy sources. The proposed global average carbon tax was 5a ton, which, according to data provider Refinitiv, would be worth .9 trillion, or 4% of global GDP, if it were applied across all emissions in all industries.

In addition, the US Climate Leadership Council has relaunched its “carbon dividend” initiative with support from the likes of JPMorgan, Goldman Sachs & BP. The plan proposes an economy-wide fee on carbon dioxide emissions starting at 0 a ton and increasing every year at 5% above inflation. It also incorporates a border carbon adjustment mechanism to curb imports from ‘dirty’ companies in foreign markets.

Whichever mechanisms are enacted, the medium-term direction of travel is clear: high carbon output industries such as airlines, construction, utilities, metals and mining look set to internalise, at least in part, their carbon costs, altering the competitive landscape.

Stranded assets are only set to increase

‘Stranded assets’ are assets that, for whatever reason, lose their value due to some kind of external change. This could be, among other things, an adjustment to policy or legislation, a loss of physical access, or a change in societal habits.

Fossil fuels offer a common example. Given the accepted global goal to limit climate change, utilising all current fossil fuels reserves is unlikely – never mind undesirable. If the Paris agreement succeeds in stopping temperatures rising by more than two degrees, an estimated one-third of oil reserves, half of gas reserves and more than 80%of known coal reserves must remain unburned. Energy producers, therefore, can expect a significant reduction in capital value.

Other industries may be affected by stranded assets too. For example, low lying coastal distribution facilities may become stranded as sea levels rise. This is becoming a concern for investors, particularly those, such as banks, with secured claims to underlying assets.

Global policy will favour those aligned to ESG outcomes

Government, industry and corporate policy is shifting to support the climate transition. Every nation on earth has signed the Paris Climate Agreement, and with countries now putting in place meaningful policies to reach their targets, the impact on industry is only likely to grow from here.

Financial stability risks brought about by climate change are also being recognised by policy makers globally. The IMF stated in its October 2019 financial stability report that the “potential impact of climate risks is large, nonlinear, and hard to estimate”. The Bank of England announced plans in December to introduce mandatory stress tests for climate-related risks for banks and insurers.

In response, major financial services companies are reassessing their activities and prioritising those aligned with a lower carbon society. In early 2020, BlackRock announced the divestment of all thermal coal holdings in active portfolios, while late last year Goldman Sachs ruled out financing new thermal coal and coal powered power station projects.

The pace of policy change globally means we expect businesses across economic sectors to be impacted as policy nudges corporates towards ESG alignment and the risks for laggards grow.

The carbon transition will affect global investors’ capital allocations

The transition to a lower carbon economy will be a major and recurring economic theme over the next decade, a point many investors are already aware of. According to the Global Sustainable Investment Alliance, global sustainable investing assets in the five major markets stood at 0.7 trillion at the start of 2018, a 34% increase in two years.

Still, there is room for growth, many of the world’s largest investment firms are only now beginning to recognise the risk. The slow response among US investors to date means we’ll likely see amore pronounced and concerted shift towards ESG focused strategies. Meanwhile, stakeholders are demanding more from some of the largest US investment institutions. College endowments, for example, have come under pressure to divest from fossil fuels. In February, Harvard faculty voted overwhelmingly in favour of divesting the university’s endowment from fossil fuels.

What does this mean for Nutmeg portfolios?

At Nutmeg, we have committed to recognise ESG criteria within our investment process. Our socially responsible portfolios exclude controversial activities, such as thermal coal or weapons manufacturing, while over-weighting towards companies with strong sustainability profiles. This means our socially responsible portfolios have a lower carbon intensity than our non-SRI portfolios – 28% less on average.

But socially responsible strategies are not just exclusive to our socially responsible portfolio range. You’ll also find socially responsible funds within our wider, fully managed strategies, reflecting our investment team’s preference for an overall lower carbon intensity, and a bias towards those securities with preferential ESG profiles.

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 arenot reliable indicatorsof future performance. Tax treatments apply.


[1] Nutmeg data accurate as of 12 May 2020