The climate change conference in Madrid has heard plenty of calls for urgent policy measures. There is a large gap between words and action. Government and financial services representatives at the United Nations Conference of the Parties are broadly united on shaping the framework for a low-carbon transition. Here are five key ways for the investment community to take decisive steps forward in 2020.
First, investors must recognise that moving towards sustainable economic models requires a wider focus beyond climate and carbon. They must consider incorporating broader environmental degradation issues, such as eroding biodiversity and land transition, that stem from the same kind of economic forces that are causing climate change. Concentrating solely on expected returns from such investments misses the point. Investing in biodiversity is not expected to offer steady, long-term returns of the sort generated by, say, an infrastructure asset. But these kinds of investments can hedge the risk of climate erosion on an investor’s portfolio. More financial innovation is needed to establish asset classes that will meet this growing investor demand for risk-hedging.
Second, the transition must be orderly and just. Public opinion appears to want speedy action. But, in getting things done, governments have to guard against taking bold but unpopular steps that exhaust their political capital. Ignoring the political economy of the climate transition is a frequently underappreciated risk. A ‘just’ transition does not merely require compensating workers disadvantaged directly by the switch from fossil fuels. The widespread ‘yellow vests’ protests in France against proposed fuel tax increases shows the political potency of opposition. On a wider plane, less advanced economies and communities must not be denied opportunities for growth and development, including access to energy. New financial instruments such as ‘transition bonds’ that target behaviour (committing the issuer to becoming more sustainable) rather than use of proceeds (such as green bonds linked to environmentally-friendly projects) can help support the shift from ‘brown’ to green.
Third, more sophisticated investment strategies are needed. Investors seriously engaged in sustainable practices are becoming increasingly opposed to divesting entirely from fossil fuels – a demand often voiced by climate activists. According to one participant at a COP gathering for institutional investors convened by the Organisation for Economic Co-operation and Development, ‘Dividends from oil and gas are higher than many other companies. Divesting means giving up dividends to those investors who don’t care as much about sustainability.’ A more appealing strategy is active ownership: using shareholder rights to engage with investee companies and steer them in a more sustainable direction. Such a ‘carrot and stick’ approach can be more effective in the long run. And it still enables investors to use the threat of divestment if the engagement route proves unproductive.
Fourth, asset managers and owners should make judicious use of external managers. Active ownership is a much more resource-intensive strategy compared with divestments. Not all investors are able to pursue it. Hiro Mizuno, chief investment officer at Japan’s Government Pension Investment Fund – the world’s largest pension fund – advised investors without the knowledge or ability to engage on individual projects to use sustainability criteria in their selection of external managers. In a public talk organised by the COP’s Chilean pavilion, Mizuno counselled such investors to prioritise active over passive asset management, and to partner with multilateral development banks to drive engagement on the project and company levels.
Fifth, the financial sector must get the optics right. Much debate among regulators and in public discourse highlights the potential of climate risks to turn into financial risks. Investors must remember that the transition also brings opportunities. From renewable energy and transport infrastructure, to carbon capture and storage and meat-free food solutions, 2020 should be the year of substantial and positive change. Investors are poised to make a big shift, not just in terms of divestments from and engagement with existing companies in their portfolio, but also in bringing once-considered-marginal sustainable asset classes and investments into the mainstream. A strong body of opinion among clients, stakeholders and regulators wants investors to move in that direction. The time is ripe for making it happen.
Danae Kyriakopoulou is Chief Economist and Director of Research at OMFIF.
OMFIF’s Global Public Investor special report on ‘Central banks and climate change’ is available here.