Capital markets must avoid the optimism trap
Sustainability is conquering finance — to judge by what the industry likes to talk about. Outside the window, the real economy continues much as before. Is all the noise about green finance actually shifting capital in the right direction — or is it just making people feel better?
The growth in interest in sustainability in the financial world is remarkable. Conferences on the subject occur every week. Emmanuel Macron, Michael Bloomberg and Larry Fink promote the issue. Investors with $82tr of assets under management — as much as the whole world’s listed equities — are signatories to the Principles for Responsible Investment.
With all this money, power and influence calling for sustainability, financial markets should surely be steering the economy rapidly towards a safer path. Fossil fuel use ought to be dwindling, over-fishing being stopped, hunger being brought to an end and housing built to put a roof above every head.
The reality is rather different. In the whole of the 1980s and 1990s combined, there were only two years when more than 6m acres were burned in US wildfires. Since 2000, it has been over 8m acres nine times.
The Intergovernmental Panel on Climate Change’s October report on limiting global warming to 1.5C said this would require cutting net human greenhouse gas emissions to zero by 2050 and a 45% cut in the next 12 years.
Meanwhile, the 119 fossil fuel producers in the S&P Global Oil index are worth $3.2tr. The index is trading at 29 times the Brent crude price — up from 22 times when oil was at its recent peak of $115 in 2014. Investors — including virtually all large pension funds and asset managers — are acting as if there is still a long term business case for oil and gas.
Somehow, the message from TV screens — global warming is here now — is reaching the conference podiums and websites of the financial world, but not its portfolios. Has all the virtuous talk in financial markets actually had any effect?
The obvious answer is a very short one, and a dark one. But people involved in sustainable finance are not in the business of being negative. They are thinking of solutions and working hard to bring them about. They want to point to positive signs of progress. Evidence is difficult to establish, however. Erika Karp, who founded Cornerstone Capital, a New York investment adviser, five years ago says: “My little company has moved over $1bn towards fossil-free, gender lens investing, investing in water, with a consciousness about the oceans, animal welfare.” The money of her investors, wealthy families and foundations, had not been sustainably invested before, she says, before adding: “That said, we need to move trillions. Money is moving too slowly, but I think it is accelerating.”
Renewable investment stalls
In the bond market, many people think about green bonds as the market’s contribution to sustainability.
The Climate Bonds Initiative identifies $1.45tr of outstanding climate-aligned bonds as of June 2018, including $389bn of labelled green bonds. Of the total, $271bn deal with energy — the front line of the fight to slow climate change — of which $90bn are green bonds.
These markets are growing, though more slowly than promoters want. The CBI had forecast a record $250bn-$300bn of green bonds to be issued in 2018; by the end of November, issuance had been $142bn, down from $162bn in 2017.
Green bonds are a visible flag that some investor money is being dedicated to help the environment, but they are a poor guide to how much. For one thing, green bonds only cover a small part of such activity; for another, almost everything they finance was already being financed by the same organisations with other debt. More green bonds does not mean more green projects.
A better guide to levels of green investment, in the energy sector, is the International Energy Agency. It recorded $1.8tr of global energy investment in 2017. The share going to fossil fuels rose slightly, to 59%.
Better news is that of the electricity industry’s $450bn investment in generation, over 65% went to renewables.
“These are still paltry numbers, compared with how much is going into traditional brown energy,” says Mark Lewis, head of research at Carbon Tracker in London. “If we had infinite time, we could already declare the battle won, because the trend is inexorably in favour of the renewable energy of the future. But we don’t have infinite time, therefore sustainable finance needs to be scaled up very quickly.”
However, renewables investment actually declined in 2017, for the second year running. That is partly because the kit has got cheaper, so you get more bang for your buck — but that is not the whole story. The 460 TWh of expected annual generation from the equipment installed in 2017 is 10% down on 2016. It will meet 70% of the expected 3% growth in electricity demand — down from 90% the year before. That means fossil fuel burning capacity is still growing, even in the power sector — let alone transport, steel making and other sectors that have barely begun to be decarbonised.
Close to a breakthrough?
Sustainable finance experts often say investors need more data, in order to allocate capital more wisely, to green the economy. But large companies disclose a great deal of information already, much of it in standardised formats through reporting mechanisms such as CDP. In any case, you do not need a spreadsheet to know what Exxon Mobil does for a living.
Could it be that, although the rise of responsible investing has not refashioned the business world thus far, it has been building up a head of steam which is about to burst forth in a visible transformation of society and the economy?
Big movements are afoot to enlist investors in the planet’s cause, and equip them for the fight.
The Task Force on Climate-Related Financial Disclosures is a systematic attempt to transform corporate governance around climate change, and has won 500 firms as supporters, including banks and investors with $100tr of assets.
The theory is that, if companies disclose, in their main financial reports, how they are planning for climate change, investors can allocate capital to those they think are best placed. Certainly, the exercise will force CEOs to confront the issue.
The TCFD has also planted the idea of scenario analysis firmly in the minds of sustainable finance specialists. This approach — imagining how climate change might play out and modelling how it would affect the business — is a completely new discipline to most and a powerful tool for grappling with risks that are likely to be severe and steadily worsening, have no precedent, and may still lie in the future.
“The TCFD recommendations need to become mandatory,” says Margaret Kuhlow, finance practice leader at the World Wide Fund for Nature in Washington. “There are multiple ways you can get there. We’ve been pushing with a number of other partners to have IOSCO [the international financial regulators’ association] take this up, as a recommendation among their members. There has been good engagement from them — we await action.”
Forces of change gather
Possibly even more encouraging is the growth in firms setting Science-Based Targets. This means committing to reduce emissions, not just arbitrarily, but in line with what scientists say is necessary to ward off catastrophic global warming. Five hundred names totalling $10tr in market cap, including Michelin, Kraft Heinz and AB InBev, have promised to set SBTs.
Pressure — albeit gentle — is coming from regulators, too. Central banks have got engaged on climate change, telling banks they expect them to have a board policy on the issue.
Meanwhile, the European Union is pushing through legislation to green the financial system. It mostly requires investors to disclose what they are doing to incorporate environmental, social and governance (ESG) issues, rather than compelling them to decarbonise. But the obligation to ask customers about their sustainability preferences could unleash people power. Surveys suggest a high proportion of savers want their money to be invested in line with their values.
“The required disclosure that the EU is implementing creates demand,” says Lauren Compere, director of shareholder engagement at Boston Common Asset Management in Boston. “But there needs to be a bit more scrutiny.” There should be an “externally verified process”, she argued, to distinguish between investors practising “sustainability-lite”, such as screening out a few names, and firms that could “demonstrate real impact”.
The green profit motive
Of course, climate change is not just about risk and self-flagellation. There is also a pull of opportunity.
“There are investors who like what the Sustainable Development Goals mean, but also see this as a roadmap for the growth industries of the next decade,” says Kuhlow.
Some argue the economy is now cleaning itself, not thanks to policy or anyone’s moral effort, but under the influence of purely economic and technological forces.
Pushers of this view point to steep falls in the cost of technologies like solar energy. The average price at which contracts to build utility-scale solar plants were awarded, for example, fell from $120/MWh in 2013 to $55 in 2017, according to the International Energy Agency, while onshore wind has cheapened from $60 to $50. In the most favourable locations, the prices are far lower.
“The cost reduction potential is still extremely significant,” says Lewis at Carbon Tracker. “In Germany at €70/MWh that could easily come down another 50% in the next 10 years.”
The New Climate Economy report published in September by the Global Commission on the Economy and Climate lays out the positive case for climate action: it is “the only growth story of the 21st century”, which has already yielded “real results in terms of new jobs, economic savings, competitiveness and market opportunities”.
An expected $90tr will be invested in infrastructure by 2030 — that must be done sustainably, or the world will pass the point at which climate change can no longer be limited even to 2C. If this is done, the report predicted an economic gain of $26tr and 65m extra jobs. “The laggards are not only missing out on these opportunities but are also putting us all at greater risk,” the authors argued.
Obstacles in the way
There is a paradox in such exhortations. Markets are pretty good at seizing economic opportunities. If the money to be made was as attractive as all that, capital investment would be flowing that way without urging. Witness the huge sums that have poured in to create new industries — digital communications, shale oil and gas, blockchain.
Jan Corfee-Morlot, a senior adviser to the New Climate Economy project, restates the question succinctly: “If there’s a $20 bill lying on the ground, why isn’t someone picking it up?” Her answer is that our economy is hard-wired to be a high carbon one. “But what we are pointing to in the report is the undeniable evidence that there is another way to do things that is as beneficial or more.”
There are powerful vested interests resisting change. The OECD estimates subsidies for fossil fuels at $370bn-$620bn a year. The violent protests in France when President Macron tried to raise petrol and diesel taxes show what a tough issue this can be politically.
Within the financial world, there are obstacles to overcome, too. “The worry is that by investing sustainably, do you have to have concessionary returns, do you shrink your opportunity set?” says Karp. “The answer is no, if you know how to do it. You can absolutely have a fossil-free portfolio that performs in line with or better than the market.”
Indeed, if climate change is real, grasping the risks and opportunities it presents is likely to be the only wise investment strategy.
An unusually clear-eyed investor is Jay Koh, co-founder of the Lightsmith Group in New York. This private equity firm treats climate change as a reality that is happening, and is seeking to invest in companies that will profit as it worsens.
Lightsmith has identified nearly 600 companies, mainly private, which provide solutions that will be increasingly needed, such as technology for analysing and managing risks. “If you own coastal real estate, a timber stand, municipal bonds, an airport, and you don’t understand how they will be affected by substantial changes in the environment, you are naked long the risk,” says Koh.
This provides a way to invest in adaptation to climate change, which so far is estimated to receive only about 5% or 6% of climate finance.
It takes three to tango
The investment world is going through momentous change, as the unsustainability of the modern way of life becomes harder to ignore. It has produced a cultural shift, with a return to favour of the idea that morality has a place in investment choice. The PRI does not push “ethics” but is now quietly guiding investors to consider the effects of their investments on the outside world, which comes to the same thing.
But the structure of the industry is such that, at least in the next five crucial years, that is not going to change asset allocation fast enough. Nor is the pure profit motive. Green technology may offer enticing gains, but there is still plenty of money to be made in dirty industries.
Markets desperately need a third impetus to push things along — regulation. “This is what is happening with weak policy,” says Corfee-Morlot. “If you have strong policy you could see an acceleration of change. Markets are hard. They are guided by and structured by public policy but have a life of their own.”
The frequency with which finance specialists mention the Paris Agreement and Sustainable Development Goals proves how finance needs government to set the direction, establish targets and create incentives that favour the right kind of innovation. Renewable power may now be growing under its own steam in some countries, but it needed a big push from policy to get it going, including subsidies and obligations.
To turn the wheel, government, the private sector, finance and civil society all need to be pushing.
Time to crack on
The policy response to poverty, environmental degradation and climate change has been so inadequate that the finance world is trying to do something on its own, while waiting for the public sector to give it a lead. This is called sustainable finance. But to make a difference, it will have to go harder and faster. That may mean being less content with its achievements, and talking more about the urgency of the perils.
Stripping away the jargon, responsible investing means three things: using one’s clout as an investor to get invested organisations to improve; reducing holdings in or completely divesting from bad performers; and seeking out winners that can provide solutions.
Each of these, if pursued vigorously, can be very effective in sending signals to markets, as well as profitable. And they are not separate strategies, but different facets of the same attitude. Many investors scoff at divestment, but they may be underestimating how much companies fear this.
It was only in 2010 that Dr Bronwyn King, an Australian oncologist, realised with horror that her pension fund was investing in tobacco companies. Two years later, she had convinced First State Super to go tobacco-free. Now, the global Tobacco-Free Portfolios movement has $5tr of assets backing it, including BNP Paribas and ING. The group pulls no punches: “Investment in tobacco companies implies endorsement of the product itself and of the industry as a whole.”
The MSCI World Tobacco Index, which had massively outperformed the wider market for 13 years, has underperformed for the last two years. Could this be related? It has certainly been good for the returns of the investor boycotters.
Climate change and many other environmental and social abuses are much worse threats to human health than tobacco. All three responsible investing tactics can be deployed together, and there is no need to wait for better data.
Kuhlow points to the IPCC’s 1.5C report and the WWF’s biennial Living Planet Report, which showed a 60% decline in vertebrate populations since 1970 and over 80% in freshwater species, a crucial food source for millions.
“What happens to your business when there are as many as 300m climate refugees? Or are there business opportunities in supporting them?” says Kuhlow. “If you’re not paying attention to these two reports, you’re just not being a good steward of your business any more, whether you are a corporate or a financial institution.”