Between 30 November and 11 December 2015, 45,000 delegates, including heads of state, from over 100 countries, met in Paris for the Conference of the Parties (COP) to the UN Framework Convention on Climate Change.
The Paris agreement is an historic deal that will lead to significant cuts in greenhouse gas emissions across the global economy through a universal system of governance for climate change. While individual country commitments have still fallen short of the stated temperature target, they are sufficient to accelerate the shift to a low carbon economy which technology is driving forward regardless.
What did countries agree to?
The highlights of the agreement include:
- A change in target from 2oC to ‘well below’ 2oC with an aim of 1.5oC which was arguably the most significant outcome. While it may seem academic, the importance of acknowledging that 2oC was not a ‘safe’ target further emphasises the urgency for action
- A five-year review mechanism with a clear expectation of more ambitious targets. This ratcheting approach should factor into investment analysis as it increases the likelihood of accelerating change
- A commitment from developed nations to grow their financial assistance for developing nations to manage climate change to more than US$100 billion a year from 2020. Much of this finance will have an explicit goal of attracting additional private investment.
Other noteworthy outcomes from the COP were outside the negotiating rooms with hundreds of companies, sub-national governments and investors making significant commitments. For the first time, the scale of private sector support reflected what is needed to achieve more ambitious climate action.
Implications for investors
The fact that greenhouse gas emissions have continued to grow despite clear evidence of the damage caused is a classic market failure. The Paris agreement establishes a predictable framework for correcting this. Indeed, at no time over the last 21 years of climate negotiations have investors had greater confidence in the necessary changes ‘really’ happening this time.
While this will be positive for low carbon investments as it signals a reduction in regulatory and market risk, the largest investment implications sit with the primary part of most investors’ portfolios – bonds and listed equities.
As the market failure is corrected, the playing field will be tilted from high to low carbon, which will impact all sectors in different ways. The nature of correcting market failures means passive portfolios are particularly vulnerable as changes in index constituents may lag.
Government regulation and international agreements are not the only factors driving this transition, and technology remains critical. Battery and solar price declines are expected to continue, further disrupting energy markets. However, the cheapest form of carbon abatement is the energy not used, making energy efficient will be an important company differentiator.
The combination of international political momentum, private sector support and technological change stand to disrupt many industry sectors faster than expected. The risk of ‘stranded assets’ has been flagged by everyone from the Governor of the Bank of England to leading sell-side analysts.
Expectations of investors will continue to grow
Scrutiny of investors from asset owners, retail investors and the public has increased over the last few years and this scrutiny will grow post-Paris. The industry itself is lifting standards, with investors representing $10 trillion in assets committing to portfolio carbon disclosure through the Montreal Pledge.
While these commitments are positive, investors need to understand the limitations of these tools. For example, carbon footprinting does not identify stranded asset risk or risks to industries like auto-manufacturing where the greatest threats are upstream or downstream. A suite of quantitative and qualitative indicators will be required to properly understand the opportunities.
What can investors do?
Leading investors are already taking actions which are low cost and process-orientated. Establishing a holistic framework which captures investment process improvements, member engagement, industry collaboration and policy advocacy will aid in the identification and prioritisation of actions for individual investors.
- Integrating and documenting carbon risk and climate change adaptation into investment processes and governance using tools like carbon footprinting and the assessment of stranded asset risks
- Formalising individual and collaborative engagement programmes with investee companies to benchmark the management of climate change and other key Environmental, Social and Governance (ESG) factors
- Collaborating with other investors to improve industry knowledge and skills and to influence the policy response by government
- Engaging with end investors to reassure them that their assets are well-positioned for the great shifts climate change will mean for the economy and society.
Research we have undertaken shows that investors are concerned about these issues. If funds are not providing sufficient information in an understandable form, investors may move to funds that do.
Final thoughts on Paris
The full effects of the Paris agreement will take time to ripple through the economy. Investors are already seeing the related structural changes that are unfolding due to existing policies and technological development.
However, preventing dangerous levels of global warming remains an unprecedented challenge. While individual country commitments fall short of what is required, the improvements in global governance of climate change achieved in Paris should provide investors with greater confidence that future action will more closely resemble what is necessary.
Arguably, the biggest challenges for investors will be blocking out short-term noise and instead focusing on applying the strategies needed to achieve long-term investment objectives in what are sure to be extraordinary times ahead.
Pablo Berrutti is Head of Responsible Investment, Asia Pacific at Colonial First State Global Asset Management.