Continuous education is an important part of any professional investor’s career, particularly as times change so rapidly. Climate change has become the biggest issue facing investors, but what it means for portfolios and the transition to a lower-carbon world is less clear.
What challenges (and opportunities) will it bring? And why should we act now? Not knowing the answers to these important questions has put some financial professionals at a disadvantage in being able to explain it to others like clients and colleagues.
This module bridges that gap. Those participating in this course are invited to digest the information and then take the test at the end. To enhance the learning experience, the module is delivered using clear language, charts, a video and case studies. Each of the eight chapters takes up to 15 minutes to read.
A score of at least 12 out of 15 correct answers (80%) for the test will count as two hours towards your professional CPD requirements. The educational module is already accredited by local and global institutes, with more to follow.
The CFA Institute allows its members the ability to self-determine and self-report professional learning credits earned from external sources. CFA Institute members are encouraged to self-document such credits in their online PL tracker.
Climate change is the long-term alteration of weather patterns caused by global warming. Left unchecked, planetary heating will lead to substantial physical risks from increasingly severe hurricanes, floods, droughts and forest fires. All have been seen in greater numbers as the Earth records progressively hotter years.
Rising sea levels as rainfall rises and polar ice caps melt threatens to displace millions of people in coastal areas, while higher temperatures threatens the future of agriculture. Global warming can, however, be contained if greenhouse gas emissions are reduced now and the world becomes carbon neutral.
Greenhouse gas emissions
Global warming has predominantly been caused by the long-term burning of fossil fuels since the industrial revolution of the 18th century. This has produced around 2.5 trillion tons of greenhouse gases since 1750, raising atmospheric concentrates of carbon dioxide (CO2) by 67% and average global temperatures by more than 1°C.1 Much of this is now locked in, and irreversible.2
The three main greenhouse gases are carbon dioxide, methane (CH4) and nitrous oxide (N2O), most of which are generated by industrial processes. Emissions differ from pollution in that CO2 is a natural byproduct of life – we breathe it out every day – while much of the methane comes from farm animals.
Most of these emissions are absorbed by the oceans, or are held on land by natural carbon sinks such as permafrost – permanently frozen ground found in areas such as Siberia and norther Canada) – and within trees. The rest becomes trapped in the atmosphere, unable to escape into space, causing the planet to heat up over many decades.
The principal effect of a warmer atmosphere is to create more moisture in the air, leading to heavier and more unpredictable rainfall, floods and storms. It has also led to more extreme summer temperatures, heatwaves in previously cold regions such as the Arctic, and the growing desertification of formerly fertile areas.
Evidence of rising temperatures can be seen in that ten of the warmest years in recorded history have occurred since 2005. The hottest was 2016, when the Earth’s atmosphere was on average 0.94 degrees warmer than the global mean since 1880.
CO2 levels rise to new records with every passing year. The level of 419 parts per million (ppm) recorded in the atmosphere in June 2021 was last seen on Earth over four million years ago, according to scientific research.3 At that time in the Pliocene Era, before humans had even evolved, the average surface temperature was 2-3°C higher than pre-industrial levels, and the average sea level was up to 25 meters above what it is today.4
Climate change also threatens agricultural production, as milder winters and earlier springs interrupt crop-growing patterns. Higher temperatures have a double whammy effect on insects. In warmer areas, they threaten to wipe out the ‘friendly’ insect population on which plants rely for pollination. In colder areas, warming threatens to expose countries to the ‘unfriendly’ disease-bearing insects that they currently avoid.
Climate change began to be taken seriously in the 1980s, partly following a successful campaign to end the use of chlorofluorocarbon (CFC) gases in aerosol sprays that were damaging the ozone layer. To study the problem, the World Meteorological Organization and the United Nations Environment Program set up the Intergovernmental Panel on Climate Change (IPCC) in 1988.
Attempts to curb emissions began in earnest with the UN Conference on the Environment and Development – which became known as the Earth Summit – in Rio de Janeiro in 1992. This produced the UN Framework Convention on Climate Change (UNFCCC), which began to meet annually as the Conference of the Parties (COP).
The Earth Summit was followed in 1997 by the Kyoto Protocol, the first international treaty that committed signatories to curbing emissions "to a level that would prevent dangerous anthropogenic interference with the climate system". The more ambitious Doha Amendment, which introduced binding targets for 37 countries including European Union member states, followed in 2012.
The UN took a bolder step in 2015 by putting a temperature limit on global warming for the first time in the landmark Paris Agreement. Its core aim is to keep global warming to below 2°C above pre-industrial levels by the end of this century, and to pursue efforts to limit it to 1.5°C. It was signed by all 196 nation members of the UNFCCC before the US pulled out in 2017 under President Trump and rejoined it in 2021 under President Biden.
Achieving these goals required clear carbon reduction targets. So in 2018, the IPCC said that in order to achieve the lower 1.5°C goal, emissions needed to be cut by 40-60% from 2010 levels by 2030, reaching net zero around 2050. To achieve the 2°C target, emissions needed to be cut by 25% by 2030 in order to achieve net zero by 2050. This includes the fact that 0.8-1.2°C of warming has already occurred.5
However, the IPCC also warned that at current levels of (in)activity, the 2°C target would probably be reached by 2030, and that global warming of 3°C by the end of the century was more likely. In September 2019, the IPCC further warned that sea levels would rise by at least 1.1 meters by 2100 unless the world takes action now.6
Other forecasts by the Carbon Brief, a UK research project, also makes for scary reading. It predicts a 56cm sea level rise even if the 2°C degree target limit is achieved, along with more extreme weather that would expose 37% of the global population to heatwaves and annual floods causing USD 12 trillion in damage.7
The most recent attempt to seriously address global warming occurred at the COP26 climate summit in Glasgow in November 2021. Agreement was finally reached on the rulebook for countries to implement the Paris Agreement, boosted by a key carbon collaboration deal between the world’s two largest emitters, the US and China.
The rulebook covers critical topics like the reporting of emissions, the monitoring of policies and, most importantly, the trading of emission rights through carbon markets. It allows the focus to shift from negotiation to implementation as governments formally adopted 1.5°C as their official warming target.
A number of new policy pledges for 2030 were made, including reducing methane emissions, halting deforestation, phasing out coal power, and stopping public financing of fossil fuel abroad. Though some of these pledges are vaguely framed and not signed by the major emitters, they still have good potential to reduce emissions before 2030.
The summit also attracted unprecedented levels of private sector participation, including deals to boost decarbonization in industry and everyday life. Among banks, asset owners, asset managers and insurance companies, there is now USD 130 trillion committed to net zero, though that figure includes some double-counting.
1. McKinsey: Confronting climate risk
Climate change can only be combatted by reducing greenhouse gas emissions, which has led to national carbon targets and net zero pledges.
Scientists agree that if global warming is being caused by greenhouse gas emissions, then it can be reduced, and even reversed, by cutting these emissions. Many countries, companies and investors have subsequently committed to decarbonization, with the aim of becoming carbon neutral by 2050.
As we saw in Chapter 1, the Intergovernmental Panel on Climate Change (IPCC) set targets for how much decarbonization is necessary in order to meet the Paris Agreement goals. Global emissions need to fall by 40%-60% from 2010’s levels by 2030 for the world to be on track to limit the increase in global temperature to 1.5°C or by 25% in 2030 to be on track for a limit of a 2°C increase. The overall aim is to make the world carbon neutral by 2050, resulting in the ‘net zero’ ambition.
However, current policies only put the world on track to achieve a 0.5% reduction in emissions by 2030, meaning there is a 100-fold gap between ambition and reality. Such policies will lead to a temperature rise of 2.8°C, according to the UNEP Emission Gap report 2021. Predictions for various levels of warming under differing scenarios are show in the chart below.
- Each pathway comes with uncertainty, marked by the shading from low to high emissions under each scenario.
- Warming refers to the expected global temperature rise by 2100, relative to pre-industrial temperatures.
Data source: Climate Action Tracker (based on national policies and pleges as of May 2021). OurWorldinData.org - Research and data to make progress against the world’s largest problems. Licensed under CC-BY by the authors Hannah Ritchie & Max Roser.
More concrete policy pledges for 2030 seen at the COP26 climate summit would bring warming down to 2.4-2.7°C, while policy pledges for 2050 (albeit currently vague ones) would lead to a rise of 1.8-2.1°C – more acceptable but still exceeding the Paris targets.
The Greenhouse Gas Protocol was set up to offer companies and more recently investors a global accounting standard with which to measure emissions and mitigation activities. This is now used around the world alongside data gathering initiatives such as the Task Force for Climate-Related Financial Disclosures and the Carbon Disclosure Project.
Scope 1 emissions
Emissions are measured in three scopes. Scope 1 emissions are those that are directly generated by the company, such as through factory chimneys or the exhaust fumes of aircraft. Scope 2 emissions are created by the generation of the electricity or heat needed by the company to sell its main products. Scope 3 emissions are caused by the entire value chain, including the consumer of the product over its life cycle.
Scope 2 emissions
A carmaker would have relatively low Scope 1 and 2 emissions for making the car, but the user of the vehicle would burn petrol to run the car over many years, causing high Scope 3 emissions over its lifetime.
Scope 3 emissions
While Scope 1 and 2 data are relatively easy to acquire, it can be very difficult to measure Scope 3; in the example of the car user, for example, one could not know over how many kilometers, or for how many years, it would be driven.
A country’s progress towards cutting these emissions and heading for carbon neutrality can be mapped because the Paris Agreement requires all signatories to quantify their decarbonization efforts through Nationally Determined Contributions (NDCs). Some 192 countries have done submitted NDCs, each committing to decarbonize.8
In all, countries representing about 61% of all global carbon dioxide emissions, and 68% of the world’s gross domestic product, and 58% of the global population are now covered by net zero targets, according to the Energy & Climate Intelligence Unit not-for-profit group.9 These are mostly pledges to become carbon neutral by 2050 to meet the main Paris goal.
European Green Deal
Some nations have more ambitious plans – Austria and Uruguay have pledged to do so by 2040. China, which has the world’s largest carbon footprint, has set a longer-term target of 2060. The country currently accounts for close to 30% of global CO2 emissions, versus 15% for the US and 9% for the EU. Under the ‘European Green Deal’, the EU has pledged to achieve a 55% reduction in greenhouse gas emissions compared to 1990s levels by 2030.
But the progress made so far has not been encouraging. The United Nations Framework Convention on Climate Change (UNFCC) reported that the current combined climate policies of national governments will reduce global greenhouse gas emissions by only 0.5% in 2030.10 On the more positive side though, the UNFCCC also concluded that governments’ longer-term targets imply a 90% emissions reduction by 2050 – almost reaching net zero – which would indeed put the world on track to limit the increase in global temperature to 2°C by 2100.
One yardstick for progress is understanding how much CO2 can still be released into the atmosphere to meet the Paris goals. According to the Mercator Research Institute on Global Commons and Climate Change (MCC) carbon clock, there is only six years and 10 months left for the 1.5°C scenario, and 24 years and 8 months left for 2°C.
Another way of monitoring progress is by tracking the predicted level of global warming according to the decarbonization work that is taking place now. One of these is the Climate Action Tracker (CAT), a German project which collects data on decarbonization initiatives by governments and measures them against the goals of the Paris Agreement.11
The CAT tracks Nationally Determined Contributions from 36 countries plus the EU, covering about 80% of global greenhouse gas emissions and about 70% of the world’s population. As with carbon clocks, it also makes for grim reading, predicting warming of 2.6°C by 2100 based on current pledges.
“If you look at climate change, it is clear that if everyone looks at his or her neighbor, it will not change. So, there is a responsibility for everyone. Countries have to act. Companies have to act. And also investors have to act. And I think specifically for investors, there is a special responsibility, because they can decide where to invest their money. And that is a very powerful tool.” – Carola van Lamoen, Head of Sustainable Investing, Robeco
Under the initiative, investors agree to set interim targets achieving the net zero goal, though how to decarbonize is the subject of debate. Simply divesting higher-carbon companies, for example, does not solve the underlying problem if the equities or bonds are bought by someone else. Many are using engagement instead to persuade higher-carbon companies to change their business models so that they can continue to invest in the longer term.
Climate Action 100+
Identifying these companies is easy enough, since the 167 companies that are in scope of the engagement program by the Climate Action 100+ investor collaboration account for more than 80% of global industrial emissions.13 These are the ‘usual suspects’ led by oil and gas majors, utilities and transport, but also agriculture, pulp and paper and metal smelting.
EU Sustainable Finance Action Plan
Legislation and regulation is also forcing decarbonization, both onto countries and on investors. The EU Sustainable Finance Action Plan aims to promote sustainable investment including a bigger push into renewable energy and carbon capture technology across the 27-nation bloc.
Emissions Trading Scheme
A world-leading Emissions Trading Scheme underpins the EU’s emission-reduction plans, as it sets a carbon price which acts as a tax on participants. A Carbon Border Adjustment agreement is being drawn up to create a level playing field and protect European industries against cheaper, high-carbon products from outside the EU.
A EU Taxonomy aims to define what economic activities are ‘green’ for the first time. And the EU also plans to enhance the sustainability of investment strategies through the Sustainable Finance Disclosure Regulation, under which investors must disclose whether their investments integrate sustainability principles including environmental concerns.
Decarbonizing is seen as the main way forward to reduce emissions and meet the Paris Agreement. This is primarily being done through net zero pledges by governments, companies and investors, backed by regulation. Progress can be monitored, so far suggesting that the world is behind target and needs to do more.
9. https://ca1-eci.edcdn.com/reports/ECIU-10 Oxford_Taking_Stock.pdf
Climate change presents a double materiality for investors because they mutually affect each other: global warming directly affects the likely returns of investments, while the investments themselves have a direct impact on climate through emissions or waste.
Environmental, social and governance (ESG)
It is also both a risk and an opportunity, which means investors need to understand how it will play out for them in the long term. To do this, it is essential to integrate environmental, social and governance (ESG) factors into the investment process, focusing mostly on the E.
The risks take two forms: physical and transitional. Physical risk primarily accrues from the increasing threat caused by more extreme weather, such as storms and floods that damage industrial plants or buildings, or make agricultural land unusable. Insurers have already warned that many businesses will become uninsurable – such as those on flood plains or coastal regions – if climate change goes unchecked.
Transitional risk mostly affects those high-carbon companies whose business models will become obsolete unless they can adapt to lower-carbon processes or products. Much of this depends on their emissions and their ability to reduce them. The Taskforce on Climate-related Financial Disclosures (TCFD) developed a framework to help companies and other organizations more effectively disclose climate-related risks and opportunities through their existing reporting processes.14 Developing a net zero carbon strategy is seen as key to this.
This means it is important to view investing from both a top-down and a bottom-up perspective at the same time. Then a strategy can be aligned with the Paris goals for long-term sustainability.
Top-down targets focus on portfolio decarbonization, and the need to monitor a strategy’s overall carbon footprint against a trajectory of reducing emissions that can meet the 1.5°C Paris goal. The bottom-up approach means analyzing the companies (for stocks) and countries (for government bonds) to assess their transition readiness.
While the focus here is on identifying risks, double materiality also brings immense opportunities. The top-down approach can identify the industries that already offer low-carbon solutions, such as in renewable energy, while bottom-up offers a means of finding the individual winners in each sector for creating alpha in portfolios. These opportunities are discussed more fully in Chapter 5.
Aligning investments with the Paris goals has been helped by a number of initiatives in recent years. The first was the creation of the Paris Aligned Investment Initiative by the Institutional Investors Group on Climate Change (IIGCC) in 2019.
The Net Zero Asset Managers Initiative followed shortly afterwards, leading to carbon neutrality pledges by 2050 or earlier from asset owners and asset managers the following year. Guidance on how to decarbonize portfolios in line with the 1.5°C goal was formulated in the Net Zero Investment Framework, launched in March 2021 that is now used around the world.
But how to judge decarbonization? Most portfolios are judged against a benchmark, such as the MSCI World Index, in order to see whether they can beat the returns of a peer group. Up until 2020, there was no benchmark against which decarbonization progress of companies or countries could be measured.
The EU responded by creating Paris-Aligned Benchmarks. Its constituent companies have to meet stringent criterial, led by having a carbon footprint that is already 50% lower than the wider investment universe, and achieving a 7% reduction in the footprint every year after that.
Sector exposure is in line with the investable universe but fossil fuel companies are excluded, subject to certain thresholds. This means excluding virtually the entire oil and gas and utilities sectors.
Achieving true Paris alignment is not just an issue of removing high-carbon companies from an index or portfolio. The key parameter is whether they are on a trajectory to lowering the carbon intensity of their business models, for example by switching to renewable energy, or insulating their real estate to cut down on heat loss. The focus is on the pathway rather than current carbon levels.
Several investor groups have been set up to assist with evaluating companies’ progress on this transition. The Transition Pathway Initiative (TPI) is a global, asset-owner led program which assesses companies' preparedness for the transition to a low-carbon economy and helps investors understand the level of ambition of corporate emissions reduction targets.
Nearly 1,400 companies are being advised by the Science-Based Targets Initiative (SBTi), a collaboration between several not-for-profit organizations, the World Wildlife Fund (WWF), World Resources Institute (WRI), Carbon Disclosure Project (CDP) and UN Global Compact. This initiative provides technical assistance and expert resources to companies in setting and certifying emission reduction targets aligned with a low-carbon scenario.
Climate change is increasingly important for sustainable investors, presenting a double materiality in they mutually affect each other. Companies now face transition risks, as many have fossil fuel-dependent business models that may become obsolete. New benchmarks are finding better ways to measure progress, while several initiatives offer pathways for positive change.
Decarbonization is essential if the world is to reduce its greenhouse gas emissions and combat global warming. The main problem is in how to do this, when the world still relies so heavily on fossil fuels. While the answer lies in switching to renewable sources of energy, that’s not so easy when there are still over 1 billion petrol-driven cars on the road, and so many economies depend on oil or gas.
It's also not just the energy supply side that is the problem – ever-increasing demand for electricity from globally rising populations, and the logistical constraints of electrifying the currently unelectrifiable present major obstacles. Aircraft, for example, cannot use batteries in the same way as cars, since none are currently powerful enough to provide the energy needed for take-off.
Buildings present another structural obstacle, since energy-inefficient buildings cannot be easily written off, demolishing them creates its own waste issues, and carbon capture technology has so far proven to be too expensive to retro-fit on large existing industrial infrastructure.
Still, most fossil fuels can be replaced, and much hope rests in emission-free renewable energy. But this has two principal problems – its reliance on the natural forces that make it possible, and a lack of scale globally. Put simply, wind turbines won’t work if the wind doesn’t blow, and solar energy won’t work at night.
Then there is the question of competing with much bigger existing resources. Renewable energy has come a long way in the last 30 years, when its share of global energy production has risen from under 10% to 29% in 2020. However, 38% of all global energy still comes from coal, 23% from gas and 3% from oil.15
Coal, on the other hand, is plentiful and can be burned in power stations night and day. World coal reserves in 2018 stood at more than 1 trillion tons, or enough to last for another 132 years at current extraction rates; the US has 342 years of coal left.16
There are more than 1.6 trillion barrels of oil left in known reserves, or enough for 45 years at current consumption rates; Venezuela has 364 years of oil left.17 For natural gas, there is 7,600 trillion cubic feet left, or 52 years supply.
The sheer cost of meeting the Paris Agreement goals is another impediment. Estimates by the OECD suggest that USD 6.9 trillion of investment in infrastructure is needed each year from now until 2030 to meet the 2°C degree target, equivalent to one-quarter of US GDP.18
Whether countries that were hard hit by the GDP lost during the Covid pandemic and lockdowns can afford it is questionable, though it is important to remember that costs are usually based on the premise of ‘business as usual’. The evidence suggests that a failure to deal with climate change means there won’t be any business as usual.
Therefore, we can’t afford not to invest the money, as the consequences are likely to be worse. Research by the US National Resources Defense Council suggests a failure to meet the Paris goals could cost the US economy up to USD 6 trillion in the coming decades, while a worldwide failure could reduce global GDP by more than 25% by the end of the century.19
Carbon pricing is often seen as a solution to curbing emissions, since it is a direct cost on the higher emitters. The problem here is that it is far from being adopted on the global scale needed to make a difference, and current carbon prices are much too low.
"Carbon pricing has been identified by economists for many decades as the key solution. However, delivering on it has proven to be a real challenge. There are around 60 carbon pricing schemes in the world, but together they cover only 20% of global emissions and the average price is USD 2 per ton. Whereas scientists agree that currently carbon pricing should be between USD 40-80 per ton and it should grow to USD 100 in 2030. So, there's a long way to go. Now there where we do see serious carbon pricing, for example, in Europe this year, prices are at EUR 40 per ton, we do see the clear benefits." – Lucian Peppelenbos, Climate Strategist, Robeco
Currently only 22% of global emissions are covered by carbon pricing schemes, at an average price of around USD 2 per tons of carbon dioxide equivalent (tCO2e).20 Research suggests that to meet the Paris goals, carbon prices should be USD 40-80 now, growing to USD 100-150 by 2030.21 This level would put most companies in carbon-intensive industries such as steel and cement out of business.
Meanwhile, at the end of 2020 there were only 61 carbon pricing initiatives in place or planned in the world, consisting of 31 emissions trading schemes (ETS) including a large one for the EU, and 30 carbon taxes.22 The current EU ETS carbon price is around EUR 33 tCO2e.
A comparison between a nation or region’s carbon taxes and their share of global greenhouse gas emissions. Sweden has the highest while remaining a mid-sized emitter, while California has among the lowest while being one of the world’s largest emitters. Source: ‘State and Trends of Carbon Pricing 2020’, World Bank Group.
These kinds of problems faced in the real economy create another one in getting enough reliable data with which governments and investors can make the right decisions so that decarbonization can progress. There are three principal problems.
1) By definition, any data acquired is historical, with an average time lapse of two years. Trying to interpret carbon footprints in 2021 means using data from 2019, which doesn't tell you about the transition readiness of a company or country.
2) The problem isn’t that there isn’t enough data, but that it is estimated, not measured, and often comes from multiple and overlapping sources that are sometimes counter-intuitive. Double counting – where the same emissions reduction is recorded twice – is also a common problem.
3) What metrics to use, as it is mostly a quantitative approach when it needs to be more qualitative. The Net Zero Investment Framework provides recommended metrics, methodologies and approaches for investors to assess a company’s alignment with net zero.23 A more forward-looking approach captures market expectations on a firm’s exposure and sensitivity to carbon risk, known as its carbon ‘beta’. 24
Finally, political will is crucial to combat climate change. This is what one of the architects of the Paris Agreement, Christiana Figueres, referred to as “distributed leadership” – everyone from the president to the person on the street needs to work collectively towards a common goal. This requires strong leadership from governments, which has been rather lacking in deforestation, for example.
Around 300,000 square kilometers of forest or woodland is still being lost every year – an area the size of Germany or Vietnam – and one-quarter of the Amazon rainforest has already been destroyed.25 Since trees act as a carbon sink absorbing CO2 from the atmosphere and replacing it with oxygen, the loss of so many each year accounts for 17% of global warming, according to the World Economic Forum.26
The solution that renewable energy offers comes with drawbacks when competing with plentiful fossil fuels, while the sheer cost of the transition is a deterrent to many. Carbon taxes offer a way of curbing emissions but are currently too low, and the data dilemma puts off some investors from taking action. Political will is also lacking, such as in deforestation.
20. World Bank, State and Trends of Carbon Pricing 2020, https://openknowledge.worldbank.org/bitstream/handle/10986/33809/9781464815867.pdf
24. See Huij, Laurs, Stork, Zwinkels: “Carbon Beta: A Market-Based Measure of Carbon Risk”, Working papers 2021
Climate change is a major risk for investors, but it also represents a multi-trillion dollar market in the solutions for it. By seizing the opportunities this offers, investors can become part of the solution by actually mitigating climate change. By not seizing them, investors become part of the problem by furthering global warming and continuing to fund it.
The biggest opportunities can be seen in four key areas either side of the 2030 deadline for ramping up investment in order to hit the 2050 net zero targets:
Switching from fossil fuels to renewable energy is perhaps the most obvious and visible opportunity. The biggest growth has been away from biomass and hydroelectric power – used in some form for centuries – into wind and solar farms.
With such a focus on the infrastructure needed for transition, the International Energy Agency’s ‘Net Zero by 2050 Roadmap’ estimates that to reach net zero emissions by 2050 in pursuit of limiting global warming to 1.5 degrees, total global investment in clean energy needs to more than triple by 2030 to around USD 4 trillion per year.27
Wind power has been the biggest new energy source, accounting for 5% of all global electricity generation in 2018, up from virtually zero in the 1990s. Much of this has been offshore; many of the world’s largest wind farms are now in the North Sea.
Aside from the energy potential, it also presents investment opportunities in the companies manufacturing the wind turbines, some of which are the size of skyscrapers.28 Indeed, many investment opportunities lie in strategies that target the companies producing the materials and developing the technology needed, rather than the wind farms themselves.
Solar power has literally been another rising star, accounting for about 2% of global electricity generation in 2018, mostly due to installations over the past decade. As with wind, much of the investment opportunity lies in the equipment makers, led by the photovoltaic panels used to capture the sun’s rays.
Electrification offers another means of decarbonizing, with a switch from the internal combustion engines used in most forms of transport being an obvious win. The share of electric cars in new vehicle sales globally is expected to rise from 2.7% in 2020 to 10% in 2025 and 58% (i.e. becoming the majority) by 2040. As most major car makers have pledged to make their fleets electric by 2035, the days of petrol-driven vehicles will be numbered by the middle of this century.29
But it’s not just traffic: a more difficult task lies in electrifying buildings and the appliances within them. Many office blocks still rely on oil or gas to power their heating or air conditioning systems, while millions of homes have gas cookers, boilers and central heating systems. Low-voltage electric induction hobs are now seen as the most energy-efficient cookers for the home.
All this will massively increase demand for electricity, which will require huge investment to boost the size of national electricity grids. This is set to raise demand for conductive metals such as copper, aluminum and steel, offering further opportunities in commodity markets, though this also has a flipside in the environmental damage it can bring.
Hydrogen is a major development area that is seen as an effective alternative power source for commercial transport. It could potentially decarbonize long-haul freight fleets, including heavy-duty trucks and trains which use diesel; container ships which use highly polluting bunker fuel; and even some types of aircraft.
It also has the potential to decarbonize some hard-to-abate industrial processes such as fertilizer and steel production. There are three main hues to hydrogen: green, blue and grey according to the production method.
Hydrogen (H2) can be extracted from water (H20) via electrolysis to make carbon-free, green hydrogen. The most dominant form in industry at present is grey, made from extracting it from natural gases like methane (CH4).
For emission-free green hydrogen, electrolysis is used to break down water into its two component parts of hydrogen and oxygen. The liberated hydrogen can then be used in fuel cells. If renewable energy is used to power the electrolysis process, the resulting product is entirely carbon free.
The market has enormous growth potential, as currently only 4% of hydrogen produced is green. Most is currently extracted from methane (CH4), resulting in ‘blue hydrogen’ if carbon capture is used to trap the byproduct, or ‘grey hydrogen’ if it is not. Grey hydrogen is not seen as a viable alternative under a low-carbon scenario, since there is no net loss in emissions.
1. Carbon capture and utilization (for chemicals production)
2. Biofuel, synfuel, ammonia
Carbon capture and storage
Finally, many decarbonization hopes rest on carbon capture and storage (CCS). This is a complex three-step process of capturing emissions from a power plant or industrial facility, transporting it by pipeline or ship, and then storing it safely underground. This stops emissions from getting into the atmosphere in the first place. However, the technology is expensive and storing the captured carbon presents its own environmental concerns.
Most industrial facilities can be retro-fitted with CCS technology, but it is cheaper to incorporate it in the manufacture of new plants. A combination of burning a biomass fuel and then using CCS can deliver so-called ‘negative emissions’, meaning that CO2 is actually removed from the atmosphere. This technology will become increasingly important over time to meet climate targets.
There are vast investment opportunities in the solutions to climate change, led by renewable energy infrastructure and the switch into electric cars. Green hydrogen offers a solution for larger vehicles such as trucks and ships, while utilities may become the heroes of transformation. Carbon capture will become increasingly important.
Investors have a role – some would say a fiduciary duty – in placing the money they control into companies that are doing their bit to become more sustainable. While most agree that low carbon represents the long-term future, the costs and risks of the transition towards that goal are not yet fully priced into the market. Being at the forefront of the transition therefore makes sense from a portfolio and risk management perspective.
"For investors to address climate change is part of our fiduciary responsibility, because climate change is investment risk and also investment opportunity. It's a key determinant for determining winners and losers in tomorrow's market. Climate change is essentially a market failure. It's emissions that are not being priced as part of economic decision-making. That puts a key responsibility for governments to put the right incentives in place and give a price, put a price to carbon." – Lucian Peppelenbos, Climate Strategist, Robeco
Environmental, social and governance (ESG), active ownership
Asset managers can do this in two main ways – through the integration of environmental, social and governance (ESG) factors into the investment process, and through active ownership. This enables them to steer client money towards the more sustainable companies and avoid the laggards. When looking at the E in ESG, an assessment is made of a company’s environmental record, carbon footprint, water use and waste management.
ESG integration has become more mainstream, as half of all investors in Europe now use it in some form.30 Analysts look at the business activities of companies primarily through negative and positive screening, a vetting process which uses models to assess their ESG credentials. It can also be used to find companies with better ESG profiles compared to their peer groups. This can be further used to build best-in-class strategies, including bespoke climate funds.
One thing that may help in steering money towards the more sustainable companies is the EU’s new Taxonomy. This will establish for the first time a unified classification system for ‘green’ and ‘sustainable’ economic activities under the EU’s sustainable finance regulations.
Under the Taxonomy, environmentally sustainable activities must make a substantial contribution to one or more of six environmental objectives. These are climate change mitigation, climate change adaptation, the sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, and the protection and restoration of biodiversity and ecosystems.
Sustainable Finance Disclosure Regulation
For investors, the Sustainable Finance Disclosure Regulation will require asset managers to say just how sustainable their funds are, under three classifications. Broadly, these are Article 6 (ESG is not used); Article 8 (ESG is integrated), and Article 9 (bespoke sustainability targets).
Climate lies at the heart of the EU Sustainable Finance Plan and EU Taxonomy.
Active ownership can be used as a tool. As shareholders, voting can be a powerful weapon in expressing concerns with companies’ transition plans towards net zero and in influencing change.
An increasingly popular tactic is to vote against the reappointment of key directors if a company has not done enough to improve their ESG performance. Another is to file shareholder resolutions on environmental topics, which is often used to force oil and gas majors to revisit contentious issues.
Say on Climate
A new type of resolution emerged in 2021, the ‘Say on Climate’, in which companies present their energy transition strategy at an AGM. Shareholders get to vote on these plans according to whether they think the company is on a sensible trajectory to decarbonize or needs to go back to the drawing board. Most have so far been approved with overwhelming majorities.
Engagement is another means of seeking ESG improvements at investee companies. Under this process, a company agrees to talk over an investor’s concerns over a set period of time, often for up to three years. This has often proved effective in getting improvements in areas such as climate action, palm oil deforestation and single-use plastic or excessive waste.
Much engagement is being done on decarbonization programs, and the focus has widened in recent years to also target the financial institutions such as banks funding high-carbon companies, and not just the large emitters themselves.
Ultimately, an investor can threaten to exclude a company that cannot or will not change its ways, depriving it of external capital. A mix of engagement with the overhanging possibility of using exclusion if discussions are not fruitful has been particularly effective in persuading energy giants to switch to lower-carbon business models led by renewables.
Since no investor can achieve much on their own, collaborations are increasingly seen as the way forward, since they allow investors to pool their resources in tackling a major issue in which they all have a vested interest. They also allow the engaged company to deal with one overarching group rather than have dozens of separate conversations on the same topic.
One of the largest is the Climate Action 100+ collaboration. Founded in 2017, this targets the world’s largest greenhouse gas emitters and encourages them to take action to decarbonize. Its effectiveness was quickly proven, as the group was behind a 2018 engagement which led to the oil giant Shell linking carbon reduction targets to executive remuneration for the first time.
Another influential body is the Institutional Investors Group on Climate Change (IIGCC), a European collaboration with more than 325 members across 16 countries. Founded in 2012, its members are mainly pension funds and asset managers with over EUR 39 trillion in assets under management.31
In 2020, the IIGCC launched the Net Zero Asset Managers initiative to pursue the Paris goal of carbon neutrality by 2050. Its members (including Robeco) have taken the Net Zero Carbon Pledge in which they promise to make all of their investment strategies carbon neutral by mid-century. This will be achieved through capital allocation decisions, stewardship and successful engagement with companies, policymakers and fellow investors.
Investors need to play their part by steering money towards the most sustainable companies and using engagement to step up transition at some of the high-carbon laggards. Exclusion is a last resort, but does not solve the underlying problem. EU regulation and the new Taxonomy are changing the landscape and collaborations among investors can be hugely influential.
Many of the solutions for climate change are coming from private enterprise. Companies are developing alternatives to fossil fuels and innovative means of decarbonizing the world. Most of these are open to investors who want to make returns while also doing their bit to combat global warming.
Direct investment is usually done by the companies themselves. Most innovation is financed by corporate capital, from the invention of cars and mobile phones to the technology that has made solar panels possible.
Most investors prefer to invest in the stocks and bonds of the companies behind these innovations, rather than directly funding infrastructure such as solar plants, wind farms or carbon capture. Investors therefore tend to buy the securities of the operators of renewable energy infrastructure, and this includes the big oil companies switching into wind and solar.
Investing in climate-related strategies has grown in popularity, led by the themes of renewable energy, decarbonization, electrification and the move to a more circular economy. Scaling up electrical grids and switching to electric cars offers opportunities in strategies for the ‘smart’ energy, mobility and materials that target the new technology, processes and minerals behind them.
The circular economy theme focuses on a move away from the wasteful ‘take-make-and-dispose’ linear system to one that uses fewer resources and generates less waste. Much of the concept involves words beginning with ‘re‘: recycling, redesigning, reusing, refining, refurbishing and repairing. The aim is to make more efficient use of the Earth’s resources, as research shows that the linear model consumes finite resources at 1.75 times the planet’s annual regenerative capacity.32
Sustainable Development Goals (SDGs)
Impact investing offers another means of making both an impact and a financial return in the arena of climate change. It has grown in popularity since the advent of the UN’s Sustainable Development Goals (SDGs) in 2015, with more than USD 700 billion of investor cash invested in bespoke impact funds at the end of 2020. 33
Several of the SDGs target solutions to global warming, led by SDG 13 (climate action), SDG 7 (clean and affordable energy) and SDG 12 (responsible consumption and production). Another two target healthy ecosystems, which are being damaged by unsustainable practices: SDG 14 (life below water) and SDG 15 (life on land). All 17 goals are geared to making the world more sustainable in some form.
Investment strategies have been created to buy the stocks and bonds of companies that can make a contribution to one or more of the SDGs. Robeco, for example, developed a proprietary SDG Impact Framework which uses a three-step process to assess what the company makes, how it makes it, and whether it has been involved in any controversies, in order to calculate its overall net contribution. The resulting scores are used to pick securities for the SDG credit and equity portfolios.
Green bonds are another means of making an impact. These are debt securities, the proceeds of which are exclusively used to promote climate and environmental sustainability goals. For a bond to qualify as ‘green’, its proceeds should be used for projects with clear environmental benefits that can be quantified, such as renewable energy, reforestation or waste management.
They are typically issued by governments, agencies or supranationals, which means they can be bought across a wide spectrum. Disagreements about what actually constitutes an environmentally friendly project led the EU to establish a Green Bond Standard, a certification scheme aligned with the EU Taxonomy, which sets out the criteria for what is truly sustainable.
A record amount of USD 270 billion in green bonds were issued in 2020, pushing the total amount now in existence above USD 1 trillion.34
Finally, there are bespoke climate funds that follow benchmarks uniquely designed to align the business activities of their constituents with the Paris Agreement. In December 2020, Robeco launched two fixed income climate strategies that have Paris benchmarks, one of the first asset managers to create something like this in this space.
The Climate Global Credits strategy targets companies that have a combined carbon footprint that is 50% lower than a standard benchmark, and then a 7% decline in the portfolio’s footprint for each year after that. Fossil fuel companies are excluded.
Unfortunately, not everything is within investors’ reach: most of the world’s coal reserves, for example, are owned by governments, so exclusions won’t work, and many of the most unsustainable activities such as deforestation are done illegally. However, technology is helping to spot unauthorized tree felling using equipment such as ‘spy’ satellites and drones.
Investors tend to buy the stocks or bonds of companies at the forefront of climate change innovation, rather than directly funding infrastructure. Thematic and impact investing offer a means of targeting climate-related strategies including the SDGs, while green bonds are a way of buying into environmental projects. Bespoke climate strategies aligned with Paris benchmarks are now available.
National efforts to replace fossil fuels with renewables lie at the heart of reducing global warming, since electricity generation accounts for 25% of all emissions.35 This is particularly important for coastal countries that will bear the brunt of rising sea levels if the issue is not tackled.
One nation at the forefront of this is the United Kingdom, where emissions have fallen by more than 40% since 1990, a higher level than any other country.36 The UK’s commitment in April 2021 to cut emissions by 68% from 1990’s level by 2030 and by 78% by 2035 is also the highest in the world.37
Part of this success has been due to massive investments in offshore wind farms, including the world’s largest turbine field, the London Array in the North Sea. Offshore wind generated 26% more electricity in 2020 than in 2019. The biggest renewable contributor remains hydroelectric power which has been harnessed in Scotland since the 19th century.
These commitments have led to the UK being placed second on the Climate Change Performance Index 2021, an annual ranking of the climate mitigation efforts of 57 countries plus the EU, covering 90% of global greenhouse gas emissions.38
However, there are caveats: when judged on a per capita basis, the UK (and also the European Union) have an average annual footprint of approximately 7.9 tons of carbon per capita, or almost five times the 1.7 tons per capita in much poorer India.39
Another issue is that the 40% figure refers to territorial CO2 emissions and so does not include emissions from aviation, shipping and the carbon embedded in imports. If these numbers are included, the reduction falls to about 10% since 1990.40
While investments in wind and solar power grab all the headlines, one increasing source of renewable energy comes directly from within the Earth itself – geothermal energy.
It is being used to great effect in Chile, where 15% of the world’s volcanoes and 8% of the world’s geysers are located. Heat from molten rock and underground springs can be converted into electricity; Chile’s potential geothermal capacity is about 16 gigawatts, enough to power five million homes.41
The country’s geography helps its renewables push in other ways. Wave power is being tapped from the tides along its 5,000 km coastline, while the Atacama Desert is the world’s driest place with the highest intensity of sunshine. The Vallenar solar plant in the Atacama was the largest in South America when it opened in 2016.42
In all, renewable energy now accounts for 46.5% of electricity production in Chile, the highest level in Latin America.43 This has led to it being placed sixth on the Climate Change Performance Index 2021.44
One sector at the forefront of transition is the car makers. With 1.4 billion vehicles on the road accounting for 14% of all emissions, electrifying them would make a substantial contribution towards meeting the Paris goals.45
Some major car makers have pledged to switch to electric fleets by 2040, while legislation in some countries will make new gasoline-driven cars illegal by 2050. Norway aims to become the first country to ban the sale of fossil fuel cars in 2025, while the UK plans to do so in 2030.46
An engagement program coordinated by the Institutional Investor Group on Climate Change (IIGCC), in 2018 sought firm commitments from car makers for the first time, and it achieved several breakthroughs.
Volkswagen and Daimler each set a long-term ambition of achieving net zero emissions by 2039 and 2040 respectively. Volkswagen went as far as to bet on a single technology – opting for battery-powered electric vehicles – the first car maker to have done so. Others are opting for hybrids, fuel cell, hydrogen or a mixture of technologies.
Another sector at the forefront of change is the electricity generating utilities. They currently account for 24% of all emissions, due primarily to their use of coal-fired power plants to generate electricity.47
However, all the major players have committed to transitioning to the use of renewables, and some have set targets to become carbon neutral by 2050 or earlier, in line with the Paris goals. All European utilities have committed to not developing any new coal-fired power capacity but to focus on less carbon-intensive sources, including natural gas in the mid term.
As the companies with some of the steepest trajectories to becoming carbon neutral, this has also made them leaders of the energy transition, while their earnings paths remain strong. This has led to the corporate bonds issued by utilities to fund transition programs being highly rated.
The motivation to change must come from the very top if it is to have any effect. One company that has done so is the Italian electric utility Enel, which became one of the first to appoint a climate specialist to its board of directors. It followed an engagement campaign by Robeco on behalf of the Climate Action 100+ investor collaboration working with the Italian asset managers’ association
Assogestioni. Under the Italian ‘voto di lista’ system, minority shareholders can propose candidates for the board at the company’s AGM. This was done through the nomination of a former wind power executive in May 2020.
As a result, he was appointed as a non-executive director, and is now expected to contribute to implementing Enel’s transition plan in an effort to make the company carbon neutral by 2050.
Much has already been achieved at Italy’s former state-owned electricity monopoly: Enel now boasts that half its energy comes from renewables following some significant investments.48 The company built one of the largest hydroelectric plants of its kind, the first grid-connected solar installation, the first photovoltaic power station, and Italy’s first wind farm.
Decarbonizing companies is crucial if the Paris goals are to be met, and engagement can be useful in achieving this. A three-year engagement with Hitachi was successful in helping the Japanese electronics giant to set targets to cut its Scope 1 and 2 emissions by 50% by 2030, and all emissions including the more difficult Scope 3 by 80% by 2030.
To help achieve this, Hitachi has become one of the few companies to set an internal carbon price for its investment planning, using an assumption of JPY 5,000 (EUR 38) per ton. The company said it will invest JPY 84 billion (EUR 640 million) over 10 years to reduce its greenhouse gas emissions. This will feed through on both the supply and demand side, as Hitachi sees rising consumer demand for more energy-efficient products that it can make.
This makes Hitachi the only major listed company in Japan which has integrated carbon pricing so deeply embedded in its strategy. The company said it would have set a more ambitious net zero target for 2050, but considered this too difficult without a globally agreed carbon price.
Several countries are using their geography to tap into renewable energy and cut their emissions. High-carbon sectors such as autos have shown that it is possible to transform business models into lower-carbon alternatives. And major companies such as Enel and Hitachi are taking the issue more seriously by appointing climate directors and setting targets. All of this bodes well for positive change.
If you have absorbed all this information, you are ready to take the test.
Now that you’ve learned the basics of climate investing, it’s time to test your knowledge. Below are 15 multiple-choice questions on the eight chapters you have completed. Click on the box that you think contains the correct answer. If you answer 12 or more questions correctly, you will be awarded two hours of CPD.
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