Tackling climate change is not easy. It means upending the status quo, inventing new technologies, and reducing the emissions causing global warming. In short, it means working together, for the same vital cause.
Finding common ground on how to act is one of the biggest challenges in tackling climate change. Acknowledging that we all have a role to play and then agreeing to act collectively are critical to creating real-world impact. Robeco’s climate strategist, Lucian Peppelenbos, argues that investment capital is absolutely critical in this, but that the real economy needs to be guided by the right incentives for finance to be able to move too.
These incentives need to be far-reaching. “For the real economy to decarbonize, you need policy frameworks, and you need consumers and technology to be onside. All of these pieces have to come together. It’s crucial for us as investors to reallocate capital towards the green, circular, low-carbon economy. But we depend critically on other pieces of the puzzle falling into place as well. I think that's the real challenge.”
Governments have a critical role in putting effective incentives in place. This begins with establishing appropriate carbon pricing schemes and ensuring they are incorporated into economic decisions, so that investors and consumers can factor in the true cost of their actions.
There’s still a long way to go in getting the incentives right. At present, only around a fifth of global emissions are priced, through a variety of carbon schemes. And most of these schemes are underpricing emissions – which means the incentives are not effective in changing behavior. Across various carbon pricing schemes, the weighted average price of carbon emissions per ton is an estimated USD 2 (World Bank data). Calculations show that pricing needs to reach USD 50 by the end of 2021 and USD 100 by 2030 to get us on the 1.5°C trajectory.
In regions where pricing does appear to be more realistic, it has clearly changed behavior. Take Europe, where carbon is now priced at around EUR 30 to 35. “This is really accelerating the phase-out of coal. It’s driving innovation in industry, because low-carbon options begin to make business sense,” Peppelenbos says.
He believes that the other crucial role for governments is to create long-term clarity. “They need to set clear boundaries, whether for emissions or technical standards, at a certain point in the future so that the market can do its job”.
He cites the example of the Dutch government signaling years in advance that, as of January 2023, all commercial real estate must have an energy label of at least ‘C’ if the owners wish to let or sell the property. “As a result, all property is now being refurbished or taken off the market. The industry has had years to adapt itself, and the process has worked well.”
Another example is the decision by multiple European countries to ban the sale of non-electric vehicles by 2030, a move that is driving huge innovation in the automobile industry. “So, the incentives combined with clarity on the long-term timeline force a phase-out and a transition in industry. There is time to adapt, and the requirements are reasonable and aligned with where we need to go. They also help people focus and spur innovation.”
A vital aspect of ensuring we’re all moving towards transition is to recognize how our individual choices and actions shape global outcomes. While it’s easy to point the finger at companies that produce carbon-emitting products, we need to think about the role of consumer behavior, too.
“We’ve focused for a long time on the oil and gas industry, blaming it for climate issues. And, while it does have a huge role as well as a responsibility, what we often forget is that the industry looks for oil on our behalf. As long as we think it’s normal to fly five times a year for a holiday trip, to eat large quantities of meat, and to discard clothes after a few months on wear, our behavior will be a big part of the problem.”
For all of this to change, both supply and demand must change. “But I don’t buy into the narrative that consumers alone determine their behavior. It takes two to tango. Companies play a big role in determining what consumers want as well.”
Developments in the judicial system are helping to accelerate this process. There are a growing number of cases of governments and companies being taken to court and challenged on the impact of their actions on the climate. Successful lawsuits have already been brought against the Dutch and French governments, for instance, for failing to fulfil their duty of care towards citizens to act on climate change. “As these cases build up, it creates jurisprudence that will support and accelerate the transition to a low-carbon economy.”
The extent and pace of progress in the real economy will determine the investment opportunities and risks. “Although as investors we are future oriented and take a leadership role by signaling to the market which direction it needs to go, the real economy does set limits as to where these investment opportunities develop. We can’t work on a net zero portfolio without the real economy moving in the same direction,” Peppelenbos says.
Meeting the challenge of getting all the elements lined up requires everybody to take responsibility. “While attributing blame to the oil industry, governments or the financial system may be justified, it is entirely the wrong approach right now – because we are all facing the same challenge and responsibility.”
What’s more, we can’t wait for all the elements to come together before we step up to the plate. “Right now, each and every one of us must assume that role. What the world needs right now is distributed leadership.”
The scale of the problem of data collection becomes clear when trying to establish where emissions come from in the first place. To give a clearer idea of their source, they are classified as either Scope 1, 2 or 3 emissions. In short, Scope 1 emissions are those directly generated by a company; Scope 2 are created by the generation of the electricity or heat needed to make a product; and Scope 3 are caused by the entire value chain, including the end user of the product over its life cycle.
But it’s not simply a case of adding up tons of cubic meters of greenhouse gases – assuming that you could even access that information. There are three principal problems, stemming from the fact that by definition, any data acquired about anything is always historical.
“A fundamental problem of carbon footprint data is that it is backward looking, with an average time lapse of around two years. So, if we're staring down the barrel of carbon, then we're currently looking at the reality of 2019,” says Robeco’s climate data scientist Thijs Markwat.
“This means the data won’t tell you about the transition readiness of a company. What we really need is more forward-looking metrics. A carbon footprint as it is now doesn't tell me about whether the company is going to decarbonize in the future.”
The second problem is not that there isn’t enough data, but that it comes from multiple and overlapping sources that are often contradictory. “Scope 1 and 2 data is relatively easy to obtain, but there’s hardly any correlation on the scale of it from the different data providers,” says Markwat. “The real problem is that it's not measured, it's modelled. That means it's estimated.”
Furthermore, the scopes themselves do not tell us the whole story. For example, while a carmaker will produce relatively low Scope 1 and 2 emissions in making a petrol-driven car, the user of the vehicle would burn petrol over many years, causing very high Scope 3 emissions in exhaust fumes.
But the data challenges should not keep us from acting. “The lack of data is being used as an excuse by some to avoid tackling the issue head on,” says Markwat. “We need to be careful not to frame the entire issue as a data challenge; it’s more of an analytical challenge caused by the data itself. We know what the carbon-intensive sectors are, so we can act on that.”
The third issue is what metrics to use, as the current approach is largely quantitative when it needs to be qualitative as well. “The carbon footprint is the numerator, but then there's also the denominator,” says Markwat.
“So, do you look at companies in terms of their carbon footprint per sales, or per enterprise value? These factors make huge differences when EU law requires one thing and laws in other regions and countries require something different. There needs to be a more focused approach.”
In its simplest form, carbon pricing is a tax per ton on the amount of carbon emitted, and is typically levied by a government. Sweden has the highest carbon taxes in the world, charging about USD 120 per ton of CO2e, according to the World Bank Group’s ‘State and Trends of Carbon Pricing 2020’ report.
Another means of dealing with emissions is through ‘cap and trade’ schemes, in which carbon allowances can be traded with other emitters subject to thresholds set by the governing authority. One of the most extensive of these is the European Union’s Emissions Trading Scheme (ETS).
In such schemes, the carbon price fluctuates according to the supply and demand of the allowances. The current price in the EU ETS is around EUR 33/t CO2e.
Most countries, however, do not have either a carbon tax or a trading scheme, or operate them at such a low level that it doesn’t act as a deterrent to emissions. At the end of 2020, there were only 61 carbon pricing initiatives in place or planned in the world, consisting of 31 ETSs and 30 carbon taxes, the World Bank Group says. These cover 12 gigatons of carbon dioxide equivalent or only about 22% of global greenhouse emissions, up from 20% in 2019.
Meanwhile, carbon prices remain substantially lower than needed to act as an incentive to meet the goals of the Paris Agreement. In 2017, the High-Level Commission on Carbon Prices estimated that a global carbon price of USD 40-80/tCO2e by 2020 and USD 500-100/tCO2e by 2030 would be needed to limit the increase in global warming to 2°C. The current global average price is about USD 2/tCO2e, according to the IMF.
“At the global level, currently only 22% of carbon is being priced, which is really insufficient,” says climate change strategist Lucian Peppelenbos.
“And the average global price of about USD 2/t CO2e is nowhere close to being serious.”
“But there are some signs now that it is finally being taken more seriously. The price of carbon in Europe is now EUR 33/t CO2e, and that's really the price at which it starts to impact economic behavior. We’re already seeing the shift from coal-fired to gas-fired power production taking place at these price levels, and it is stimulating low-carbon innovation in industries.”
The issue is clearly being taken more seriously within the EU, which has committed to becoming carbon neutral by 2050 in the European Green Deal. Its first target is to achieve a 55% reduction in greenhouse gas emissions compared to 1990s levels by 2030. As part of this ambition, 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.
“The ETS is the cornerstone of EU climate policy,” says Peppelenbos. “To achieve its objective of a 55% reduction by 2030, the EU understands that the carbon allowances will need to become scarcer, which will push up the price per ton of CO2. The carbon border tax would be a game changer globally.”
Higher carbon prices and border taxes may be good for the climate, but won’t they harm the economy? One way of making it more palatable to those actually paying the taxes is to compare it with existing taxes on fuel. “If you take the average amount of taxes on gasoline in Europe, this would equate to a carbon price of around USD 300 per ton,” Peppelenbos says.
“This taxation has not stopped the European car industry from being competitive, and it hasn’t stopped consumers from buying or driving cars. But it did help to produce much more efficient cars in Europe versus the world average.” “This shows that it’s possible to introduce higher prices without killing the car industry or consumer purchasing power. You just need to do it in a clever way; none of this needs to be a threat.”
Lucian Peppelenbos - Climate Strategist
“Put simply, it is reducing the carbon intensity of the portfolio by including companies with low emissions or which have made credible commitments to reduce their emissions. Similar to a portfolio’s financial performance, progress in this area requires continuous measurement against a reference point.
Otherwise, the informational value of reported emissions is low. That reference could be the overall market, such as the emissions performance of a global index, or an internal standard such as a point in time from which a portfolio’s year-on-year progress is measured. The emissions amount is irrelevant; what matters is that you start to measure.”
“It would be if company-reported data were complete, but the bulk of emissions generated is excluded from this, so true emissions performance is underestimated. Currently, companies report and investors measure emissions from production processes (Scope 1) and the electricity used to power those processes (Scope 2). But they don’t report emissions generated further along in the supply chain by a product’s consumers. Oil and gas producers have a high carbon footprint in the production phase, but that’s still only 20% of total emissions. The other 80% is generated when the oil is burned by customers (Scope 3).”
“Oil and gas companies aren’t alone; economy-wide scope 3 emissions are underestimated. Many food companies, for example, have comparatively low operational footprints upstream, yet hefty unaccounted emissions from things such as deforestation and fertilizers in other parts of their supply chains. Comprehensive supply chain data is not yet calculated, publicly disclosed or considered by most investors (see Figure 1).”
Source: Robeco, Trucost
The graphic shows the annual weighted average carbon intensity (WACI) of constituents of the MSCI All World AC. Constituent emissions data are based on average annual emissions reported by companies for 2019. WACI measures the carbon intensity (Scope 1 + 2 + 3 emissions / enterprise value including cash in millions USD) for each portfolio company multiplied by its portfolio weight.
“It can lead to the emissions of some companies and sectors being underestimated or overestimated. Many ‘green and clean’ solution providers have paradoxically high carbon emissions if you only take backward-looking emissions into account. For example, wind turbine operators, electric vehicle makers and hydrogen producers, are all clean technologies but their carbon-reducing benefits lie in the consumer use phase further down the supply chain.
Given they may need steel for parts or use electricity from a carbon-intensive regional power grid, their Scope 1 and 2 emissions may still be high. That means their decarbonization potential is not being fully realized in portfolios. Predictive power is needed to combat this effect.”
“Our most advanced decarbonization strategies take Scope 3 emissions into account. For other strategies, we use proprietary estimation techniques and third-party modelling to derive best case estimates of future emissions. This involves mapping out net zero transition pathways for sectors based on available or near-term technologies. Besides Scope 3 emissions, we incorporate other types of forward-looking data to help predict companies’ climate preparedness and future climate-adjusted performance. Which companies have strategic plans that incentivize a shift to low-carbon technologies and business models?
How are they expected to benefit and profit from the net zero transition? Which are financially strong enough to make the capital investments needed to transition?”
“The ultimate goal is to ensure client portfolios are climate proof by reducing their exposure to carbon risk and ensuring they are climate-ready. This is a much more complex responsibility, involving many more considerations than how a portfolio measures up against a benchmark in terms of emission reductions.”
“ESG integration brings more information across a wide range of risk factors; social, economic, governance and environmental. This can be combined with financial analysis to more accurately assess future risks, evaluate financial performance and make better-informed investment decisions.”
“Decarbonization, on the other hand, is often done to reduce climate risks as well as to combat climate change. An investor’s decision to decarbonize their portfolio is not always based on purely financial objectives. Often, it is motivated by a desire to invest in companies that are making positive impact by not contributing to climate change and environmental damage.”
“The economy grows where capital flows, so channeling capital towards companies with strong carbon reduction momentum and away from laggers accelerates the transition to a carbon-free global economy. That said, selling the securities of a high carbon emitting company has no immediate effect on the real economy. Real world impact requires large pools of investors to ‘vote with their feet’ by refusing to own securities of heavy polluters. This will ultimately raise their financing costs and expedite change.”
“However, there are caveats to this approach. For one, denying financing will hurt many companies that want to transition but need capital to do it. In addition, some heavy polluters are so cash-flow rich, they don’t need new capital. In the latter case, financing boycotts may have little effect. But even cash-rich companies care about their reputations, so if investors position their portfolios away from these companies, it sends an amplified, high-alert message to company management.”
“Investors must also use active engagement and voting as a tool to exert their influence over company management. Given that carbon emissions are spread across entire economies and require major structural changes, engagement needs to take place not just with the company but also at the country level.
Robeco has recently started engaging with country leaders to help them understand the aggregate effects of conflicting carbon policies at the national level. It is counterproductive to force some industries to decarbonize while allowing others to cut down forests or to offer protective subsidies to heavy carbon polluters. Country leaders must also understand that national decarbonization policies will impact their ability to attract global businesses, foreign investments and financing via sovereign bonds.”