Having provided the answer in the title, it is only polite to also provide the question: what should the investment industry do, assuming it is serious about addressing climate change? This note documents the thinking required to navigate from the question to the answer.
Some brief context
I always enjoy being part of a TAI working group for a number of reasons ranging from conviviality to genuine surprise as the work product emerges as greater than the sum of its constituent parts. This year is no different and I am part of two great groups grappling with different aspects of climate change. However, and this is confession time, I have been struck by the complexity of the subject, and by how hard it is to make progress. We are definitely climbing the ladder rung by rung – but is our ladder leaning against the right wall?
That heretical thought prompted two questions:
- how much of the climate problem does the investment industry own?
If it turns out that 99% of emissions come from state-owned coal companies, wildfires and melting permafrost, does it really matter if the investment industry completely decarbonises it’s 1%? By my estimation the investment industry owns 25% of the climate problem[1]. Meaningful enough to proceed to question #2 - how do we cut through the complexity to find the ‘one thing’ the industry should focus on? Or, to continue the above analogy, how do we make sure our ladder is leaning against the correct wall? This is the question I address in this note.
The simplifying assumption
The way to cut through all the complexity of scopes 1, 2 and 3 and the ensuing double counting is found in a CDP report[2]. In that report CDP attributed 30bn tonnes of (2015) carbon emissions to 224 fossil fuel extraction companies – genius. The logic here is that if fossil fuels were not extracted from the ground, they would not be burned and emissions from this source would be zero. We can therefore simplify the emissions problem as comprising only the scope 1 and scope 3 (‘use of product’) emissions of the fossil fuel extractors. In other words, emissions from (most) other commercial activity fall within scope 3 of these fossil fuel companies.
I am effectively assuming that energy is fungible – we can painlessly and costlessly switch between carbon-based energy and zero-carbon energy. This is patently not true, particularly in the cases of aviation and shipping. It also ignores other sources of demand for oil in particular, such as the chemicals industry. We will not be able, therefore, to limit our intervention to a small number of fossil fuel companies. In some cases we will need to take the next step down the supply chain.
Despite the fact that this assumption is obviously flawed, it yields a very powerful insight. It’s all about the cleanness of the energy supply that the economic machine runs on. This in turn leads us to conclude that ‘the answer’ (the interim answer, in our case) is zero-carbon energy.
Zero-carbon energy | the $110trn transition problem
The International Renewable Energy Agency (IRENA) estimates that the cumulative investment required between 2016 and 2050 to transform the global energy system to meet the objective of the Paris agreement is $110trn[3]. This is a very big number – approximately the same size as the total assets currently stewarded by the investment industry. And, for the avoidance of doubt, this is the ‘lot more’ new, primary investment we are taking about.
The path to zero-carbon energy
To define the path of decarbonisation we must consider two further questions. First, how close to zero are we aiming?
To answer this question let’s define a spectrum. At one end, net-zero emissions are achieved by reducing absolute emissions to zero. We label this the ‘low-carbon risk, high-transition risk’ (LCHT) path. At the other end, absolute emissions could, theoretically, grow as achieving net-zero is driven by scaling-up negative emissions technologies (NETs). We label this the ‘high-carbon risk, low-transition risk’ (HCLT) path. It is clear, then, that the choice of how low to drive absolute emissions will be driven by a belief concerning where on the spectrum we should aim[4]. It is worth stressing that this is a belief – the consequences of running either high-carbon risk or high-transition risk are unknowable at this point in time.
It is worth stressing that the choice of position on the spectrum does not change the requirement for a massive amount of new primary investment. At the LCHT end the investment is into renewable energy capacity; at the HCLT end the investment is into NETs.
The second question is what ‘shape’ of decarbonisation path do we prefer? (We can worry about practicality later.) The Institute’s 1.5C investing working group have already adopted an exponential shape (-7%pa) as a foundation, but the path could take a close-to-infinite number of forms. The key point we make here is the difference between front-end loading, where the big carbon reductions are done early (as with the exponential) and back-end loading, where the big carbon reductions are left until the end of the target period. This is another angle on the carbon risk issue. Back-end loading the reductions is choosing to run higher carbon risk and would be a characteristic of any path relying heavily on NETs which will require time to be scaled up.
An aside on carbon- versus transition-risk beliefs
According to my beliefs, carbon risk and transition risk are very different, and therefore should receive different consideration.
Whether you subscribe to Joseph Schumpeter’s idea of creative destruction, or to the Santa Fe Institute’s conception of the economy as a complex adative system, the global economy is always in transition. Sometimes the transition is smooth and gradual, at others it is abrupt. So, as we transition from a carbon-based economy to a zero-carbon economy new jobs will be created. We just don’t know whether they will be more or less numerous, or better or worse than the jobs that get destroyed. In any event we should expect some individuals to be adversely affected, perhaps severely so. It is only humane, therefore, to minimise and carefully manage the transition risk.
Carbon risk is different in that the economy (and humans for that matter) hasn’t had to deal with this concentration of carbon in the atmosphere before. Not only is the carbon problem novel, it is also non-linear. The physical consequences of the next 0.1C rise in temperature are more severe than the previous 0.1C increment. And, most significantly of all, at some unknown level of temperature rise humans, and most other life forms, will face existential risk. In my beliefs, an existential tail risk like carbon should carry a far higher weight in any decision than a ‘mainstream’ risk like transition. This pushes me towards the LCHT end of the spectrum. To be clear this is about prioritisation, not either/or. I believe the top priority is rapidly to reduce absolute emissions, but I also believe we are at a stage where ‘all of the above’ is the correct answer[5]. We need to invest heavily, and rapidly.
The investment industry and (net-)zero-carbon energy
It is now time to consider the investment industry. To play its part in achieving (net-)zero-carbon energy it is clear that two actions are required:
- Manage the existing investor-owned fossil fuel companies to net-zero emissions
- Decide what to do about the new primary investment thing.
Managing existing fossil fuel companies to net-zero emissions
The first action throws up an immediate problem. An investor’s incentive to preserve capital value is in opposition to the goal of running down their fossil fuel companies’ carbon business. This means the natural incentive must be over-ridden by either (i) a risk narrative, or (ii) a pro-social (impact) narrative, or (iii) a combination of the two. A suitable risk narrative would explain possible threats to capital value, such as write downs (permanent reduction in demand for fossil fuel products; stranding of reserves), or future litigation. Hopefully it is obvious that this framing is dripping with issues, but as they lie outside our current argument I will leave them for future treatment. For now my focus is on new primary investment.
The new primary investment thing
The simple truth is that the current industry infrastructure is set up to manage portfolios of securities. New primary investment is a tiny part of current activity. Outside a handful of Canadian funds and a similar number of the largest soverweign wealth funds who have the internal teams to pursue genuine primary investment, most investors are not doing any[6].
We need some sense of scale for this discussion. Assuming the IRENA figure of $110trn is correct, and that the investment industry owns 25% of the problem, investment’s share of the cumulative total over the next 30 years is $27.5trn. If you will allow me a little rounding, this is new primary investment of $1trn per year. For a size comparison, it is estimated that the private equity has $1trn in ‘dry powder’ ie cash waiting to be invested.
The comparison with private equity dry powder raises the question of supply of capital versus the demand for capital. The presence of dry powder could be taken to mean that there is a greater supply of capital, looking to be invested, than there is demand for it – or, alternatively, there is a shortage of institutional-grade innovations to fund. I think a more nuanced explanation is warranted – involving normal speed of drawdown, and general partners having fairly high return targets – but the main point remains valid. The bulk of private equity investments, by value, are mainly buyouts rather than the funding of new ideas (such as venture capital). In other words, it is hard to invest large amounts in new ideas. Technologies can take decades to mature until they are capable of being scaled significantly. This is the main reason why the carbon reduction benefits of NETs would necessarily be back-end loaded. Thankfully there appear to be some seasoned technologies which could be scaled – solar and wind electricity generation! However, as a regulated utility business, these investments would not offer high-enough prospective rates of return for those with high return hurdles.
Can’t we deploy this capital through the secondary markets?
If the bulk of the investment industry’s expertise lies in the secondary markets, why not deploy the required capital that way? This would be a pragmatic option, but equally problematic. This route would outsource the capital allocation to listed company managements. On the one hand this is very sensible as company managements do primary investment as part of their day job. On the other hand we need to worry about (i) size and (ii) incentives.
With respect to size, there are two aspects. First, we should expect the larger listed companies to do more primary investment than the smaller ones, and hence the investment will be biased towards what already-large companies think is required. Second, will listed companies invest enough? Hold that thought for a moment.
The incentives point overlaps with size (large, leading companies find it hard to cannibalise their own revenue even if that is necessary to survive and thrive long-term[7]) but is wider. The classic formulation would be to investigate whether the executive pay arrangements promote large-scale uncertain capital projects.
Returning to the thought we held, BP offers an interesting case study. While its market capitalisation has fallen, it remains a large company. In September 2020 it announced its strategy review, part of which was a commitment to invest $5bn in low carbon energy each year. How should we assess this commitment? It is 0.5% of the hypothetical $1trn annual need we derived above. May be that is OK for a single company. But the $5bn is perhaps around 33% of the new capital BP intends to invest in its existing carbon business[8]. May be that is less OK. Is it to do with the internal incentives?
The final point to make is that if the primary investment is done from cashflow, it is unlikely to be big enough. Investing at scale via this route will still involve handing over large amounts of cash for newly issued securities.
Didn’t we get burned by the last clean tech bubble?
Irrational exuberance and bubbles are an occupational hazard for investors and it is always possible to provide capital at the wrong price. This note simply lays out a flow of logic – if we want to solve the climate problem we need to reduce emissions to net zero; this requires us to replace carbon energy with clean energy; this requires a level of new investment, for a length of time that none of us have experienced in our careers. There will be plenty of opportunities to invest in more speculative NETs, but there is also an enormous opportunity for lower-risk, lower-return investment in renewable energy infrastructure. My belief is that the demand for clean energy will not disappear. It will therefore be about the entry price.
It seems clear, to me at least, that we need to massively scale the investment industry’s ability to deploy primary capital. This will be non-trivial to say the least. What does this say about quantum and quality of skills required in industry? And where will those people reside – within mainstream asset managers, boutiques, or within large asset owners?
Conclusions
This note set out to identify the ‘one thing’ the investment industry should focus on, to play its part in addressing the climate crisis. The answer is new primary investment. My beliefs lead me to favour investment in renewable energy; other beliefs would favour NETs. In truth we will need both – and we will also need to invest in energy efficiency, electrification and infrastructure. But we must keep the most important thing the most important thing: we should start with the fossil fuel companies, and the need to get net-emissions to zero as fast as possible.
This note has assumed the investment industry wants to play its part. That is not a given. I alluded to problematic incentives. We must also act in accordance with fiduciary duty, respecting the primacy of financial returns. Consequently, acting in line with the thinking expressed in this note would require a careful and complete narrative that explained to all stakeholders how the proposed course of action is compatible with strong financial returns through time. That said, I would also argue that not acting should also require a careful and complete narrative as to how the portfolio will avoid the inevitable distruptions caused by climate change.
[1] See our note How much of the climate problem does the investment industry own? Thinking Ahead Institute 2020 [2] CDP Carbon Majors Report 2017 [3] See the IRENA.org website: summary page here, 2019 report page here [4] This spectrum is analogous to the four illustrative model pathways within the IPCC special report on 1.5C. LCHT corresponds to the IPCC’s P1 path, and HCLT to P4 (link here) [5] For example, the IRENA report referred to above suggest four large, necessary categories of investment within the $110trn total: $27trn in renewables, $26trn in electrification, $37trn in energy efficiency and even $20trn of new investment in fossil fuels (and others)- presumably in the near term only [6] Even if they have a private equity program the majority of this will be dedicated to changing ownership (eg buyouts) rather than primary investment (eg venture capital) [7] The theme of The innovator’s dilemma by Clayton Christensen [8] Source bp.com, new strategy statement dated 4 August 2020 (link here): “Within 10 years, bp aims to have increased its annual low carbon investment 10-fold to around $5 billion a year “ and “bp intends to maintain annual capital expenditure — including inorganic investment — in a range of $14-16 billion to 2025”