Sustainability and climate change | project guide

This document sets out the thinking behind, and intended direction of, the sustainability and climate change research project. It is primarily intended for the members of the working groups, but also to be informative for all the Institute’s membership. The goals of the project are to change the dialogue, behaviours and actions within the investment industry regarding climate change. Members are encouraged to challenge the contents of this document, particularly the research plan which can, and should, adapt to ensure it is of the best practical use.

Why should TAI get involved in climate change?

Climate scientists have been telling the world for 30+ years what the consequences of our actions will be. Carbon emissions have risen steady throughout that time. The significant efficiency gains we have harvested have been more than offset by greater demand for energy. Why hasn’t the global system (actually, a whole set of interrelated systems) been able to adjust to the inconvenient truth? The answer given by Mark Carney, in 2015, was that climate change is a tragedy of the horizon. The “catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors”[1]. Most, but not all. Many asset owners have an open-ended life span ahead of them. Asset managers can, if they choose, consciously run themselves for the benefit of future generations.

Each investment organisation, and each institution in the economy beyond, has its own objective function – the ‘good’ that it is seeking to maximise on behalf of those stakeholders it deems important. A perfect alignment of those objective functions is an odds-against proposition. And yet economies tend to operate rather than splinter, suggesting that perfect alignment is not necessary but adequate alignment is likely to help. And economies adapt. Further, ideas matter in that adaptation[2].

The scale of the climate problem, and the lack of meaningful progress so far, could engender a defeatist attitude. But it can also encourage a certain humility, and a focus. We, as the executive team supporting the work of the Thinking Ahead Institute, have a degree of experience in bringing together asset owners and asset managers with their differing objective functions to address common problems. We also have long experience of holistic, systems-thinking. It is by collaborating with members on this supremely important topic that we can hope to surface the influential ideas, and change the dialogue within the investment industry. And from there we can hope to see changed behaviours and actions of industry participants to make the significant reallocation of capital that is needed.

The task, then, is to do what we can – and to persuade others of its merit. But before we explore what the actual task might be, we need to recognise that the current global pandemic has changed our immediate context – and may meaningfully influence our future context.

Climate change in the era of Covid-19

This Thinking Ahead Institute research stream had its genesis before the world encountered the SARS-CoV-2 virus, but formally launched at the start of 2020 – several weeks after the first deaths from Covid-19. The first working group call was on 13 February and, at that stage, the world was hoping that the (apparently draconian) lockdown of a Chinese region would prevent the further spread of the virus. Roll forward eight weeks and Covid-19 has reached most, if not all, countries and claimed many lives. The ultimate economic cost of locking down economies can only be guessed at. But locking down economies has had a swift and quantifiable impact in terms of reducing green house gas emissions (and other pollutants). And so we have been given an extraordinary glimpse into the complexities of both climate change and economic life, and their interaction.

Differing arguments over how we should emerge from lockdown are already being laid out in the media. Simplifying, it is a case of restarting the known economic machine and recognising that any transition to a lower-carbon future will necessarily be delayed by changed sovereign finances and the priority of restoring jobs, versus a desire to make permanent the reduced emissions and restart down a different economic pathway. For our part, we choose to recognise this shorter-term tension while re-focussing on the longer-term goal of carbon neutrality by 2050. The current pandemic has affected almost all humans in some way, and in a very dramatic way for many. In a less dramatic manner, but with increasing cumulative significance, climate change will also (absent changes to the way we run our economies) affect almost all humans. We therefore see it as critical to continue to work on this topic.

What is the task?

At the highest, planetary, level the task is straightforward. It is to reconfigure the economic machine to produce the same, or higher, level of benefits but without the waste products that cause climate change and global warming. The goal is a carbon-neutral economy, and the timeframe is generally set as 2050.

For the investment industry, as owners and/ funders of a subset of the economic activity, the task is more complex because the objectives are fuzzier. Can we own a carbon-positive set of assets in 2050 because the public sector has gone carbon-negative? Or, is there more money to be made from owning a set of carbon-negative assets? Do we even get an unconstrained choice in this matter, or will be forced into certain actions by the inevitable policy response as proposed by the PRI[3]?

From one angle, then, the task is actually about making better decisions under conditions of uncertainty. In our past we have worked on both the theory and practice of that[4].

From another angle, the task is to set our organisations up for success. This has multiple components including: setting a strong purpose; clarity of mission and goals; understanding sustainable value creation; refining values and beliefs; and making our culture fit for the change that is coming. Again, we have worked on all of those[5].

And from a third angle, the task is about the continuous management of a portfolio of assets through this highly-uncertain future. ‘A’ portfolio, not ‘the’ portfolio. Just as every investor has their own context, mission and goals, set of liabilities, and risk tolerance, it is reasonable to expect their portfolio to be somewhat different to those of other investors. So the task is not to create the perfect climate change index. It is to provide practical guidance and/or tools to assist in the management of a portfolio through a changing climate.

The current plan

It feels slightly hubristic to even use the word ‘plan’ at this time of writing. We have all had first hand experience of how fast things change when an exponential is at work. So we are really talking about a combination of ‘plan plus agility’: a rough idea of where we are heading, and the steps necessary to get there, plus a commitment to be agile – to modify the plan as new information comes to light.

The project started with an invitation to members to join a working group and a kick-off call on 13 February. The response from members was overwhelming and a clear action from the first call was to split the effort into two working groups: the +1.5C portfolio group and the duty of ownership group. Interest within the membership continued to grow and so it was clear from the +1.5C portfolio call on 19 March that we needed to split the group once more.

Given this context, we outline the current plan below. 

  • Beliefs and principles
    A paper describing why an investor should pay attention to climate change and documenting the beliefs and principles that will guide decision making and behaviours
     
  • Mapping the future
    As mentioned at the beginning of this note, the shutting down of economies to reduce the transmission of SARS-CoV-2 has also caused a drop in emissions. This is a useful illustration of the kind of trade offs that will need to be confronted in addressing climate change. In August 2019 the Business Roundtable of CEOs announced that corporations should serve a wide set of stakeholders, not just shareholders. However, it seems inevitable that some decisions will favour some stakeholders and will harm others in the next immediate period even if, over the long run, all ultimately benefit. How can, or should, the investment industry navigate such issues?   Climate change is not a problem that can be solved by holding a different portfolio tomorrow. As alluded to above, it is partly about living with the consequences of, and managing, past capital allocations to high-carbon businesses. It is also about identifying, funding and scaling new technologies; and about adapting to the new policies and regulations that are inevitable. It will therefore be necessary to be dynamic. In a sense, this is saying nothing new – all portfolios have always needed to be managed through time – but we suspect the scale and speed of the required dynamism in future will be a notch or several higher. The working group has already voted to adopt the idea within the exponential roadmap[6] as the foundation for our work in this area. The idea is to halve carbon emissions over the next decade to 2030, and then to repeat that for the next two decades. This is equivalent to a 7% reduction in emissions each year (sustained for the next 30 years). This is the task at the planetary level. Translating this into investment portfolios is work that is yet to be done. We envisage that most of this work will be done within portfolio construction, as described below, supplemented by any insights we might have on the impacts of policy and technology.
     
  • Portfolio construction
    The generic portfolio construction options are already well known. For existing securities, and if you have a benchmark, they are buy / increase weighting; hold; sell / reduce weighting; avoid / not hold at all. At this stage we are including private assets in ‘securities’ but acknowledge that benchmarks are less well defined for private holdings. In addition there is the option to provide new funding (via public or private markets).   Moving portfolio construction on will involve (i) better security analysis, and/or (ii) evolved portfolio construction practice. The work could therefore consider (amongst other possibilities) how to incorporate climate data into discounted cashflow analysis; how to assess ESG-related risks and impact in private equity and venture capital investment; a standardised framework for integrating ESG risks in sovereign bond investment; shifting from strategic asset allocation approaches to total portfolio approaches for better ESG integration. We propose to split the +1.5C portfolio working group into an equity group and a fixed income group to run for the remainder of 2020. Later in the year we will initiate a third group to consider the issues within private markets. During the first half of 2021 we hope that working group members will wish to continue in order to bring these strands together in a holistic, total portfolio manner as we do not believe climate change can be tackled within asset class silos.
     
  • The duty of ownership
    Consideration must start with the structural impediments attaching to a system where small fractional ownership interests do not command much influencing capital. Key aspects here are how collective action could be configured more successfully. We believe the thinking that is developing among large asset owners to address sustainability directly via beta-activism needs to be explored.   Ownership is typically discussed in terms of the rights or benefits accruing to the owner. But could there be obligations or duties attached to ownership? A large part of investment activity takes place under the umbrella of fiduciary duty, and so this work will need to consider whether there is scope to evolve the definition, and/or interpretation of fiduciary duty. The work will then consider what ownership is, and how it relates to other investment activities. From here we can explore how, or whether, owners of capital should assist an orderly and just climate transition. Several questions could be explored here:
    • What can be done about the problems associated with fractional ownership (‘ownerless corporations’ to quote Paul Myners)? Is asset owner collaboration the only approach, or are other options available?
    • What can investment organisations do to clarify their own mission and purpose?
    • What can investment industry do to encourage stronger climate related reporting (eg TCFD)?
    • What does a 3-D (risk, return and impact) investment mandate look like?
    • How do we evaluate, report and manage the impact of our investments?

The work is also to consider what tools are at owners’ disposal to engage with underlying businesses, and whether there are some tools that are more effective than others. This needs to be considered through a multi-asset lens: equity, credit and private markets. The option to divest / exclude is considered here too. Finally, this paper (or section) will suggest what re-imagined ownership could look like.
 

  • Reshaping the real economy
    Returning to the ultimate planetary task, the real economy needs to be carbon-neutral. The natural conclusion to this work is to identify how the investment industry, and its reactions to the climate challenge, might help with this planetary need.

[1] Speech by Mark Carney at Lloyd’s of London, Tuesday 29 September 2015, https://www.bankofengland.co.uk/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability

[2] I would cite Milton Friedman’s idea, that the purpose of a corporation is to increase its profits, as proof that ideas are powerful – and can influence entire economies for decades. Even if the idea turns out to be unhelpful, possibly destructive.

[3] See www.unpri.org/esg-issues/environmental-issues/climate-change/inevitable-policy-response

[4] Visit www.thinkingaheadinstitute.org and search for ‘decision making’ for a number of papers, thought pieces and other materials

[5] Many of these items can be found at our culture, leadership and diversity hub: https://www.thinkingaheadinstitute.org/en/Library/Public/Research-and-Ideas/2020/03/Culture_Leadership_hub

[6] Exponential roadmap, scaling 36 solutions to halve emissions by 2030, https://exponentialroadmap.org/