Capital Climate

Climate science and why it’s important for long-run capital allocation.

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It is now globally accepted that to limit the long-term extent of global warming and its economic and socio-ecological consequences, the world must rapidly transition to a decarbonised economy, beginning now.

In August the United Nations’ (UN) Intergovernmental Panel on Climate Change (IPCC)¹ released its sixth assessment report on the physical science of climate change.

The report shows unequivocally that the main climate driver is the accumulation of greenhouses gases (GHG) in the Earth’s atmosphere which is growing because of the burning of fossil fuels. The main GHG is carbon dioxide, which represents some 70% of global emissions, primarily released through the burning of coal.

Scientists are observing changes in the Earth’s climate in every region and across the whole climate system. Many of the changes observed in the climate are unprecedented in thousands, if not hundreds of thousands of years, and some of the changes already set in motion – such as continued sea level rise – are irreversible over hundreds to thousands of years.

The report shows that we have to date warmed the global temperature by 1.1°C since the mid-19th century. The current global consensus is that we should limit global warming to well below 2°C, preferably to 1.5°C, compared to pre-industrial levels. These ambitions were legally agreed in 2015 by 196 countries in Paris at COP 21².

The sixth assessment report provides new estimates of the chances of crossing the global warming level of 1.5°C in the next decades, and finds that unless there are immediate, rapid and large-scale reductions in greenhouse gas emissions, limiting warming to close to 1.5°C or even 2°C will be beyond reach.

The constraints on the management of climate change are not technological, they are mostly seen as political and social. The main technological challenge is well understood i.e., “Change the way we generate energy.” Already there are a growing cohort of commercially viable renewable alternatives at scale. Smart grids, battery technology and the hydrogen economy all further extend decarbonisation into energy-intensive sectors such as mining, heavy transport, rail, cement and steel.

Applying a hard screen to the JSE on primary producers of fossil fuels would exclude some 12% of the market cap.

Glasgow will host COP26 in November and will provide a sobering lens on government appetite to act on climate change. Countries such as the US, Canada, Japan and China have all pledged to reduce their carbon emissions substantially over the next 10 years.

For investors, climate risk or transition risk is visible at a portfolio level by way of the percentage exposure to primary producers of fossil fuels as well as through the weighted average carbon intensity of earnings and “green revenues” exposure. Alongside this, understanding the relative sector strengths and the quality of strategic management response provides investors with a picture of a fund’s climate-risk positioning. It is of course important to note that simply shifting investments away from climate-exposed counters is not the panacea to managing long-run climate risk. Notwithstanding this, investors can make a strategic call on how to manage climate-risk exposure across their portfolios.

As the depth of climate metrics grows, there is also a corresponding growth in the development and application of climate-aware benchmarks. Most traditional performance benchmarks were not designed with carbon constraints in mind and so it’s no surprise that many of the existing benchmarks have carbon intensity levels that put the world on a pathway to a greater than a 2°C outcome, closer to 3°C or 4°C.

The EU, for example, has published benchmarks for funds that are either 1.5 or two degrees aligned, with specifications for issues such as percentage holdings of primary producers of fossil fuels, carbon intensity level relative to a benchmark and rate of carbon intensity decline on a year-on-year basis. We see growing appetite in the institutional space for such benchmarks and so expect long-term capital to flow toward these climate-aware benchmarks. Alongside this, there is also the growing array of thematic-styled funds that aim to capture the opportunity set associated with green economy transition. These thematic funds have gathered a lot of support in the retail environment of late, and while good opportunities exist, buyers of such funds must be mindful of green washing and green bubble risk.

South Africa’s climate transition is underway and tracking the intersection of science, policy and capital flows will be important for investors in the coming years.

For domestic investors looking to manage their climate exposure, it makes sense to use differing approaches across asset classes and geographies, i.e.:

  • Global Equity. Given the depth of the market, investors could take a hard exclusionary approach or make use of Climate Smart Index products and/or carbon-constrained smart beta products. Lastly, global thematic-styled active products that target beneficiaries of the transition are available. Presently, there’s a growing array of products across the risk-reward continuum. Green-washing risk exists and so it will be important for advisors to keep an eye on the emergence of fund sustainability reporting regulations such as the EU Sustainable Finance Disclosure Regulation (EU SFDR).
  • Local Equity. The South African economy is carbon intensive, principally driven by the emissions released through industrial/chemical process (ie Sasol/ smelters) and emissions associated with the generation of electricity (Eskom). Applying a hard screen to the JSE on primary producers of fossil fuels would exclude some 12% of the market cap. Further to this, over 80% of the annual emission from JSE comes from 20% of the market cap. Simply put, the carbon intensity of the JSE means there are material constraints on the design of 100% decarbonised investments products for the South African market. Investors can presently select from a limited number of local equity products that have hard-coded carbon and climate-risk attributes. Aside from targeted low-carbon products, at a minimum, investors should demand that their asset managers are proactively engaged with climate-change risk.
  • Alternatives. This is the most direct way to get exposure to the renewable theme in the South African economy, an area that is set to expand as set out in the Integrated Resources Plan. Access to these investments has traditionally been limited to institutional investors: however, retail investors could potentially obtain exposure via Reg 28 compliant balanced funds with “green” alternatives exposure. An important item to keep an eye on here is the National Treasury Green Economy Taxonomy work that is underway. South Africa’s work here is consistent with what is happening globally. A taxonomy of this nature will better help policy, and capital and projects to align.
  • Fixed Income. Climate bonds are the most direct way to play the decarbonisation theme in the fixed-income asset class. The growth in climate bonds globally has meant that there are now several climate and green bond index products that are available. Locally, the issuance of green bonds is still nascent, consequently there is not sufficient depth to support locally focused green bond investment products.

Most industry trade bodies in South Africa are pushing government to accelerate climate action. The Presidential Climate Change Coordinating Commission is playing an active role across business, government departments and Eskom. There is growing awareness of the potential for Eskom to access green climate finance as well a growing appreciation of the nascent opportunity associated with our world-class solar and wind resources. South Africa’s climate transition is underway and tracking the intersection of science, policy and capital flows will be important for investors in the coming years.

What is certain is that the race to decarbonise is on and we should anticipate enhanced policy support, shifts in capital flows, and technological disruption. This will have implications for investors over the coming decade and beyond.

¹ Established in 1988, the IPCC is a 195-country strong intergovernmental body, that is self-mandated to provide objective scientific information relevant to understanding human-induced climate change. The work of the IPCC covers the natural, political and economic impacts and risks associated with long-range climate change. The IPCC produced its first assessment report in 1990 and has released updated summary reports every six to seven years. The 6th assessment report comprises three volumes – the first is on the physical science aspects and contains over 14 000 citations and presents the collective work of 234 authors from 66 countries. A total of 78 007 expert and government comments were received. Now in its 33rd year, the work of the IPCC is a multidecade human endeavour that presents the most comprehensive summary of the understanding of climate science.
² COP – Conference of the Parties to the UN FCCC – https://unfccc.int/process/bodies/supreme-bodies/conference-of-the-parties-cop