COP26 is over - how should investors think about it

So, in their private jets the world leaders came, and accused of “blah blah blah” they met, slept (a little) and sampled the local specialities . And they left. Yes cop26 is primarily a talking shop, but global policy signals do matter for long term investors. Amid the usual criticisms of hypocrisy, greenwash, puffery, politicking and weak wording, the dust is now settling on the Glasgow Climate Pact and on a convention that can be spun as either a success or failure. What should investors be taking away from a frantic two weeks of announcements, commitments, pledges and promises?

It's real, it's on the agenda

Many asset owners and asset managers have moved quite far quite fast on climate and Net Zero,?but there remains a significant proportion of the industry that tends to believe that either governments will address climate in isolation from the private sector or that the whole thing is fiction, a transition that exists only in the minds of activists. Cop26 should have firmly shown that neither of those positions is tenable.

There are really 7 areas that matter to investors from cop26

1.?????The Role of the private sector

One of the enduring successes of cop26 may be seen as the intertwining of the agendas of the private and public sector, as epitomized by the “$130 trillion” figure from Mark Carney. Now of course, caveats apply and I do have some sympathy for the argument that this figure is “too big to be credible” – but really this just confirmed what many of us already knew, that the private sector has moved far, fast in its commitment to climate and Net Zero. The question was really, would governments move far enough to support the private sector? In the end I think the answer was yes, just about. With c90% of the world’s GDP now covered by Net Zero commitments asset owners ought to take comfort from these clear policy signals that governments are sending, and have the confidence to commit to aligning their own portfolios if they have not already done so.

I talked in my previous article about announcements from the likes of the Net Zero Asset Managers Initiative, The Science Based Targets Initiative and the Transition Pathway Initiative, none of which grabbed a lot of headlines but all of which do matter for investors.

The thread that runs through these is the idea of looking at the alignment of portfolio companies, of assets. We’re finding this to be the most helpful concept when helping asset owners think about their portfolios from a climate perspective.

We were pleased to see movement on two other under-the-radar things that we’ve been calling for: a focus on harmonisation of a growing global patchwork of standards and reporting criteria which was starting to become problematic, and an acknowledgment of the broader interconnected web of sustainability issues of which climate is but one part.

2.?????Mind the gaps: risk and opportunity

In my week 1 cop roundup I went into more detail about what all the government announcements meant, but this image from climate action tracker probably sums thing up best.

Source: climate Action Tracker https://climateactiontracker.org/global/cat-thermometer/

What matters is there are now 2 gaps to think about, both of which matter to investors as one represents a risk, and the other an opportunity.

·???????The gap from current promises to 1.5 degrees. The idea of limiting warming to 1.5 degrees remains alive, but barely (even according to the biggest optimists). Current promises do not amount to enough. Investors should therefore increase the probability they attach to a damaging “disorderly transition” scenario as policymakers frantically pull levers later this decade in an effort to close that gap.

A key point to bear in mind here is that a 1.5 degree pathway differs significantly from a 2-degree pathway in the amount of emissions reductions required this decade. In that world 2030 is a much more important date than 2050.

One win from cop26 was the request for an accelerated 2022 review of country commitments, which is absolutely the minimum of what’s needed if 1.5 degrees has any hope of remaining on the table. Future updates to NDCs could become flashpoints that signal a disorderly transition and over a time period (the next decade) that impacts nearly all investors. It’s wrong to think that climate change is only a long-run investment risk.

·???????The gap from current policies to the policies that governments have committed to . herein lies the opportunity as a vast transition from fossil fuels to renewable energy has been signalled across the globe over the next decade. In the short term this isn’t about new ideas or technologies, simply a vast rollout of existing well known technology. Effectively it’s a complete turnover of the global economy’s capital stock of energy producing assets. A huge flow of capital however you cut it and in understanding global markets investors are well advised to take into account such huge flows in their own capital allocation decisions

3.?????Coal & fossil fuels

The inclusion of the words “coal” and “fossil fuels” in the final agreement was considered symbolic, and while a final wrangle watered down the wording this seems like an area already being largely anticipated by financial markets and the private sector. This is not really new news in the investment world, many funds have been excluding assets that deal in thermal coal for some time, although that isn’t universal and some portfolios do have non-trivial amounts of exposure. This ought to be a worry, particularly on the debt side of the equation – would you want to be lending money for 10 years to a company involved in coal mining, trading or burning right now? A question for your corporate bond manager.

The same is sort of true for oil & gas, in that a transition away from these sources of energy is not new news, share price performance for most of the last decade has lagged well behind global indices – perhaps reflecting this- ?and new investment in the sector has plummeted.

But there are still important considerations here for investors – the speed of the transition away from oil and gas really matters, and any shift in the mood music will have consequences. Many large oil and gas companies, and projects are transitioning to renewable power and the classic playbook is to use the short term cashflows from selling and transporting fossil fuels to fund the investment in the transition. So far, so sensible, but a forced, quicker transition away from fossil fuels than what these management teams expect could challenge this model. Remember that to keep 1.5 degrees on the table it’s the emissions pre-2030 that matter more than anything.

But with the opposition we saw at cop26 to clear statements on coal phase-out, it’s hard to see a global compact on this anytime soon.

The message from several quarters at cop26 was : “the investment case for high-emitting infrastructure is rapidly collapsing” if true, this would matter to asset owners who have made long term commitments to infrastructure funds which do typically contain high-emitting assets. But of course the inverse is also sort of true: if there is a collapse of investment in the future it may increase the value of current producing assets like pipelines that funds already hold.

A piece of analysis by Goldman Sachs got plenty of airtime during cop26 as it shows what many market participants have long suspected in that the cost of capital of new oil projects has soared above 20% while that for renewables has fallen below 5%. What didn’t get mentioned so much though is that this is a really double-edged sword for investors – highlighting the potential attractiveness of oil projects, and we may we see more of these cropping up in the private markets away from the scrutiny of public markets shareholders. Any such projects would have material stranded asset risk so investors would be wise to be aware of this.

A falling cost of capital for renewable projects is broadly good news but we should want to see this settle around a sustainable level with supply and demand balanced in a way that attracts the flows of capital that are needed. We see huge potential demand for renewable energy assets from investors at the right risk return levels.

A final reflection on this part is that while many in investment might consider the “divest or engage” debate on fossil fuel companies to be yesterday’s discussion, this is really not the case when it comes to the wider public and there needs to be substantial work to be done with underlying members and fund unit-holders to land an “invest and engage” approach over one that simply divests the assets.

4.?????Emerging markets are on a different path

As I predicted at the start, the question of equity and fairness between developed and developing countries was a clear point of tension throughout cop26 and the failure to really get an agreement on adaptation and loss-and-damage finance to developing countries that really satisfied all parties cast a long shadow over the second week of proceedings.

It is worth reminding ourselves of a few important points: viewed on total cumulative emissions China ranks only 3rd globally (behind the US and the EU) with India far lower. Cumulative per capita changes the picture yet further. Asking emerging markets (who have not yet peaked emissions) to hit Net Zero by 2050 is asking them to embark on a far more ambitious decarbonisation program than what developed markets have been on (the UK and Europe peaked emissions in 1990, so have 60 years from peak to Zero). This matters, and asking developing countries to apply the same standards as developed countries is likely to end in failed agreements.

What all this means for investors is a need to look carefully at emerging market assets and take a nuanced view. You can’t apply the same criteria to these countries and assets as the developed world, and indeed providing transition finance into these areas could be one of the more meaningful things investors can do. Steering away from emerging market allocations because you don’t like the look of the emissions numbers is not good thinking.

Real change in emerging markets is still possible though, the South African coal deal shows what progressive policy can look like.

5.?????Net Zero

Net Zero by 2050 remains the investor-standard for action. And this is important as one of the key things that investors can do to actually have an impact is to set clear standards for portfolio companies. These are far more effective if they are collective so that companies have a consistent idea of what they need to aim at in order to be investible. Many asset owners have made Net Zero commitments and the policy signals at cop26 were just about enough to given them confidence in proceeding with them. For those that have not yet done so this may provide the comfort they need. 1.5 degree aligned pathways are the standard for this , with targets for the next 10 years vital, as for 1.5 degrees 2030 becomes the key date, not 2050.

Net Zero is not without its critics of course, it is not a panacea and can be easily mis-applied. But to paraphrase the famous Winston Churchill quote on democracy it might be better than all the other approaches that have been tried.

6.?????A Carbon price?

Most economists agree that a global price on carbon would be one of the most impactful policy steps in addressing climate change, by “internalizing” the un-priced externality, and thereby creating a market mechanism to encourage the more efficient use of emissions. More detail on why that is here

A carbon price would also be huge news for investors as this would really bring emissions to the fore as a risk that could hit the bottom line of portfolio returns.

Well, the second week of cop26 did deliver success on the completion of the previously unfinished article 6 of the Paris agreement which sets the rules for?a global carbon market. I do think this is important news, although much of the details appear so arcane and technical that even the subject matter experts are still processing what it means. The best writeups I have seen so far are from Bloomberg Green and Reuters It doesn’t lead to a global carbon price in the short term, but it signals that this is on the cards longer term. It’s an outline of how things might work, which resolves a couple of long running standoffs on key issues.

?Some companies (such as Microsoft ) already use an internal carbon pricing system which allows capital to flow easily to emissions-reducing activities, some large investors are starting to do the same, this is surely the future.

For sectors where offsets play a large part in their Net Zero plans (eg airlines) there is also important news here as the rules governing offsets look set to become more globally consistent and robust – which is to be welcomed as the fragmented and self-policed system that was developing lacked robustness to put it mildly.

7.?????Methane and deforestation

The multi-party agreements struck during the first week of cop26 on methane and deforestation are things that investors need to reflect on and check they are building into their stewardship criteria in the relevant sectors (eg oil & gas, agriculture, food, commodities). One big gap we tend to see in the investment world is on stewardship, and investors would want to ensure they are at least conducting their stewardship in a way that supports these commitments and votes against the boards of companies that are not in sync.

The deforestation point broadens the discussion to a broader biodiversity perspective which is makes sense and is good news considering the interconnectedness of many of these sustainability issues – asset owners ought to take note and widen their focus to a broader sustainability perspective.

Success or Failure?

Hopefully it’s clear that with so much detail, a more nuanced position is warranted than a simple binary view. And the perspective might be different depending on whether you reflect on the early, multi-party side-deal agreements of week 1 (which lacked full consensus but were genuine advances) or the final agreed-upon text which had almost all the material points of ambition taken out or watered down.

It is useful to take a look at where we’ve ended up relative to what we thought was important going in. Bloomberg journalist Akshat Rathi has been consistently providing the best ways to think about cop26 and here are his 5 success criteria going in:

On this basis I would only score 2.5 or 3 out of 5.

1.?????Update Paris pledges – FAIL/PARTIAL. New pledges did not keep 1.5 degrees on the table, this was only achieved by kicking can down the road which cannot be regarded as a win

2.?????Global carbon markets – SUCCESS

3.?????Finance: $100bn for poorer nations – FAIL: a re-commitment to a decade-old and as-yet-undelivered promise didn’t hit the benchmark here and surely overshadowed the second week

4.?????Cut methane – SUCCESS: the multiparty side-deal agreement in week 1 was a promising starting point for this

5.?????Coal – PARTIAL: the multiparty agreement in week 1 to end coal financing looked like a win on this front, but the watering down of the final text somewhat took the gloss off this one.

ECIU seem to broadly agree with this take (you should read their excellent summary ) - that the sector side-deals, overall momentum and Paris rulebook completion are all real positives. Bloomberg Green also see the overall outcome - compromised as it was - as better than what was expected -read their take here . George Monbiot, writing in the Guardian was more negative - making the point that it is a little too late now for incremental change. Thinktank e3g welcomed the deal as throwing a "lifeline" to 1.5 degrees but emphasised that it all depends on actions in the next 12 months. Carbon brief have written the most epic of summaries - excellent as a reference piece that really gets into every single issue of importance.

Finally, market reaction has ben hard to discern clearly, so either markets feel it was already priced or wasn't market moving. But looking deeper there has been a bit of a slide in coal miners and coal-users, particularly in emerging markets, and the EU ETS carbon price hit a new high.