Cop26 week 1 - quick take for investors

It's been quite a week with announcements and press releases coming thick and fast. I'm taking stock and trying to summarise where we after the first week, and asking the question: is cop26 a success so far? And, importantly - so what should investors make of it?

One of the key points I tried to highlight on the way in to cop26 was the balance between public and private sector announcements and action. I believe the private sector in the UK and Europe has gone quite far quite fast in terms of commitments and does need policy structure from governments to deliver on these. The private sector can't get out too far ahead of governments without their commitments falling apart and this is a risk. I don't think we're there yet but there was interesting evidence of this public/private dynamic in the first week of cop26.

In fact, I think it may be likely that cop26 is remembered as a success precisely because of the extent to which the private sector "came to the party". It has been referred to as "the most corporate cop ever", maybe that's a good thing?

We saw this dynamic a little with the finance announcement on wednesday with the huge $130trn numbers being announced by Mark Carney (I know, I know, caveats apply). While perhaps eye-catching for some, in the finance sector this wasn't new news, the existence of that level of commitment is well known.

Let's take some of the government actions first:

Action: Governments

Main goal: Higher NDCs & “Keeping 1.5 degrees alive”

What was announced:

New government (“NDC”) commitments brought to cop26 meant that a majority of Paris agreement signatories DID upgrade their commitment level since 2015

But, taken together the commitments do not yet add up to a credible overall 1.5 degree pathway (at the most optimistic end taking into account all pledges you can just about get to 2 degrees, which is an improvement, but not as far as 1.5)

But a commitment statement and acceleration mechanism of future NDCs may keep this on the table (watch out for that in the second week)

Important note: 1.5 degree pathways are much more sensitive to emissions trajectories this decade, 2030 really becomes the key date in these strategies, not 2050

Investor takeaways:

• "disorderly transition" scenario becomes a little more likely as more extreme action may be triggered later this decade along with pricing / sentiment shock in markets
• 1.5 degrees is the global standard for action so investors should align targets with science-backed pathways to 1.5 (as most already are) BUT
• At the same time, with less 1.5 degree aligned economies, we are going to see less 1.5 degree aligned companies therefore it will be harder/slower to achieve 1.5 degree aligned portfolios
• Despite falling short of 1.5, new NDCs still signal a vast shift to renewable energy over the next decade, that's the first and biggest leg of most of these transitions: huge flow of capital happening
• Care needed in emerging markets with a need for realistic Net Zero plans reflecting the different trajectory in EM
• ?Increased risk to sectors more exposed in a world where an accelerated 1.5 degree path becomes likely: shipping, airlines, steel, aluminium, cement. Maybe we start to see more differentiation between aligned and non-aligned companies in these sectors
• Lots of work to do to get sector-specific stewardship working properly in alignment with latest Net Zero thinking and all the sector specific announcements at cop26. Recent reports have been a reminder that most large asset managers still support the status quo in non-Paris aligned companies.

Potential investment winners and losers from announcements & agreements so far at cop26

• Increased risk in fossil fuels and mining sectors?
• To some degree this is already known and probably priced in at least in part because it is not really new news: a transition away from fossil fuels has been on the cards for a long time, perhaps partly why energy stocks have lagged the market so massively over the last 5 and 10 years. But the devil is in the detail, perhaps the rhetoric and pledges at cop26 add to the urgency of this, starting to build momentum behind a faster and steeper shift and that does matter. Those fossil fuel investments relying on bridging between current and new world (using cashflows from fossil fuels to fund renewable development, which is quite a common theme I see eg Shell) look increasingly vulnerable if 1.5 degree commitments are stepped up and “sunsetting” of fossil fuels starts to begin earlier this decade.
• Public markets might well already be reflecting this but I would be increasingly concerned with private markets (eg infrastructure equity and private debt, particularly distressed debt) where projects that can no longer be owned by listed entities are likely to end up - as suggested by Larry Fink. The rates of return may look high, but the key question here for asset managers is are you really taking a fully-informed view of the risk in these assets. In this atmosphere, things could change quickly at a future cop.
• One area where maybe climate action has been accelerated a bit is in the US, where corporates have not on average focused on this as much as in Europe (some US corporates absolutely have, but you tend to see a bigger spread than in Europe), and there are some high profile laggards with no climate policies (Berkshire Hathaway is a commonly cited example but there are others). One result of cop26 might be more momentum among US companies.

Net Zero

What was agreed:

?A lot of new government Net Zero pledges were made around cop26. Net Zero tracker now shows commitments covering 90% of GDP and 85% of population.

There was a lot of variation around what was being pledged in those Net Zero announcements, particularly regarding end date (China 2060, India 2070) – previously Net Zero commitments have gravitated around 2050 particularly in the developed world

Takeaways for investors:

• Most asset owners have aligned around a 2050 Net Zero date and this remains the standard in the developed world
• Asset owners should continue to feel confident putting in place a Net Zero policy within their investments , as this is the direction governments and economies are moving in so much (but maybe not all) of the “work” there will be done by a general market shift toward Net Zero
• If asset owners expect to have large emerging market allocations over the long term this might call into question a 2050 net zero date if these economies are not supporting that date
• Regardless, the end date of a Net Zero commitment is not as important as it first appears. What is more impactful is the reductions being made this decade pre-2030, so don’t focus too much on the date

Fossil fuels

What was agreed:

Multiparty agreement to end overseas fossil fuel project funding to new projects from development banks

A multi-lateral push to “make coal history”

Open question with regard to gas and oil – some reports and speeches starting to advocate for earlier phaseouts of these than current policies / government positions indicate eg “Gas is the new coal”. The debate around the Cambo oil project typifies this

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

Takeaways for investors:

• From an investor perspective an end to coal feels like it is already priced in and other listed fossil fuel assets probably accurately reflect some sort of transition already so in some ways this is not new news.
• However a position of no new projects at all would probably be a step up in the pressure on fossil fuel companies and represent a faster-than-expected flow of money away from broader fossil fuels
• Still early days for this trend, but one to watch
• For infrastructure investors to pay particular attention to new investments to understand the level of stranded fossil risk being taken on if this theme accelerates
• This could have counterintuitive impacts –

o??If development banks step back from funding these projects this could push up the cost of capital and therefore the returns available to other capital providers such as the private markets or other sovereigns not committed to the agreement

o??Research by Goldman Sachs (below) suggests that the cost of capital (and hence returns) to new oil exploration projects have already been pushed up to c20% p.a. over recent years

o??It might increase the value of existing, incumbent assets such as pipelines if new projects become untenable

Source: https://www.goldmansachs.com/insights/pages/gs-research/carbonomics-gs-net-zero-models/report.pdf

Deforestation

·??????An agreement to end deforestation was signed (with some critics)

• Investor takeaway: make sure stewardship and engagement policies & redlines in relevant sectors are aligned with no deforestation
• Particular attention likely to be paid to food and commodity sectors, and perhaps those with supply-chain influence over deforestation such as supermarket retail

Coal and methane

Agreement to end financing of coal plants by more than 40 countries

?Agreement to cut methane 30%

These were significant positives that should rightly be logged as successes for cop26 (considered by some as a minimum threshold on the way in), they represent the lowest of low-hanging fruit to keep 1.5 degree on the tables

• Investor takeaway: make sure stewardship and engagement policies in oil and gas sector are aligned with these new commitments
• For example, Net Zero Asset Owner Alliance has signalled it will invest in line with a phasing out of coal by 2030 and 2040.
• I think broadly that’s where investors were already, so I would see this more as a necessary government commitment to allow investors to make good on their existing commitments

Private sector actions

Science based targets initiative bolstered with new Net Zero standard

• Essential to set standards and maintain trust in the system
• Bolsters science based targets as a key standard setter with clear use in Net Zero programs for asset owners

Net Zero Asset Managers Initiative bolstered with new signatories and progress report (criticised by Share Action for low %s of asset committed to Net Zero)

• ?Majority of those reporting interim goals use IIGCC Paris Aligned Investor Initiative framework, adding credibility to this as a standard setting framework for Net Zero
• Reported percent of assets within the commitment initially ranges from 12%-70% with an average around 35%
• This is lower than expected but the bar set for joining was never high, so the criticism is fair, but this is a minimum standard not a gold standard.

Transition Pathway Initiative to expand coverage to all sectors

• Another crucial tool (publicly available) designed for investors to help align portfolios
• Investors consider how to build this into target setting

Regulations announced for UK companies to publish transition plans to Net Zero by 2023

• This supports the existing direction but probably doesn’t change things radically as this was already very much the direction. Eg 60% of the FTSE 100 had Net Zero targets albeit only 25% of these were actually robust enough to be signed off by the SBTi
• A key issue is standardising of Net Zero commitments and asset owners being clear on what a robust, credible commitment looks like compared to greenwashing

COP26 success criteria source Akshat Rathi / Bloomberg

Overall - it looks to me like 3 of 5 key success criteria can be fairly claimed as being hit from the first week, although the two biggest and most significant remain