Marcus Weyerer, CFA, Senior ETF Investment Strategist, Franklin Templeton
- The world remains on a dangerous course for global warming to far exceed the 2°C-limit set in the 2015 Paris Agreement
- For 2030, the greenhouse gas emissions gap is expected to be around 25 GtCO2
- Companies must prepare for escalating physical and transition risks from climate change, but the challenge also presents us with unique opportunities
- Investors looking to decarbonise their portfolios and tilt towards companies better positioned to deal with the necessary changes for a net zero transition, and potentially benefit from them, may consider Paris-Aligned benchmarks as one instrument.
Mind The Gap
Scores of Londoners working in the main financial district known as ‘The City’ hear these three words every morning. They blare through loudspeakers at Bank Station and elsewhere as passengers get ready to disembark from their underground train to make their way to the office, reminding them to be careful not to step into the gap between the train and the platform. Accidents – and worse – are rare but they do happen. However, there is another much more consequential gap that looms large over the financial industry in the UK and elsewhere, and indeed over the entire world economy.
This gap, of course, is related to climate change. To avoid the most catastrophic fallout from global warming, the world vowed in 2015 to undertake measures to limit global warming to 1.5°C to 2°C by 2100 – codified in an international treaty known as The Paris Agreement. Reaching the Paris goals require net zero greenhouse gas emissions sometime around mid-century and likely even net negative emissions thereafter.2 In numbers: The Intergovernmental Panel on Climate Change estimates that humanity can afford to blast just under 400 additional gigatonnes CO2 into the atmosphere to stay within the Paris targets – this is known as the emissions budget. Breaking this figure down to an annual near-term target, it means that in 2030, the world could emit some 33 GtCO2. Current policies mean, however, that the world is on track to emit around 58 GtCO2 in that year. The difference, 25 gigatonnes or 43%, is what is known as the emissions gap.
Why does it matter?
Numbers like these are abstract, but the consequences are real. With the world’s current emissions trajectory, we are set to experience global warming of around 2.7°C, perhaps more.4 Humanity is already witnessing rising sea levels, more frequent extreme weather events, biodiversity loss and other adverse effects that are only going to get worse. The social and economic costs of a warming scenario above 2°C are projected to be immense. A Deloitte report predicts a US$178 trillion hit to the global economy over 50 years if climate change is left unchecked.5,6 Food and water scarcity as well as an unprecedented loss of productivity and employment options could leave people’s livelihoods – and lives – in tatters.
Climate risks to companies today are categorised as physical and transition risks. The former category is again split into two types of hazards, acute and chronic. Acute hazards include weather events like floods and droughts, whereas chronic hazards stem from long-term changes like rising sea levels. Important drivers of transition risks are regulatory changes like tax increases or bans of certain products, but also technological shifts and crucially, changing consumer behaviour and societal pressure. It goes without saying that not all sectors, companies, and even facilities face the same exposure to these risks and therefore exhibit different levels of vulnerability to climate change. Companies’ bottom lines will be affected in various ways, and the economy as a whole will be deeply impacted. Eventually, this will feed through to financial markets and ultimately, investor returns.
Change Brings Opportunity
Just as much as investors should consider risks, there will be opportunities resulting from a changing regulatory environment and consumer patterns. Deloitte’s Global Turning Point Report estimates a US$43 trillion boost to global GDP by 2070 if governments facilitate a systemic net-zero transition.
Modelled economic losses from unchecked climate change
In 2022, the energy transition has been turbo-charged by Russia’s invasion of Ukraine which (sadly) added an element of geopolitical urgency on top of the existing climate argument. While it is true that climate mitigation and adaptation is a costly undertaking, co-benefits of climate action, like public health improvements from dietary changes and better air quality likely outstrip the direct costs. Taking into account climate related damages that could reach up to 50% of global GDP baseline growth in worst case scenarios, make the case for mitigation crystal-clear.8,9 That is on an aggregate level; the outcomes for certain sectors and individual companies will vary much more and produce clear winners and losers.
That is not to say that a company’s fate will solely be decided by how well or poorly it prepares for managing climate risks – but it will undoubtedly be a material factor.
Tilting towards, not betting on winners
For investors, the task of separating winners from losers is a daunting task. One way of approaching the issue is through climate change benchmarks. In 2020, the EU Technical Expert Group on Sustainable Finance issued guidelines on constructing financial benchmarks that align with the goals of the Paris Agreement. The guardrails of the so-called Paris-Aligned-Benchmarks include non-eligibility of certain industries, a mandatory emissions reduction of 50% versus a standard index like the S&P 500 or the Stoxx Europe 600, a 7% annual self-decarbonisation target, and, crucially, accounting for company-specific Science Based Targets (SBTs) implementation. SBTs “provide a clearly-defined pathway for companies to reduce greenhouse gas (GHG) emissions, helping prevent the worst impacts of climate change and future-proof business growth.”10
The Science Based Targets initiative (SBTi), a partnership between United Nations Global Compact, research institutes and non-profit NGOs, describes setting a science-based target as a five-step process:
- Commit: submit a letter establishing your intent to set a science-based target
- Develop: work on an emissions reduction target in line with the SBTi’s criteria
- Submit: present your target to the SBTi for official validation
- Communicate: announce your target and inform your stakeholders
- Disclose: report company-wide emissions and track target progress annually
This process ensures both comparability and accountability, and allows index providers to structure their Paris-Aligned indexes in a way that prefers companies with strong SBTi results. In turn, this enables investors to shift their portfolios towards firms that are potentially better positioned to deal with – and perhaps are even beneficiaries of – changes that result from climate risks, while remaining diversified across sectors and individual stocks. It’s not about trying to find every single winner or selling every loser of the transition. It’s about tilting to and supporting an economy that is better prepared for one of the greatest challenges we have faced.