Can you tell us a little about the concept behind the 2° Investing Initiative?
After the 2008 financial crisis I noticed two things. First, the ensuing regulatory debate highlighted the unintended consequences of financial policies for the real economy. Secondly, climate and energy research were pointing to a financing gap for green technologies and a “locked-in” effect of fossil fuel investments.
I had been working as a consultant with large corporates and the finance sector, but felt frustrated by an inability to break silos. This led me to found 2° Investing Initiative. Our aim is to connect the dots between climate goals, investment decision-making and financial regulation. We initiate collaborative public-private projects, and coordinate the work of governments, central banks, financial institutions and research organisations, in order to deliver the metrics, the data, the tools, the standards and the public policies needed to address the 2°C climate goals.
How is technology driving change?
For the financial industry, energy transition is primarily a bet on how fast we will transition to renewables and electric vehicles (EVs) for example, and which technologies will emerge to address high polluters such as aviation and cement production.
And with this comes possible scenarios – what will the fuel mix be in the power sector, the share of EV vs Internal Combustion Engines (ICE), the cost curve in oil, etc? However, sector classifications (e.g. Industrial Classification Benchmark and Global Industry Classification Standard) and mainstream financial analysis do not reveal how investors are betting. This is where 2°C scenario analysis for investment portfolios can be useful. An investor can take the assets and investment plans of energy-related companies (e.g. oil and gas, power, auto, aviation, heavy materials) in a portfolio and compare these with the 2° technology-specific roadmap of the International Energy Agency, and then see whether he / she is implicitly betting on a 2°, 4° or 5°C future and take appropriate action (e.g. reallocate portfolios, engage with investee companies).
This level of analysis is possible thanks to business intelligence databases that gather geolocated forward-looking asset-level data (e.g. capex associated with a power plants, production plans of car makers by model, order books of aircraft manufacturers, etc.). In the future, thanks to big data analytics, open data (e.g. public registry of permits for power plants), and data collection by satellite – the availability of asset-level data will increase exponentially and will likely complement or even replace data from corporate disclosure, which is today the main source for ESG analysis.
COP21 was seen as a game-changer – what is the next milestone in combating climate change?
The Paris Agreement provides a common goal – limiting global warming below 2°C - and an international framework to gradually increase the ambitions of the national contributions. Interestingly, the Agreement now expects contributions from non-state actors such as companies, investors, and cities. This dimension becomes even more critical with the withdrawal of the US from the Agreement.
The next step is to create a framework to define, foster, consolidate and track these contributions. 2° Investing Initiative has just signed a partnership with the United Nations Framework Convention on Climate Change secretariat (the UN body in charge of climate negotiations and monitoring) to develop this framework and a global web-based platform that will track the alignment of assets and investments with the 2°C target.
Which asset classes or parts of the financial services sector are best positioned to support energy transition?
Now that’s an interesting question. At the moment the focus is on the financial industry needing to 'shift trillions’ from brown to green financial assets, in order to create that same shift in the real economy. That focus on 'big figures' is leading investors to focus their attention on large liquid asset classes (e.g. divesting from coal-related stocks, investing in green bonds).
However, the reallocation of individual portfolios in liquid markets has very limited impact on asset prices. As a consequence, the impact of investors’ climate actions on the cost of capital for issuers and their influence on the issuers’ investment decisions (e.g. invest in a coal-fired power plant or renewables) is likely to be very limited to non-existent.
Investors can play a much more critical role when they influence investment decisions in early stage technologies and projects. Ultimately, venture capital, private equity and infrastructure represent smaller, 'less headline-grabbing' amounts but are far more strategic.
The use of shareholder rights is also critical. Today most energy-related companies have capex plans and R&D expenditures that are misaligned with climate policy-goals. In many cases, they do not have a strong rationale to justify this, and they operate in sectors with a track record of underestimating disruptive energy-transition trends (renewables for German utilities, shale gas for US coal mining, EV for car makers, etc.).
Investors are therefore in a position to make 2°C investing the norm. An interesting figure in this respect is that about 60% of retail investors declare they want to contribute positively to solving environmental problems with their savings. This figure even reaches 70% for millennials.
Today most climate-related shareholder engagement focuses on disclosure. We are now working with large asset owners to help them focus on changes in investee companies’ investment plans.
If you were going to redesign the concept of ESG, how would you approach it?
Actually, we are currently addressing this challenge in the context of the High-Level Expert Group on Sustainable Finance, set up by the European Commission. From a policy-maker perspective, the concept of ESG integration is confusing because integrating ESG factors into investment decisions is still not an objective.
Let's take energy transition as an example. There are two different goals related to investment strategies:
These two goals require different metrics, different tools and different policy actions but are usually mixed together. The Task Force on Climate-related Financial Disclosures (TCFD) recommendations are a prime example.
The same applies to ESG approaches more broadly. The social and environmental criteria are primarily selected because they relate to externalities that investors are more or less expected to internalise on moral grounds. However, when they integrate ESG criteria the actual objective pursued by these investors is, in many cases, unclear.
As a consequence, most ESG investment strategies are not designed to make a difference in the real economy, even though the social or environmental impact is what the beneficiary cares about. As a response to this gap, many ESG managers present their approach as a way to mitigate financial risks related to social and environmental factors that could be mis-priced by the market, because of their long-term nature.
However, in this case, there is no reason to ignore other long-term disruptive trends (such as automation and artificial intelligence) that are not related to social or environmental factors, but would be relevant for such a long-term risk focused approach. It is a challenge to the consistency of the approach. Ultimately, I think SRI investors will have to clarify their goals which will probably lead to different approaches, labelled differently.