Despite the clear need for their involvement, finance-industry players currently remain largely disengaged from the investment needs of the low-carbon economy. ‘Carbon risk’ and ‘climate performance’ are two relevant approaches the finance industry can take to effectively address the climate challenge.

Limiting climate warming to 2°C above pre-industrial levels1 will not be possible without the financial sector’s involvement. Climate-aware investment occupies an increasingly central place in both international negotiations and the specialist literature. As the IPCC emphasises,2 reallocating capital to the low-carbon economy is a key challenge. Unfortunately, private investments currently remain largely disengaged from the energy transition movement (Morel et al., 2014), creating the risk of a disconnect between the financial markets and the real economy.

And yet, through the choices it makes about how capital is allocated, the financial sector could meet the investment needs of the low-carbon economy. As we see it, there are two ways the finance industry can take the climate challenges we currently face on board. The first approach is based on including ‘climate risk’ as part of standard financial decision-making processes, by incorporating the concept within the traditional risk analysis models. This approach is underpinned by a purely financial rationale – the drive to maximise returns – and yet many obstacles remain in its path and need to be removed. A second, more proactive approach involves adopting objectives which would ultimately encourage a high level of ‘climate performance’ – a strategy, it should be noted, that largely pertains to public-sector actors and the responsible investment sector, at least in the first instance, although it has the potential to interest the wider investment community, too.

Carbon risk – from specific assets to the whole financial system

The financial risk associated with climate change can come from changes to the climate itself – the impact of changing rainfall patterns, changes in the frequency and intensity of extreme events, rising sea levels, etc. – but also from the regulations adopted to combat climate warming. ‘Carbon risk’ (ADEME and OTC Conseil, 2011; 2° Investing Initiative, 2015 and WRI & UNEP-Fi, 2015) encompasses all the risks associated with the transition towards a low-carbon economy: potentially more stringent regulations governing CO2 emitting technologies, changing consumer habits, reputational controversies, legal actions, etc. Carbon risk mainly materialises in relation to physical assets, but can extend throughout the investment chain. Consequently, corporations, financial institutions, governments and civil society can all find themselves exposed to it.

The carbon risk concept is linked with two other concepts: stranded assets and the carbon bubble. In order to limit global climate warming to 2°C above pre-industrial levels we need to keep greenhouse gas (GHG) emissions below a certain threshold. Yet the fossil fuel reserves proven to date exceed this estimated quantity by at least a factor of three (Meinshausen et al., 2009; McGlade and Ekins, 2015). Keeping climate warming under the 2°C limit means that these reserves cannot all be used: a large proportion of them will need to remain underground. These ‘stranded assets’ will become obsolete and will need to be devalued by the companies holding them. As the financial valuation of oil companies is partially based on these assets, the whole of the fossil energy sector would then be endangered – a crisis that could spread across the entire financial industry. This is what is called the ‘carbon bubble’.

The ‘stranded asset’ concept – relatively well documented now with respect to energy production – could also apply to any kind of industry or infrastructure dependent on fossil fuels (airports, motorways, etc.). The risks associated with fossil-based industrial assets are beginning to be studied seriously. Ratings agencies are undertaking analyses and research studies assessing carbon risk and the physical risks relating to climate change. If this trend continues, climate risk exposure will become a credit rating factor in its own right. At the level of projects or companies, therefore, the risk is significant. With respect to financial institutions the question remains open. Are the risks sufficiently concentrated to jeopardise the stability of a bank’s balance sheet, or of the financial system as a whole? A study by the Mercer consultancy group (2015) identifies the significant impacts of various climate scenarios on investment portfolio profitability and risk. The recent mobilisation of the financial regulators in this area, and recent announcements by governments – the G7 announcing that GHG emissions from fossil fuels would be phased out by the end of the century, for example – continue to come down on the side of those financial institutions which believe that the transition to a low-carbon economy is currently getting under way and that they need to anticipate its effects.

Obstacles and outlook

Most of the carbon risks mentioned here are not as yet material enough to play a significant part in standard investment decisions. Yet other factors, too, lie behind the lack of consideration accorded to these risks (Figure).

Even though they are increasingly significant and well-documented, carbon risks tend to be expressed over the medium or even the long term (10, 20, 50 years) – whereas investors, even those with long-term liabilities like pension funds and insurance companies, have a much shorter time horizon (between one and five years). Investors therefore tend to overweight short-term risks relating to market volatility and to underweight medium-term economic risks, including those arising from climate change. Expanding investors’ time horizon is therefore probably the first crucial step in order to promote investment processes aligned with the climate challenges we face. Other obstacles are also worth highlighting. Funds practise ‘passive management’, for example, which means tracking an existing index (such as the S&P 500) and therefore investing in the largest corporations. This practice gives an excessive weight to fossil fuel sector securities, oil in particular (2° Investing Initiative, 2014), compared with their importance in the real economy. Additionally, portfolio managers sometimes limit the concept of their fiduciary duty – the obligation to act in the best interests of their clients, the shareholders – to maximising the profitability of their investments. The work of organisations like ShareAction and the Asset Owner Disclosure Project, along with initiatives to promote transparency – notably from the British government – are gradually helping to overturn this perception by showing that taking climate factors into account is fully aligned with beneficiaries’ long-term interests. Finally, financial regulation, by focusing on short-term risks, can represent an obstacle in itself – or at any rate fail to encourage to take climate risk into account.

So does this mean that we should be stopping all investment in fossil fuel sectors? This is the argument proposed by the militant divestment movement, which originated in the United States and advocates disinvestment from fossil fuels. Supported by various groups, including the NGO 350.org, this movement is gathering momentum in continental Europe, calling on investors, especially public-sector and responsible investors (religious communities, universities, NGOs, municipal authorities, etc.), to divest their investments in the fossil fuel sector. In June 2015, the Norwegian parliament voted for its government pension fund – the world’s richest sovereign wealth fund, with USD 900 billion of assets under management – to withdraw from the coal sector.3

What holds true for the energy sector can be generalised across all sectors which have a significant impact in carbon terms: corporations’ production techniques involve energy technologies with higher or lower levels of GHG emissions. Energy diversification involves measuring and managing a portfolio’s exposure to these technologies. A high level of exposure to oil companies, for example, can be ‘offset’ by exposure to post-oil technologies: electric vehicles, organic substitutes for plastic materials, etc. Finally, a diversified portfolio that anticipates the economic changes driven by climate change will also help to finance the energies of the future. In this way it also has the potential to exert a positive impact on the economy’s capacity to meet the current climate challenges and leads us on to the concept of climate performance.

Towards climate performance

With the concept of climate performance we move beyond a strictly financial perspective and ask ourselves about the impact of investment decisions on the economy, and, via the economy, on climate change. ‘Climate performance’ here is defined as a contribution to financing the low-carbon economy, helping to limit GHG emissions and therefore also to limit the extent of climate warming.4 There is no single measure of a company’s climate performance – even less so, therefore, of an investor. Evaluating this performance depends on the specific objectives defined: financing the energy transition, helping companies reduce their emissions, withdrawing finance from the most highly polluting projects, etc. Depending on the particular strategies involved, it might be relevant to analyse – and potentially to combine – three kinds of indicators: the GHG emissions of companies or projects; exposure to green sectors or technologies compared with exposure to polluting technologies; a climate ‘rating’ obtained by various methodologies incorporating elements that are otherwise difficult to quantify (such as the existence of a strategy for reducing GHG emissions, for example).

The leading strategy adopted by investors at the current time involves ‘decarbonising’ portfolios by reducing the total quantity of GHGs emitted by companies represented in the portfolio. This method provides an indicator that is simple and quantitative – and therefore by its nature comparable – but does not provide a way of measuring the positive impact of financing itself. In highly liquid markets (equities, bonds) it is virtually impossible to isolate the effect of any investment decision and to know what would have happened if that decision had not been taken. To complement these existing approaches, therefore, new methods propose taking the future as a starting point: what needs to happen for us to achieve a low-carbon economy? Based on these ‘2°C scenarios’, climate performance becomes the alignment of an investment or loan portfolio with the financing needs identified in these scenarios.

2°C scenarios and performance indicators

Approaches based on alignment with these scenarios reflect the transformative aspect of energy transition: the low-carbon economy will not simply be identical to our current economy with lower GHG emissions. It will be a different economy altogether, bringing with it different price equilibriums and various rebalancing effects between sectors and technologies. Two methodologies are currently under development.

The first is based on trajectories for reducing GHG emissions: in order to limit climate warming, each economic sector needs to reduce its emissions at a relatively faster or slower rate, depending on the technology barriers and changing demand patterns that apply in each case. The ‘Sectoral Decarbonization Approach’ (SDA)5 sets targets for each company according to the carbon budget allocated to its respective economic sector. Significantly more sophisticated than a vision which would allocate a single target to a whole portfolio, this approach invites investors to make choices within a particular sector rather than merely trading off low-emission and high-emission sectors against each other.

The second approach6 involves measuring the alignment of portfolios with 2°C scenarios. Here, the issue is no longer to ascertain how much or how little CO2 the companies financed are emitting, but rather whether the assets they own (power stations, raw materials, plants, technologies, innovative patents, etc.) are necessary, compatible or incompatible with the emergence of a low-carbon economy. Under this approach, ‘climate performance’ for the financial sector involves financing what is necessary and not financing what is incompatible. Investors cannot know exactly how far they, individually, have contributed to the financing of new activities, but they know that if everyone operated in the same way the financing of the low-carbon economy would be assured. Finally, and here we circle back to the subject of financial risk, they are removing from their portfolio any assets that could not survive over the long term if credible climate policies are adopted worldwide.

Risk and performance represent two different dynamics, which converge at some points and diverge at others. They both have the potential to mobilise different elements of the financial sector, according to their respective priorities. And now the growing momentum driven by twenty or so initiatives involving more than 400 investors worldwide7 is being backed up by regulatory changes, too. In France, article 173 of the law on energy transition and green growth, passed in August 2015, requires institutional investors to evaluate and make public their exposure to climate risks, their carbon footprint and their contribution to furthering the international goal of limiting climate warming. Ultimately these two dynamics, risk and performance, enrich and reinforce each other. We contend that in a few years’ time both will be widespread across the entire financial sector.

Footnotes:

1 In order to limit global warming to 2 °C and adapt to the changes this brings, the World Bank estimates that developing countries will need USD 75-100 billion per year over the next 40 years and that the cost of mitigation measures will be between USD 140 billion and USD 175 billion per year by 2030.
2 The Fifth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC, 2014) devotes an entire section to investment issues.
3 This decision effectively means divesting around 100 investments worth an estimated total of USD 9 billion, i.e. nearly 1% of the funds under management.
4 Here the concept of performance refers not to financial return but to the impact of the financial sector. Similar terms such as climate impact or climate-friendliness might also be used.
5 ‘The whole methodology is freely available on this website:http://sciencebasedtargets.org/methodologies/
6 This approach is explored in the SEI Metrics project supported by the European Commission and coordinated by 2° Investing Initiative (2015-2018).
7 The Investors on Climate Change platform, at http://investorsonclimatechange.org/, lists all these initiatives.

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