The United Nations Climate Change Conference (COP26) attracted plentiful interest and media coverage during the final quarter of 2021, as prominent world leaders convened in Glasgow, Scotland, to accelerate action towards the goals of the Paris Agreement and the UN Framework Convention on Climate Change. Given that several months have now passed, it is a good opportunity to reflect on what was promised and what is being achieved. How is this influencing the companies and funds we invest in? And, particularly around net zero ambitions, what more should we expect?
Glass half full?
There is a sizable degree of subjectivity when analysing the success of COP26, as is often the case when reviewing events of this ilk. Those who took a glass-half-full approach will point to the reaffirmation of the Paris Agreement goal of holding the increase in global average temperature to well below 2 degrees above pre-industrial levels and pursuing efforts to limit the rise to 1.5 degrees. A clear highlight was the fact signatories recognised that limiting global warming to 1.5 degrees requires rapid, deep and sustained reductions in global greenhouse emissions, including reducing global carbon dioxide emissions by 45% by 2030, compared to 2010 levels.
What is more, two of the most damaging fossil fuels in use, coal and methane gas, were specifically targeted by pledges under the new deal, the Glasgow Climate Pact. Over 190 countries agreed to reduce their use of coal for power generation and around 100 countries committed to reduce methane emissions by approximately 30%. Also, more than 130 countries, accounting for over 90% of the world’s forests, made pledges against deforestation, agreeing to halt and reverse the process by 2030. The private sector also made significant commitments, with over 450 financial institutions, overseeing more than US$130 trillion of assets, pledging to align their portfolios with the goal of achieving net zero emissions by 2050.1
That said, those who were less enthused with the outcomes of the conference would argue that while progress was made, the agreed upon measures lack the requisite size and scope to achieve the stated goals. Although the 1.5 degrees target was kept alive, the commitment to deeper emissions cuts has been kicked down the road to the next COP. Simply put, the longer the delay in implementing these cuts, the deeper they will need to be. Notably the IPCC report published on 4 April 2022 has stated that emissions must peak in 2025.2
Despite conference president Alok Sharma urging countries to consign coal to history, late interventions from China and India saw a commitment to “phase-out” its use reduced to “phase-down”. Furthermore, the largest users and extractors of coal, including China, India, Australia and Russia, didn’t explicitly pledge to reduce its use significantly. Progress on climate financing was also underwhelming. An estimated US$140bn will be needed to make the transition and put in place adaptation measures, and pledges in the region of US$100bn were shy of the total amount.
1 Figures source: COP26-Presidency-Outcomes-The-Climate-Pact.pdf (ukcop26.org)
2 Figures source: Climate Change 2022: Mitigation of Climate Change (ipcc.ch)
No show from China
The absence of high-level representation from China attracted several negative headlines and was perceived by some as suggestive of a lack of ambition and commitment, but there were mitigating circumstances, with Xi Jinping dealing with an energy crisis not too dissimilar to that currently facing Europe. Though the lack of centre stage participation will be noted, China is making significant progress in renewables with ambitious plans to completely change its energy mix and reduce carbon emissions. Global investments into renewable energy increased 30% in 2021 to circa US$750bn, with China accounting for around a third of the total spend and double the expenditure of the United States.
The investment perspective
Overall, the response from asset managers has been mixed but positive. Most highlighted disappointment around topics such as coal, but generally there was a more optimistic feel than usual. They have aligned themselves with the glass-half-full crowd and perhaps, due to a desire to be seen as part of the solution, those harbouring negative views have largely kept quiet. A lot of the larger managers were active in promoting and participating in the event as well as deciding to join initiatives, such as net zero, in the run up to the conference. One shortcoming with the approach of most managers, as well as many large companies, is the targeting of carbon intensity, rather than an absolute figure. As carbon intensity is measured per unit of revenue, it is quite feasible that a company could claim a reduction in intensity even though its overall carbon footprint has increased, providing revenue growth outstrips the rise in carbon emissions. At Quilter Cheviot we favour looking past carbon intensity targets for these reasons.
Our recent engagements with companies have focused on the number and quality of carbon reduction ambitions, or even better net zero strategies. We’ve been speaking to the largest emitters that we invest in, with conversations naturally centring around certain industries such as energy and mining companies. Specifically, we are looking for a thorough and robust climate transition plan.
We want to see alignment with a 1.5 degree pathway and in our view that is the crux of the net zero commitment - still some companies are only aligning their plans with a 2 degrees pathway. It is industry specific, but we are looking for a focus on the next decade. 2050 targets are admirable but, given the time to delivery, their effectiveness can be hard to measure until a significant amount of time has elapsed. Therefore, we prefer to focus on the short and medium-term targets that are in place.
We want to see a reduction in absolute emissions, on a scope 1, 2 and 3 bases as well as companies taking ownership of scope 3 emissions, which can be notoriously difficult to calculate. The recognition and acceptance of their presence demonstrates desirable transparency characteristics. Linking executive remuneration to carbon reduction targets is an example of good governance and the alignment of capital expenditure with climate change transition displays action to support rhetoric.
Can’t be too simplistic
Due to the complexity of the challenges involved, it can be misleading to label companies as simply “good” or “bad” from a responsible investment perspective. For instance, there is a paradox regarding large energy companies, simultaneously among the worst emitters but also arguably best placed to provide solutions. Their geographical reach and expertise could provide significant value to the transition and while they may only be spending 10%-15% of capital expenditure on renewable solutions, the figures involved are just as large, if not larger, than some pure-play renewable firms. They are also already fully operational and largely profitable businesses, meaning investments can be self-funded, thereby negating the aforementioned financing issues. Mining companies are among the largest emitters but provide in-demand goods, some of which, like cobalt, are essential for other lower carbon businesses.
Tesla is a prime example of conflicting pressures when analysing a company under ESG criteria. As it purely makes electric cars it scores among the highest ranks for E, the environmental aspect, but its S, social, and G, governance, ratings are less favourable. Cobalt mining has become increasingly controversial from a social standpoint, with Tesla sourcing the element from the Democratic Republic of Congo which accounts for around 70% of the world’s cobalt. Tesla is committed to a number of cobalt mining initiatives as well as conducting third-party auditing and verification of sourced cobalt. It is also working on reducing cobalt use in batteries and has an ultimate goal to eliminate the need for cobalt, but for now it represents risks from an ESG integration perspective.
Energy transition and energy security
Since COP26, there has been a seismic shock to energy markets due to the Russian invasion of Ukraine. Its impact on the energy transition is yet to be known, but there’s a sense that while it is negative in the short run, longer-term it could be beneficial. In the near-term, power prices have surged due to higher gas prices, which in turn have caused a switching from gas to coal. This means meeting energy needs in the short-term will see higher carbon emissions, but this could be merely an interim solution. Ultimately, there is growing hope that it accelerates the energy transition. Energy security and the energy transition should not be seen as mutually exclusive, rather they can be viewed as two sides of the same coin. A coordinated effort on a policy standpoint is required along with significant funding but it is entirely possible that recent tragic events will provide a catalyst for this process.
Along with energy security, an additional method for incentivising the transition to a low carbon economy is the effective pricing of carbon. This would essentially see a bill for the environmental and social damage levied on those responsible for production, a bill which would be made smaller by producing less. Pricing carbon at a sufficiently high level would stimulate carbon innovation and new technologies. The implementation of this would create the possibility of carbon leakage, where high prices in areas leading the approach, such as the European Union, would see companies shift production to countries without the same constraints. The proposed solution to this is called the Carbon Border Adjustment Mechanism (CBAM), which would place the same carbon price on imports as those on goods produced in the EU. At COP26, the EU and US announced a deal to remove tariffs on steel and aluminium for two years but retained them on other countries that have failed to hit the standards for lower carbon production. Details on this are still scarce, but there is clearly a strong signalling effect, especially to China.
COP27
The next United Nations Climate Change Conference (COP27) is scheduled to take place in Egypt this coming November. More detailed and ambitious commitments are required to keep the 1.5 degree target alive and additional pressure on countries such as China, Brazil and India to step away from coal could go some way to achieving this.
Greg Kearney
Senior Responsible Investment Analyst
Jamie Maddock
Equity Research Analyst
Mamta Valechha
Equity Research Analyst