White Christmases are not guaranteed. They have historically been so uncertain that we sing and dream about them. As long as we continue to emit greenhouse gases at an unprecedented rate, ensuring white Christmases for our children and grandchildren is even more complex. Climate commitments are a good start. Growing numbers of organizations that have made net-zero pledges by 2050 or sooner. In fact, net zero commitments represent over 68% of global GDP and 61% of CO2 emissions, including over 65 members of the UN-convened Net-Zero Asset Owner Alliance (representing over $10 trillion in AUM), 220 signatories of the Net Zero Asset Managers initiative (representing $57 trillion in AUM), and the 450 financial firms representing over $130 trillion in assets in Mark Carney’s Glasgow Financial Alliance for Net Zero.
Setting and supporting climate commitments is laudable, but not enough. As Ninety One Portfolio Manager Deirdre Cooper notes, “Targets must reduce climate risk in the real world. Targets should not be met by tilting toward asset light sectors, moving capital out of emerging regions, selling assets to less responsible owners, or outsourcing. This will not reduce real world emissions. It will not meet the objectives of the Paris Agreement. And it will not lead to an inclusive energy transition.”
Challenges to Perpetuating White Christmases
Tilting Toward Asset Light Sectors. Allocating to tech giants reduces portfolio emissions, not real world emissions. According to Refinitiv analysis, the majority of AUM of the 28 largest and best-known ESG funds are allocated to Microsoft, Google, Apple, and Amazon (and Facebook for passive funds) primarily because of the tech giants’ low carbon footprints. By contrast, allocating more to the largest clean utilities, including Enel SpA, NextEra Energy Inc., and Iberdrola SA increase emissions because these providers still burn fossil fuels. Fortunately, investment in companies developing technology to try to combat the climate crisis increased by 210% to $87.5 billion for the year ending June 30, 2021 from $28.4 billion for the twelve months prior, and 14% of venture capital dollars now go to climate tech, according to PwC’s new State of Climate Tech 2021 report.
Moving Capital Out of Emerging Regions. According to Bloomberg, halving a typical global equity portfolio’s exposure to Indonesia and the BRICS economies—Brazil, Russia, India, China, and South Africa—reduces its carbon intensity by 3%. The higher carbon intensity of grids in many emerging markets—and coal-dependent South Africa and Indonesia in particular—increases Scope 2 carbon emissions, which represent emissions from purchased electricity from the grid. Nuanced climate commitments are critical: trying to meet simple net zero commitments would give institutional investors the incentive to deny emerging markets of the $2.5 trillion per year that they need to meet Sustainable Development Goals (SDGs) and comply with the Paris Agreement.
Selling Assets to Less Responsible Owners. Divesting the dirtiest assets can send a signal to the market and to regulators, and it can also increase real world emissions. To illustrate, since 2010, the private equity industry has invested at least $1.1 trillion into the energy sector—double the value of Exxon, Chevron, and Royal Dutch Shell combined—purchasing offshore drilling in the Gulf of Mexico, fracking operations, and coal plants from divesting publicly traded companies. With less public scrutiny and less public pressure, these divested assets continue to emit greenhouse gases when under private control.
Dreaming About a White Christmas is Not Enough: Select Elements of a Comprehensive Solution
Investment in Solutions with the Greatest Potential for Emissions Reduction. According to PWC research, solar power, wind power, food waste technology, green hydrogen production, and alternative foods/low greenhouse gas proteins represent over 80% of emissions reduction by 2050, but received just 25% of climate tech investment between 2013 and 2021. However, two-thirds of climate tech funding during the year ended June 30, 2021 went to mobility and transportation companies, and within this, more than half went to electric vehicles and low greenhouse gas emissions vehicles. Investors seeking to reduce real world emissions may wish to allocate a greater share of their climate tech investments to sectors with greater emissions reduction potential.
Special Purpose Acquisition Companies (SPACs). According to Vice Chair of Mergers and Acquisitions at BakerBotts Travis Wofford, SPACs allow industry experts to raise money and find diamonds in the rough. Over the past 18 months, SPACs have been tested as a new tool and have raised a third of all climate tech funding during the year ended June 30, 2021. Wofford explains that many of these are in climate tech because “high-growth industries focused on new technologies require smart people who can see the potential in a technology and a business.”
Most of the SPAC climate tech deals are in low-carbon transportation, such as electric bus manufacturer Proterra. The emerging trend of SPAC deals further up the value chain, such as Live Oak Acquisition Corp II’s recently completed merger with energy efficient Navitas Semiconductor, whose products enable the energy efficiency technology of their customers, are encouraging.
Effective executive compensation structures. Roughly half of the largest US and UK companies base executive compensation in part on ESG targets. Academic research supports the wisdom of this executive compensation trend. Caroline Flammer, Bryan Hong, and Dylan Minor’s recent study found that the adoption of environmental, social, governance (ESG) criteria in executive compensation is associated with an increase in long-term orientation, an increase in firm value, an increase in social and environmental initiatives, reduction in emissions, and an increase in green innovations. When executive compensation structures include emissions reductions targets, it’s critical that at least the vast majority of the emissions reduction must come from business operations, rather than from the purchase of carbon offsets, a number of which face significant credibility problems.
Capital improvements that increase energy efficiency. More broadly, it’s critical to invest in businesses that prioritize capital expenditure and innovation that increase energy efficiency and reduce emissions rather than purchasing carbon offsets and renewable energy credits. This is also critical to align with increasingly stringent regulations. As a case in point, substantial capital investments are necessary for most buildings in New York City over 25,000 square feet to comply to Local Law 97’s mandate to reduce emissions by 40% by 2030 and by 80% by 2040.
The Big Picture on Making All Our Christmases White
More broadly, reducing portfolio and real world emissions starts with a philosophy about the carbon transition. It proceeds with understanding each portfolio manager’s and each portfolio company management team’s philosophy and approach to the carbon transition. It involves identifying the carbon-intensive and stranded assets in portfolios and gauging both the value of these assets and value at risk due to climate change, including extreme weather events. It also involves identifying where managers have exposure to emissions mitigation or emissions removal or to companies with climate pledges or where managers strategically engage on climate, size based on climate, or exclude fossil fuels from their portfolios. The low carbon transition will be fraught with challenges, making collaboration across the investment value chain key to making our days merry and bright and all of our Christmases white.