Mark W. McDivitt, Managing Director of State Street Global Markets and Head of US Alternatives, and Tim Nixon, Managing Editor of Sustainability at Thomson Reuters, examine how the private sector is adapting to climate change and how it intends to cope with the objectives of the Paris Climate Change Agreement.

"What was once unthinkable is now unstoppable.  The private sector is already investing increasingly in a low-emissions future. The solutions are increasingly affordable and available, and many more are poised to come, especially after the success of Paris."…. Ban Ki-moon, Secretary-General of the United Nations.

Did the Paris Agreement on Climate Change really change anything?  The short answer is absolutely yes. The immediate results are mostly aspirational, but momentum will pick up in months to come as the 195 member-states follow up on their Intended Nationally Determined Contributions (INDC) to reduce carbon emissions. In addition, increased awareness and related commitment by the global investor community will prove to be among the main drivers that start to mitigate global warming. The Paris Agreement, unlike Copenhagen, Kyoto, and other COP gatherings, drove home the point that the private sector, partnered with individual Country INDCs, will be the impetus needed to start to limit overall global warming to less than 2°C.

Within the global investor community, this will not be just limited to “playing defence” with negative screening and divestiture away from carbon intensive assets. Instead, it will also be about “playing offence” where asset owners, asset managers, endowments, insurance companies and hedge funds will utilise this new growth sector, “ESG (Environmental, Social & Governance) Finance,” to drive above market returns. One important example of this movement is the Portfolio Decarbonisation Coalition, which represents a diverse collection of investors with the dual aim of earning a competitive return while at the same time supporting the ethical and social goals of the COP21 agreement .

Playing Climate Defence

Asset owners and asset managers such as pension funds, endowments, insurance companies and hedge funds are already taking steps to implement strategies to play defence against two new-founded risk categories in their portfolios:

• Stranded Assets: Exposure to fossil-fuel intensive assets as part of a portfolio’s overall value.
• Carbon Intensive Operations: Scope 1, 2, 3 GHG emissions from business infrastructure activity and related holdings across supply chains and stakeholders.

These two overarching risks can be broken down into a list of latent risk factors which can, and do emerge to impair the value of portfolios. These risks also tend to reinforce each other, as they become extant within a portfolio.  For example, an increase in “reputational risk,” (e.g. a major oil spill) can also increase the risk of divestment, regulatory notice and sanction, and/or litigation.

These factors include:

• Regulatory: Intervention such as a tax or price on carbon, financial penalties like what we are seeing with Volkswagen and BP, and the potentially stranded assets of companies heavily dependent on fossil fuel reserves which may be prohibited by regulation from full monetization in the marketplace.
• Operational: Damage or disruption to business infrastructure and global value/supply chains by socio/political forces (e.g. strike or social movement), or to increasingly extreme or unpredictable weather and climate conditions from climate change itself.
• Emerging Legal: Risk as exemplified by the recent court decision in the Netherlands in favor of citizens demanding a government response to climate change or by the efforts in U.S. Courts to hold carbon intensive industries liable for damages from climate change.
• Reputational or Brand: Reputational risk through being perceived as responsible for the increasingly dire consequences of climate change, as established by the Intergovernmental Panel on Climate Change (IPCC) and global scientific consensus on required greenhouse gas reductions.
• Divestment and Fiduciary: Risk of divestment or activism by asset owners as exemplified by the growing number of entities like universities, pension funds and governments seeking less carbon intensive portfolios, and the emerging view that fiduciary care extends to the consideration of ESG broadly, and climate-related risk factors specifically.

Playing Climate Offence

In addition to defensive and risk mitigating strategies, there is increasing evidence that investors may be able to outperform their benchmarks by integrating (ESG) factors into their investment strategy and decision-making process. New funds are rapidly emerging with strategies that look to optimise returns while mitigating the above-mentioned risks and leveraging “big ESG data” to identify attractive risk-adjusted returns. Arabesque, a new UK-based Quant fund, is one example of a fund playing offence in its relationship with the environmental finance sector. 

Paris COP21: The Tipping Point

The COP 21 Paris Agreement will be viewed as a tipping point event in history. This tipping point in global climate action has sent the right signal to the global investor community, thus creating new and unique investment opportunities which have immediate and increasing value. 

So why is Paris any different from past COP events? This time it was not about setting the rules of the game through a single, binding “top down” approach but rather about a “bottom up” approach where the majority of countries abide by a pledge-and-review system.  Business and public interests have truly started to merge. The momentum is set to effectuate change going forward. The global investor community is taking action by applying a right balance of pressure, both defensive and offensive, on the 195 member-state countries, to honor their INDC commitments.

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of The Economist Intelligence Unit Limited (EIU) or any other member of The Economist Group. The Economist Group (including the EIU) cannot accept any responsibility or liability for reliance by any person on this article or any of the information, opinions or conclusions set out in the article.