The ambitions and provisions of the Paris Agreement are clear, as is its future impact on returns. Investors responding to growing and changing risks can contribute to stabilising both the climate and capital markets in the coming decades. And as Jane Ambachtsheer writes, the ball is now in the court of the world’s fiduciaries – strong governance is a prerequisite for the effective management of climate risk.
The 21st UN Climate Change Conference of the Parties (COP21) concluded with a landmark agreement.
For the first time, countries committed to lower their greenhouse gas emissions sufficiently to keep a global temperature rise well below 2°C this century, relative to pre-industrial levels.
This outcome raises the level of near-term climate transition risk for investors – based on the strength of climate change policy that is now needed.
This is balanced by the opportunity for investment in low-carbon technologies and infrastructure, which is likely to grow significantly.
These developments present some immediate challenges for investors – most notably the need to add “What is our approach to climate change?” to their 2016 to-do list.
But they also offer the best hope of a stable and secure climate, which is a necessary condition for stable and secure capital markets over the coming decades.
It is for this reason that many investors adopted the role of “climate cops” and sought to directly influence the outcome of the negotiations.
Making climate risk assessment easy
What is critical to mainstreaming climate risk assessment is to create straightforward tools that allow investors to easily assess financial risk.
In June 2015, Mercer published its second ground-breaking study on climate change and investment, entitled Investing in a Time of Climate Change.
Undertaken in collaboration with 16 investors representing $1.5 trillion in assets, this study established a formal framework for considering the impact of different climate change scenarios on investment risk and return across asset classes and sectors.
The report drew some important conclusions – that climate change will have an impact on returns regardless of which scenario unfolds and that investors can take specific actions to make their investment portfolios more resilient. The outcome of COP21 means that Mercer’s “transformation” scenario, which sees warming limited to 2°C this century, is now more likely than it was just a few months ago.
The study also introduced the concept of “future maker” investors – those that make a concerted effort to influence the climate scenario which comes to pass.
What is the Paris Agreement?
The approach taken at COP21 was very different from previous attempts. First, rather than using the meeting to negotiate specific emissions reduction targets, countries were invited to submit their pledges in advance.The Paris Agreement is a bold commitment to drastically reduce carbon emissions and transition to a low-carbon economy.
More than 180 countries did this, via Intended Nationally Determined Contributions (INDCs) reflecting their own circumstances.
Second, there was unprecedented engagement by non-state actors – investors, businesses and civil society – committed to achieving a strong outcome.
Their efforts have a reinforcing effect: the level of ambition reflected in the Paris Agreement sends strong policy signals which businesses and investors cannot ignore.
It was known well before Paris that the INDC pledges were – in aggregate – insufficient to limit warming to 2°C this century.
Thus, the Paris Agreement sets out the overall level of ambition and a framework to facilitate monitoring of each emission reduction pledge as well as the tightening of pledges over time.
Key features of the Paris Agreement
- Temperature goal– An aim to limit overall global warming to less than 2°C, and possibly even down to 1.5°C. Given that we have already reached 1°C of warming, this will require a significant ramp up of national pledges by 2030.
- Coming into forcein April 2016 – Once at least 55 countries accounting for 55 per cent of global emissions have formally signed it.
- Net zero emissions goal– It was agreed that we would reach net zero emissions in the second half of the century (by balancing carbon released with an equivalent amount sequestered or offset), with emissions peaking as soon as possible.
- Five-year review cycle– Pledges will need to ratchet up over time, with countries resubmitting every five years. Submissions can only be strengthened (i.e. no backtracking on prior pledges) and long-term targets are encouraged.
- Climate financing– To provide financial support to poor countries on the cost of the transition, the agreement has a climate finance goal of $100 billion per year by 2020. This amount is a floor, so it is anticipated that it will increase over time.
- Legal status– Emission reduction plans are not legally binding, but the reporting mechanisms (yet to be determined) and the five-year review process is. There will be a strong role for non-state actors in policing the agreement.
We expect investor focus on climate to continue to grow
Hundreds of investor representatives participated in the numerous events taking place in Paris. During the two weeks in which COP21 took place, the assets committed to the Portfolio Decarbonization Coalition increased from $100 billion to $600 billion.
Also, Mark Carney (governor of the Bank of England and chair of the Financial Stability Board) announced that Michael Bloomberg will chair the Financial Stability Board’s new climate disclosure taskforce, which will make recommendations to the G20.
This will bolster the push for corporate reporting on emissions that the Carbon Disclosure Project has been driving for more than a decade.
Since COP21, we have also seen the launch of the Paris Pledge – where more than 800 non-state actors, including Mercer Investments, “affirm our strong commitment to a safe and stable climate in which temperature rise is limited to under 2 degrees Celsius”. Expect more signatures to follow.
The investor 2016 “to-do list”
Going forward, fiduciaries are expected to look to stress-test their investment portfolios under different climate change scenarios over a 10 to 35 year time horizon to ensure they’re prudently managing this growing and changing risk.
In addition, we can expect that investors will increasingly work to:
- Educate their boards and committees about climate science and climate-related risk factors, and establishing climate-related investment beliefs
- Integrate climate considerations with other important ESG factors
- Allocate to sustainability-themed and low-carbon private and public market investment strategies across asset classes
- Engage companies and regulators on the effective implementation of the Paris Agreement
- Map location-specific environmental risks for aggregate real asset portfolios (real estate, infrastructure, natural resources)
- Report activity and progress to beneficiaries and other stakeholders.
While the ambition of the Paris Agreement is important, it is the implementation of the commitments that will ultimately determine the climate pathway we follow.
For “future maker” investors, this means they will need to continue their role as climate cops. For “climate aware future takers”, it means that ongoing monitoring of climate-related developments will be essential.
Modern investment practices require building straightforward frameworks to quantify and manage the world’s increasing number of long-term and complex risks.
Significant innovation across the industry has made this possible. The ball is now in the court of the world’s fiduciaries – strong governance is a prerequisite for the effective management of climate risk.
Jane Ambachtsheer is partner and global head of responsible investment at Mercer, she lives in Paris and attended COP21.