Perhaps the most powerful thing about Al Gore’s 2006 documentary about global warming was its title. Climate change remains ‘An Inconvenient Truth’. It would be great if human activity were not the cause of potentially irreversible damage to our planet. But it is. We know that. And as we approach the COP-26 climate summit in Glasgow this weekend, we also know what to do about it. Reduce emissions by 45% by 2030, keep average temperatures less than 1.5 degrees above pre-industrial levels and achieve net zero by 2050. To achieve those targets, we, and crucially we as investors, need to address a set of inconvenient questions.
Let’s start with an easy one. Can we have our cake and eat it? The answer, obviously, is no but this is nevertheless the approach being taken by Australia this week. Belatedly, the lucky country has pledged to achieve net zero carbon emissions by 2050 but it promises to do so without either ending its reliance on fossil fuels or beefing up its reduction targets for 2030.
Prime Minister Scott Morrison is in a bind. Without the support of rural voters who oppose reducing emissions, and of junior coalition partner the National Party, he will lose the next election some time before next May. To keep them onside he has been forced into a logically inconsistent position. He can placate the voters at home, or the global community gathered in Glasgow, but not by being honest with both. If the truth is inconvenient enough, it can take more than bushfires, floods and drought to see it.
Inconvenient question number two: what is the cost of doing the right thing and can we avoid it? There are a number of different flavours to this question. Unfortunately, the answer to all of them is most likely no. The first inconvenient truth to overcome when answering this question is that the world sinks or swims together when it comes to climate change. At COP15 in Copenhagen in 2009, developed countries pledged to mobilise US$100bn a year in ‘climate finance’ to help poorer countries cut emissions and protect themselves from the impact of global warming. We have failed to do so and won’t for at least another couple of years.
A less obvious, but equally important, cost in the climate battle is so-called ‘greenflation’. Part of this is the as yet little talked about cost of putting a price on carbon emissions, which some believe will be essential if achieving net zero within 30 years is to be a realistic possibility. To do that, according to the Network for Greening the Financial System, the price of carbon will need to rise from around US$3 a tonne today to US$150-200 by the middle of the decade and perhaps as high as US$800 a tonne by 2050. This will have a significant impact on inflation. The only doubt is how quickly that happens. And that is before we have even factored in the inflationary impact of building the infrastructure needed to effect a renewable energy transition.
A third way of looking at the cost of doing the right thing from a climate perspective is in terms of investment returns. One of the theories underpinning environmental investing is that if we put our money into companies that are behaving well, and take it away from those that are not, we will make the world a better place by reducing ‘green’ companies’ cost of capital and raising it for their dirty counterparts. But there is no free lunch here. A low cost of capital is good for a company, but it implies a lower return for the provider of that capital. The more you pay for a share the lower the returns you should expect from it. So yes, investing in good companies may make the world a better place but the inconvenient fact here is that it comes at a cost.
However, and this just goes to show that the inconvenient questions cut both ways, there is plenty of evidence that ‘green’ investments have recently outperformed ‘brown’ ones. Proponents of ESG investing tend to suggest that this is because companies that rate highly on environmental factors are in other ways also ‘better’ companies. A recent US academic paper put the outperformance between 2012 and 2020 at 35%. That sounds good. But ascribing causality is trickier. Over that period, awareness of, and interest in, the environment has increased dramatically. The outperformance may simply reflect rising demand for green investments and a greater willingness to pay up for companies exhibiting those characteristics. By definition, this re-rating cannot continue indefinitely.
The third inconvenient question for big institutional investors is whether they should engage with dirty companies to encourage them to raise their game or simply disinvest from them. Al Gore and his investment partner, former Goldman Sachs investor David Blood, stepped into the debate this week, calling on big investors to shift from carrot to stick. They called on investors to give companies a clear warning that in the absence of a plan to decarbonise they will move their capital elsewhere. The problem with this approach is that it is far from clear that walking away will solve the problem, if it simply makes it cheaper for less scrupulous investors to pick up polluting assets on the cheap. Engagement feels like investors being part of the solution, however superficially attractive the nuclear option might seem.
The final inconvenient truth for us as individual investors is that sometimes the environmentally unappealing investment just has its moment in the sun. Unfortunately, an inflationary environment like the one we may be entering now, has historically favoured dirty sectors like energy. This makes sense. Energy has pricing power because we cannot choose whether to heat the house or fill up the car. The now or never message that COP-26 needs to drive home will not be made any easier if natural resources stocks start to look like 2022’s hot investment. That really would be inconvenient.