Whether you believe in climate change or not, as an investor you will not be able to hide from climate investing and its ripple effects. As the world looks beyond superficial efforts to reduce emissions by adopting paths to deep decarbonization, climate investing will provide an opportunity for returns with impact. In this Arcus, we share our understanding of what climate investing entails, why it’s important, climate investing’s biggest risks, some myths about carbon markets, and along the way some observations on how to make climate investing work.
What is climate change in the context of markets? Climate change may be viewed as a global market failure caused by Greenhouse Gas (mostly carbon) emissions. We have polluted excessively because pollution was costless and these harms were “externalized” on others, including future generations. Now we are being asked to “internalize” these costs. How? One approach is to have markets set the price for carbon and let polluters pay. The other is to have industrial policy and regulators internalize these costs and again let polluters pay. As investors our training and instinct is to let markets do the work. However, after 30 years of diplomatic meetings on climate change which have centered around carbon markets as the preferred solution, the market’s invisible hand has still not been able to scale up technologies to deliver the carbon cuts that policy makers envisaged. In this Arcus we will explain why we need to ignore these instincts and look more to industrial policies for returns with impact. What is climate investing? Climate investing is the deployment of capital to help address the challenge of climate change. Simply put, investing to help the process of decarbonization. Given where we are at in terms of IPCC scenario analysis of our current carbon glidepath, it won’t be new news that we need Deep Decarbonization. Climate Investing = Technological & Industrial Transformation = Deep Decarbonization Deep Decarbonization will no doubt be expensive, difficult and could harm economic competitiveness, not to mention a firm’s profitability. Deep decarbonization is hard because it is as much a political problem as a technological and industrial challenge. It is political as it pits public interest of the future against the private interest of the present. Furthermore, technology to transform industry does not grow on trees and doesn’t lend itself to easy planning with current policy tools. That is why deep decarbonization is seen as needing transformative change through policy and investments. What does deep decarbonization require? Deep decarbonization is a complex process that is fraught with technological, political, administrative, and financial challenges. When investing in deep decarbonization, new technology is the easy go-to idea for most analysts who focus purely on returns. However, real world success requires industrial policy carrots and sticks to strengthen innovators that are paving those pathways to a low carbon future. Policies that help with the scaling up of technology across various industries and making it more acceptable for all has a bigger impact with more sustainable returns. As an example, Hydrogen Electrolysis as a technology has been around for almost a century, but it’s only as a result of the policy support for renewables over the last decade and the current incentives (both carrots and sticks) for green hydrogen, that the technology is now seen as a game changer and, thus, one of many climate investing opportunities. Observation #1 – Technology in a policy vacuum has lower prospects for attractive returns, let alone returns with impact. Why is climate investing needed? First of all, investors with a multigenerational investment horizon (e.g. SWF, Endowments, Foundations and Family Offices) are already moving their portfolio to a risk, return and impact framework. Climate investing is a long duration commitment to this new framework, which also provides diversification benefits that may not be obvious in the short term. Second, and more importantly, green revenues generated by carbon taxes and auction of credits are still very small and misspent compared to what is needed to incentivize the industrial transformation globally. As an example, in 2018 roughly US$46bn was raised in revenue by carbon pricing policies in Europe and only US$25bn of that was then spent as green spending. Similarly, by 2020 California had collected US$12.5bn in carbon allowances, of which only $5.3bn was appropriated and implemented by specific California Climate Investments (CCI) projects. Climate investing is needed to “move the needle” in deep decarbonization. Observation #2 – Climate investing should be a good long duration diversifier of risk, return and impact. Where should climate (carbon) investors focus? Most investors tend to focus on the cost of carbon as a proxy for the investing opportunities and market size, a reasonable approach but one fraught with danger. There are many ways to ascertain the size of carbon costs, the simple one being volume X price. While volume of carbon globally has been defined within an agreed range (35-40bn tn pa in 2021), the cost of carbon per tn has a larger range. In 2021, the US Government Interagency Working Group on the Social Cost of GHG calculated a global cost of carbon to be US$51/tn; carbon taxes globally range between US$2.50/tn in Mexico and US$130/tn in Sweden, while carbon credit prices on regulated markets such as Regional Green Greenhouse Gas Initiative (RGGI) are bound between US$6-$13/tn. That said, even with varying carbon prices, valuing the cost of carbon to a firm or industry within a region and country is doable, but not investable. Climate investing is more about estimating Decarbonization as an investment opportunity. Currently the value of decarbonization is still in the eye of the beholder - who pays what for a tonne of carbon removed, in some cases saved or even avoided? Here the payer of carbon removal can be a collective of governments (EU CBAM); a national government (carbon taxes); industry regulator (California’s Air Resource Board mandate); regulated carbon markets (EU ETS, RGGI); voluntary carbon offset markets (CIX, HKEX Global Carbon Market) and, finally, the consumer. As investors we need to understand the size, ambition and ability of these decarbonization payers. Only then can companies that are decarbonizing rely on incentives for the industrial transformation needed and make profits. As an example, companies facing legislated carbon taxes are more likely to pay for sustained reduction in carbon than those buying voluntary carbon credits on markets where there is no, or little verification required. The former being a preferred payer of decarbonization. Observation #3 – Policy makers are better and sustainable decarbonization payers then markets. Why don’t carbon markets work? Currently there are 32 jurisdictions which have cap and trade Emission Trading Systems (ETS) in place, with another 19 considering them. Theoretically, market forces should unleash powerful incentives (through carbon prices) for firms and households to find the cheapest way to control and reduce emissions regardless of sector or activity. To be clear, carbon markets should have seen a slow and stable increase in carbon prices along with identifiable reduction in carbon emissions of participants, but they haven’t. Prices have been very volatile and overall cuts to carbon emission modest at best.
There are 3 broad reasons for failure of carbon markets:
Carbon prices themselves have stayed low because
Excessive allocation of allowances/credits,
Liberal emission credit banking,
Generous and dubious carbon offset programs (Voluntary Carbon Markets)
Inefficient use of revenue from auction of allowances and credits with too much leakage,
When carbon markets try to cover many sectors, all the sectors together must follow the politics of the least ambitious sector, thus ensuring low carbon prices and higher caps.
Observation #4– Carbon markets have design flaws ensuring they work in limited situations. How can you engage in climate investing? If you are only concerned about risk and returns, and not impact, climate trading can be profitable as market design flaws mentioned above will see increased volatility in many of the carbon credit markets, whether regulated or voluntary. Also, climate technology (whether scalable for impact or not) is going to be a potentially lucrative space. Lastly, Carbon Policy arbitrage can be used by those engaged in long-short trading strategies. For those wanting returns with impact, climate investing will not be easy, but we believe worth it. Many mutual funds and ETFs are embracing this challenge of climate investing with varying levels of commitment to deep decarbonization. As an example, one US$4bn Global Climate Change Fund has Alphabet, Microsoft, and Amazon as their biggest positions…showing that decarbonization is in the eye of the beholder. The good news is that there is some attempt to ensure climate investors stay true to their climate claims. The EU Sustainable Finance Disclosure Regulation (SFDR) framework* especially its Article 9, is in early stages of outlining what a Fund claiming climate credentials should disclose to investors. The adoption of Article 9 by a Fund should not be taken lightly, as the monitoring and disclosure requirements on a portfolio of companies to deliver EU aligned emission reductions is extensive and increasing. Article 9, while still being finalized, could potentially give climate investors’ confidence that their funds are having the intended impact. Observation #5– Climate investing will be different to climate trading, the former will need skill sets and expertise most investors don’t have. What is the biggest risk in climate investing? There are two risks that worry me. First being the voluntary carbon markets for offsets/credits. The voluntary carbon market is where many companies seek to neutralize their carbon footprint by buying offsets from private projects claiming carbon reduction. This sector is most ripe for growth but it is also where financial engineering and greed are most likely to create a structural challenge to deep decarbonization and climate investing. At the risk of sounding like a prophet of doom for voluntary carbon offsets, I have often enough seen in my investing career concepts and ideas only understood by some, monitored by a few, and regulated by none, become financial products of mass excitement and greed. Voluntary carbon offsets have the making of another such financial product frenzy, especially given the bottleneck in verification of legitimate offsets. Some estimates see their value increasing from US$400mn in 2021 to US$10-25bn by 2030. Such financial securitization and marketing of an intangible concept (promise to reduce carbon) would usually not concern me (e.g., crypto currencies), but this time it does so because it has an impact on carbon prices and climate investing globally.
The second risk sits around the overhang of Article 9 Climate Funds, their claims and potential reversal as Article 9 enforcement becomes stricter. As at the end of 2021, in Europe alone there were 563 Climate Funds with US$325bn in management, 64% of these were Article 9. As Article 9 classification for Funds was only introduced in 2021 many Funds have repurposed themselves to this classification with high risk of not fully appreciating its disclosure and investment guardrails. As Article 9 claims get checked, many funds may be caught for misreporting as will their investors. Observation #6 – Voluntary carbon offsets can be counterproductive and may yet prove to be a bubble; Know Your Climate Fund (KYCF) is critical. What about financial returns you may ask? At Panarchy Partners we believe climate investors will move away from returns vs impact, where some climate agnostic index is the benchmark for returns and investors worry about whether their returns will be above or below it, to a focus on returns with impact. This is where an acceptable absolute financial return target with verifiable impact will be demanded. With that in mind the Panarchy Team is looking to launch our Asian Environmental Action Fund (AEAF), potentially an Article 9 Fund with a US 5-7% p.a. financial return target over the medium to long term. How? Our thesis is that there is a massive gap between Asian countries’ decarbonization promises and their industrial policy incentives. Given our doubts over carbon markets and their ability to decarbonize, we expect an unleashing of industry specific environmental policies by Asian countries, which should ensure certain companies deliver the decarbonization targets our investors want and achieve the financial returns we aim for. Conclusion I hope this Arcus and its observations along the way will provide some insights into how we at Panarchy Partners are looking at climate investing. One thing missing from the above discussion due to time limitations, is the issue of TIME itself. Time is running out as we are reminded almost every day with actual weather events. The next few decades require transformational investment in our industrial and agricultural complexes. While market forces cannot be ignored by investors, they will play second fiddle to targeted industrial policies, especially in Asia. Understanding and following the latter is what should provide the best investment opportunities and ensure returns with impact. Happy Panvesting, Munib Madni, Founding Panvestor