Net Zero: the role of capital markets

1. Directing capital to finance and reward businesses which are creating solutions to the climate crisis

The role of public equity markets in helping solve key sustainability challenges is not lost on politicians and regulators.

Governments' climate commitments are creating wider opportunities for market participation thereby leveraging a more significant pool of capital and incentives that can reward genuine solutions to the climate crisis. This was acknowledged by the European Central Bank which concluded that ‘equity investors, who tend to have a longer investment horizon and a greater appetite for high-risk high-return projects might be better placed to finance environmentally sustainable innovation than banks,’ adding that, ‘deep and liquid capital markets could help mobilise the funds needed to finance the transition to a low-carbon economy.’² The mobilisation of private capital towards sustainable investment was also a centrepiece of the EU Sustainable Finance Action Plan which aims to ‘reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth.’³

We agree with the potential positive impact that equity market participants can have with regard to key objectives such as net zero. As we have previously highlighted, efforts to limit climate change and the transition to a lower-carbon economy also present a range of opportunities for investors.⁴ However, we have also emphasised that investor involvement should be authentic and well-thought-out to avoid capital being deployed in areas where the perception of positive change is high, but actual sustainable outcomes are low – the so-called ‘greenwashing’ effect

As long-term, high-conviction equity investors we believe an effective way to do this is by channelling our clients’ capital towards businesses that are creating solutions. For instance, to solve challenges such as net zero or to support other sustainable development frameworks such as the UN Sustainable Development Goals. Specifically, we look at how companies can contribute rather than simply align to these goals. In our view they can best do this through the products and services they create rather than simply just aligning through their behaviour (although we will come to the importance of that later).

This therefore implies an important distinction when assessing impact. We believe that the most impactful investments should have evidence of:

2. Using active engagement to push for, assess and ultimately price the presence and credibility of Net Zero

A second key area of impact for investors to actively contribute to net zero is by creating incentives for companies to adopt credible net zero targets.

This can be through supporting those companies which have proactively created credible transition plans as well as helping companies adopt best practice in moving to specific, scientific and timebound net zero targets. This is what we would refer to as alignment with net zero goals through their behaviour and their operations. As such, all companies can help support net zero ambitions and investors can assist in accelerating decarbonisation through active engagement and ensuring company goals are credibly aligned to net zero.

In our own case we hold ourselves to a standard on engagement based on outcomes rather than just dialogue. We believe that this kind of approach – where we can see the status of every engagement in terms of its stage of completion at investee companies – gives us a strong insight into how effective investors can be at facilitating and accelerating adoption of credible net zero targets.

There is a real challenge currently in the sizeable disconnect between ambition and action on net zero. To be clear, this is not just a challenge facing corporates, but also one facing governments who now have the task of translating long-dated targets into specific action plans. However, a recent study from sustainability consultants South Pole found that although net zero commitments had doubled over the last year, just 11% of organisations have set a scientific-based target in support of these.⁵

As we made clear in our previous article in this series Net Zero: From Policy to Action⁶, there needs to be a sense of urgency in translating high-level commitments into more specific targets. A key part of how investors can do this is through active engagement around the adoption, measurement and tracking of key climate-related pledges, and by voting in support of these ambitions, such as supporting proposals that increase transparency. Ultimately, it may involve voting against management when we believe companies are not effectively addressing their climate risks.

Our experience suggests that a two-way conversation between investors and industry is the most effective means of sharing best practice. There are four key aspects we look for and advocate to our investee companies:

1. Transparency and strong disclosure: any future targets should be predicated on having a clear view of the current carbon intensity of a business. We expect businesses to provide as much information as possible to investors around their carbon footprint not just as it pertains to their own operations, but also their supply chains and the ultimate carbon footprint of their end products. We also expect them to provide consistent data, structure and frameworks to track their progress to their net zero ambitions alongside transparency on their direct and indirect lobbying activity and the extent to which this is aligned with net zero.
2. Ambition and specific actions: we recognise that different industries have different pathways towards net zero. This will look different by industry in terms of the starting point, scale of action and technology challenges. However, we expect that companies try and put themselves on a pathway to net zero that is credible within their own industry, is consistent with net zero by 2050 and with short and medium-term targets for their scope 1 (direct), scope 2 (indirect – typically electricity consumed by a business) and, where relevant, scope 3 (other indirect or end product) emissions⁷ . Bodies such as the Transition Pathway Initiative (TPI) – a global asset-owner led initiative – provide invaluable information in assessing the current status of companies and industries in aligning to climate goals. Specific targets are an integral part of this. Without them high-level policy goals lack credibility and structure. There is still much work to be done in this area with the TPI highlighting that 86% of publicly listed industrials are failing to align with a pathway to 2°C or below.⁸ Targets should also have a linkage to the investment decisions of a business in terms of how they are changing both their capital investment and operational expense assumptions in response to their targets.
Accountability: key executives and the board should have the ultimate responsibility for shaping and delivering on climate targets. There should be encouragement to have remuneration linked to climate targets. In high-risk industries it may also be important to give shareholders a ‘say on climate’ at the AGM. However, this should never relieve ultimate responsibility for delivering on climate targets away from the board. Companies should also be cognisant of the imperative of aligning to a ‘Just Transition’⁹ as they navigate their journey to net zero.

Absolute carbon reduction focus: we must be clear that the ultimate goal is reaching net zero. While in the short term especially there may be merit in having relative measures of carbon intensity for a business, any plan must show a path to lowering overall absolute emissions to be credible with longer-term net zero ambitions. In a similar way, the structure of how companies reach their reduction targets is also important. Carbon offsets and credits should form a limited and decreasing part of company’s climate pledges. The focus should be on real operational change rather than how to offset it. Ultimately, as carbon prices rise over time, companies who choose to use offsets longer term may find these schemes to be uneconomic and will have to accelerate their own plans to decarbonise more aggressively at a later date. Since the intention of net zero is to avoid a damaging extreme policy response, collectively we encourage companies to avoid this approach.

We believe companies which are strong in these areas provide reassurance to their investors that they are effectively managing climate-related risks. As such, they are likely to be rewarded with a lower cost of capital¹⁰. The importance of net zero in this sense is only likely to grow as the regulatory landscape continues to shift, carbon pricing becomes more widespread and consumers continue to exhibit strong preferences for brands and businesses that are managed sustainably¹¹. A study by Schroeder's hypothesised that at a US$100 carbon price up to fifth of corporate profits could be at risk¹². Accordingly, at Martin Currie we adopt a Carbon Value at Risk approach across portfolios to track the exposure of our investee companies to a changing carbon landscape.