investment insights
How did COP26 measure up?
Lombard Odier Private Bank
1.5°C is still alive. Just. While deals on methane, deforestation and electric vehicles stood out at COP26, crucial steps to reduce fossil fuel dependence and price carbon accurately disappointed. The “last chance” on climate leaves much to do next year and beyond.
1. Moving from net zero targets to reality
VERDICT: The hard work lies ahead
COP26 was billed as the last chance to keep the goal of limiting global warming well below 2°C on track. Countries and companies needed to show greater ambition in achieving net zero emissions by 2050, and more clarity on how to get there by 2030. Detailed pathways for the coming 5-10 years are needed by everyone from inhabitants of low-lying Pacific islands, to companies and investors: as the basis to assess and mitigate physical climate risk, make investment plans and price assets.
The direction of travel at COP26 was encouraging. Many countries have set new targets, including India and Saudi Arabia. In a rare joint declaration, China and the US agreed to boost climate co-operation over the next decade. If all new pledges are implemented and achieved in time, the International Energy Agency calculates that 1.8 °C of warming is now within reach. Looking only at 2030 targets, not taking into account pledges out to 2050, the figure is closer to 2.4 °C, indicating that near-term efforts are far from sufficient. Common reporting frameworks were agreed; in the past, countries used their own accounting methods. Private sector participation at COP26 was unprecedented, and a new, global standard for setting science-based corporate targets was unveiled. As the speed of the transition accelerates and the tipping point of irreversible climate change nears, pressure is mounting – both on paper and in the real world. Countries have been asked to submit new, more ambitious targets by end-2022, rather than the usual five years. Indian delegates returned to a New Delhi lockdown caused by severe air pollution.
If all new pledges are implemented and achieved in time, the International Energy Agency calculates that 1.8 °C of warming is now within reach
But the challenges ahead are stark. China and India are not targeting net zero before 2060 and 2070; 10% of emissions are still not covered by a net zero target at all. Countries’ interim plans lacked detail: the host nation’s Net Zero Strategy spoke of “ambitions” rather than “commitments,” and the UK Chancellor was criticised for cutting domestic air passenger duty in the same week. Even as new pledges look insufficient to meet 1.5°C, few countries are on track with their current commitments. There is no mechanism for enforcement, other than peer pressure, and the risk that misaligned countries will be locked out of key export markets. As climate risks and opportunities begin to crystallise, investors are increasingly aligning their portfolios with net zero. As even moderate levels of global warming may cause significant climate damage, these should also include strategies to mitigate climate risk and improve resilience.
Nowhere was the gap between intentions and action more evident than in support for developing nations to adapt to climate change. For countries already plagued by flooding, droughts or fires, a global temperature rise above 1.5°C could be a disaster. Industrial nations agreed to double their contributions to finance this climate mitigation to USD 40 billion a year by 2025. But this looks insufficient. India asked for USD1 trillion to 2025; Africa as much as USD1.3 trillion a year by 2030. Shamefully, developing nations are still chasing unpaid funding promises from 2015. Most private sector climate financing is still channelled to developed countries and proven technologies. A more equitable distribution, and a faster ramp-up of decarbonisation efforts, is sorely needed.
2. The shift from fossil fuel dependence
VERDICT: Underwhelming
Phasing out fossil fuel use and ending subsidies is perhaps climate change’s biggest challenge. In what some saw as a symbolic pivot, fossil fuels were named in COP26’s ‘Glasgow Pact’ for the first time. The Pact agreed to “phase down” (not “out”) coal and “inefficient fossil fuel subsidies” by 2030: vague wording at best. A separate pledge seeks to phase out coal in the 2030s for major economies and 2040s for poorer nations “or as soon as possible thereafter” and end investment in new coal power generation. This was signed by 40 nations, but not the US, China, India and Australia. More than a hundred countries pledged to cut methane emissions by 30% by 2030. In a first-of-its-kind agreement, South Africa will receive USD8.5 billion to end its use of coal, a hefty price tag, but one that offers a potential model for future deals. These actions in turn should spur investments in renewable energy.
But they fall far short of legally binding commitments, while major polluters were often absent. Fossil fuels remain entrenched in economies worldwide The International Labour Organisation (ILO) estimates that nearly 6 million people are directly employed by the petroleum industry and that it indirectly create jobs for ten times more. China’s recent shift away from coal has exacerbated a global energy price crunch and boosted demand for natural gas. President Biden’s talk of a “leading by example” on climate came even as he asked leading oil nations to step up production, highlighting the tension between long-term ambition and short-term energy requirements. Just days after COP26, a petroleum conference in Abu Dhabi pledged USD600bn in annual investment to 2030 just to keep up with consumption demand. The UK and the Netherlands have been desperate to court Shell, as it announced a planned UK relocation.
A simultaneous – and potentially greater – spur could be simple economics. In China, renewables are expected to become cost-competitive with coal-fired power by the middle of this decade. In many countries, solar is already cheaper than coal. Corporate innovation will be a key catalyst. The cost of batteries is falling fast; economies of scale are rising. Public sector commitments can spur private sector advances in a virtuous circle. One of COP26’s successes was more investment from 40 countries in clean technologies, from electric vehicles to clean steel, affordable green hydrogen and sustainable agriculture. Another “coalition of the willing” will work towards selling purely zero emissions vehicles by 2040. Financial markets are gradually realigning valuations with net zero – punishing “burning log” companies (high emitters with no plans to decarbonise) and rewarding green solutions providers. While Saudi Aramco remains one of the world’s top five most valuable companies, Tesla is now not far behind.
3. Better carbon pricing
VERDICT: New rules should help
In another tentatively encouraging move, the Glasgow Pact set new rules for trading carbon credits. These allow governments to achieve their emissions goals by funding reductions in other countries. A new and comprehensive set of accounting rules elaborated on those in the Paris Agreement: countries selling reductions adjusts their emission level upwards, buyers adjust theirs downwards, preventing double counting. Five percent of the credits will be transferred to an adaptation fund, to help improve resilience. The agreement could foster growth in voluntary carbon markets, where companies buy carbon credits. These would be governed by countries’ national emission trading schemes. Carbon markets reacted positively: EU carbon prices jumped to a record high of EUR66 per tonne after the conference.
The hope is that the new rules could speed the creation of a global carbon marketplace. But businesses – via the International Chamber of Commerce – criticised them for lacking sufficient bite. There was no announcement at Glasgow of a global carbon price, let alone one sufficiently high enough to spur rapid change. This area was one of the most contentious during negotiations. Still, piecemeal national and regional carbon markets are gradually expanding. The EU’s “carbon border adjustment mechanism”, which is designed to price the carbon content of imported goods the same as those made within the bloc, will soon provide some sort of effective carbon price for all its trading partners.
4. Common frameworks for investment
VERDICT: Progress made
COP26 was billed as the “Finance COP.” UN Special Envoy on Climate and Finance Mark Carney was under pressure to deliver. Under the new Glasgow Financial Alliance for Net Zero (GFANZ), 450 financial institutions with USD 130 trillion in assets have committed to the transition to net zero: not via a new flow of capital into green solutions, but via a commitment to decarbonise existing assets. The challenge is vast. Firstly, not all corporate commitments are created equal. Here, a new UN “net zero standard” will help, by measuring and analysing private sector net-zero commitments. Sustainability disclosure standards from a newly-created International Sustainability Standards Board (ISSB) should help investors make more informed decisions on corporate climate performance. The second challenge is greater: Lombard Odier estimates that only a quarter of large cap firms today are aligned with 2°C, and only 6% with 1.5°C. This makes it difficult to allocate capital at scale with a net zero mind-set.
But as we have long argued, it is a thistle that must be grasped. Finance is finally at the centre of discussions, as a motor to avert climate change. Investing solely in low carbon firms will not bring down emissions in the real economy. The greater challenge – and the greater potential for cooling the climate – is through changing the practices of today’s high-emitting firms. As GFANZ members seek to decarbonise portfolios, interest in forward-looking assessments of companies, such as Implied Temperature Rise, will rise, helping identify climate leaders. Already, nine jurisdictions have either already included reporting regulations along these lines as part of their frameworks, or propose to do so. This should drive interest in “ice cube” companies: those in climate-relevant sectors with credible plans to decarbonise. It is here we believe some of the greatest investment opportunities lie.
5. The role of nature
VERDICT: Greater awareness achieved
One of the most striking achievements at COP26 was a greater recognition of the role nature must play in halting climate change. Oceans and forests act as important carbon sinks. The Glasgow Pact explicitly recognises the need to protect, conserve and restore nature, “including through forests and other terrestrial and marine ecosystems.” Climate change is just one of nine “planetary boundaries” including ocean acidification and air pollution, which define the safe operating space for humanity. Many are at risk. The End Deforestation Pledge, signed by countries that are home to over 85% of global forests, seeks to halt and reverse forest loss and land degradation by 2030. While one may question the commitment of countries signing the pledge, and its enforceability, the pledge could still help deepen the voluntary carbon offset market, via using trees to sequester carbon. This is one of the lower-cost, ways to accelerate the transition to a net zero and more nature positive economy. A separate commitment was made by 30 financial institutions, including Lombard Odier, to eliminate deforestation risks from their portfolios by 2025 or before. Meanwhile, forty-five governments pledged to shift to more sustainable farming methods. Belize said it had closed a USD364 million “blue bond”, whose proceeds will be used to protect its oceans; Fiji plans to issue a sovereign blue bond in 2022.
Conclusion
Progress at COP26 was both encouraging and disappointing in equal measure. This is perhaps understandable: a single conference cannot solve the world’s most complex problem.
While new pledges, standards and agreements have been made, the hard work will be in implementing them. One of the biggest changes required is on mind-set. All too often, measures needed to achieve net zero have been classed as a cost. Yet we believe investments in decarbonisation must be seen as a net gain, offering a positive return, especially when the costs of not acting are taken into account.
Halting climate change is both an environmental and economic imperative. Such transitions rarely happen in a linear fashion. The spirit of reconvening at COP27 in Egypt in 2022 with new climate commitments attempts to ratchet up the pressure. As the world increasingly sees the visible impact of climate change, and the cost of capital increasingly reflects this reality, the transition should accelerate.
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