Investing – Rather Than Divesting – For A Greener Future

Capital markets reward businesses and investors that solve big problems—and climate change presents one of the biggest. In the lead up to COP26, companies have been making net zero commitments and working to align with the Paris Agreement. Approximately one quarter of S&P 500 companies have made net-zero commitments to improve their environmental impact. Companies can have a significant effect on the climate by changing their operations, but what about investors?

Large investors are already mobilizing against this issue. Over 30 of the world’s largest asset owners, representing $5.1 trillion in assets, committed to achieving net zero portfolio emissions by 2050. And the launch of the Net Zero Asset Managers initiative, with investor signatories controlling $9 trillion, represents a new commitment on the part of the asset management industry.

Nevertheless, many investors are struggling with how to address climate change in their portfolios.  Investors can choose to:

·      Ignore climate change and assume the future will match the past

·      Incorporate expectations about climate change in their analysis of potential investments

·      Use their assets and influence to catalyze change

·      Walk away from carbon-intensive industries on principle.

Today’s typical approach to climate investing concentrates on divestment and exclusion. Investors choose to divest from fossil fuels, for example, or other companies that go against their principles.  While divestment seems appealing, it comes with limitations. By excluding certain assets, investors miss out on companies that are transitioning to a more sustainable business model, and the potential returns that come with it. Divesting may make an investor’s portfolio look better, but it leaves them with no seat at the table to influence change.  Most important, one person’s divestment is another’s investment. A “dirty” asset will have the same climate effect in another’s portfolio, and divestment often transfers the asset to a less climate-conscious investor.

So, how can investors put real money to work in a way that addresses climate change? Despite some promising financial innovations (e.g., green bonds, sustainability bonds, green microfinance), there is still a relatively small amount of capital deployed against climate solutions. Impact investing with climate related objectives, typically with a willingness to focus on a “double-bottom line,” is critical but difficult to scale. Given the potentially lucrative upside of early action, the lack of capital from investors is surprising. But by utilizing a “top-down” approach, investors can structure their portfolios to meet the global climate challenge while capitalizing on a significant opportunity in the process.

Investors build their portfolios “top-down” – focusing on themes, sectors, or macroeconomic trends – or “bottom-up” – selecting companies and then seeing how those trends come together. But when looking specifically at climate-conscious portfolios, building from the bottom leaves investors with a painstaking level of detail and a lack of direction. Tallying up the emissions of every asset in a portfolio is a seemingly insurmountable task and one that discourages buying assets that need to improve.

The need for a more nuanced approach is apparent - a top-down approach gives investors a clearer path toward decarbonizing their own portfolios and capitalizing on climate opportunities. Here are a few examples of top-down approaches to climate-conscious investing:

An Analytical Approach

This investor recognizes that the status quo of “free” carbon is unlikely to last forever, and tries to incorporate the trajectory of change into its decision-making process. Some ways to build the future into the analysis are to:

·      Incorporate a potential carbon price today

·      Prioritize adaptable companies, while underweighting those transitioning more slowly

·      Invest in unproven technologies, with a venture capital or options-pricing mindset.

This approach assumes there will be changes in policy, technology, and relative asset pricing that create investment opportunities, and constructs a portfolio that aims to capitalize on them. Investments in innovation may fail, but the value of “solving” climate change is potentially enormous.

A Catalyst-Based Approach

This investor takes a proactive approach to use their assets to scale solutions and encourage transition.

·      By investing in known climate solutions, a catalyst-based investor drives adoption of technologies such as green infrastructure, renewable energy, sustainable agriculture, and climate-friendly mobility.

·      By engaging directly with companies as they execute their own climate strategies, this investor influences and supports a more effective and faster transition.

And by holding themselves and companies accountable for making real strides in decarbonization, investors can positively impact not just their portfolios, but the climate itself.

A Principles-Based Approach

A “principles-based” approach focuses on divesting from carbon-intensive industries and/or making investments that are not commercially competitive but have positive benefits for society. In other words, this investor is generally willing to concede some returns in order to achieve a social or environmental goal – to invest in line with their principles. This trade-off creates a fiduciary duty conflict in some areas, limiting the ability of many institutional investors to adopt this approach. Allocating some portion of the portfolio to impact investing and/or divesting from direct holdings of certain companies may be important to an investor’s constituents, brand, or the broader dialogue, even if it has little effect on the planet itself.

Investors work every day to anticipate and capitalize on the future. Ignoring climate change and assuming the future will mirror the past is unlikely to be a winning strategy. Anticipating potential changes in carbon pricing or green technology or being a catalyst for change – whether by scaling solutions or engaging with companies – can yield benefits for portfolio and planet alike. These approaches allow investors to shape a greener future rather than simply cleaning up their own portfolios through divestment and exclusion.