Climate change is the defining challenge of our time, and institutional investors can play a pivotal role in driving real world outcomes by influencing the companies they invest in, through stronger engagement practices.
It may even be appropriate in some instances, to actually increase their exposure to carbon-intensive companies to gain sufficient influence to drive the necessary changes.
Scientists say global warming must be kept to no more than 1.5°C above pre-industrial levels to limit the worst effects of climate change, and that is the goal of the COP26 conference being held in Scotland. This will require deep and immediate reductions in greenhouse gas emissions (GHG). However, if all the pledges made by countries to date at COP26 come to fruition, warming could be limited to 1.8°C by 2100. This is according to the International Energy Agency. Nevertheless, this is positive as prior to the conference, the UN said in September that the planet was careening towards 2.7°C.
Reducing real-world greenhouse gas emissions in a diversified investment portfolio is complex, with no simple solutions. There is a big distinction between lowering emissions in an investment portfolio and reducing emissions in the real economy. Investors can decarbonise a portfolio by tilting it away from high-emitting sectors such as energy while increasing exposure to lower-emitting sectors such as healthcare. However, we need to have climate strategies that reduce emissions at the company level, not just a portfolio’s carbon footprint.
Engagement is a powerful tool that can drive deeper commitments to decarbonise at the company level. It is also the mechanism by which the impact on real-world emissions is most likely to materialise.
However, sole reliance on an engagement strategy might not lead to enough reductions in emissions by 2050 and can expose a portfolio to high transition risks, i.e., the inherent risks related to the process of adjustment towards a low-carbon economy. Divestment can play a critical role as an escalation tactic and a last resort in an engagement strategy where the requested changes do not materialise.
Physical and economic cost if we fail to act
Every degree counts and even at 1.5°C, were that to be attained, the world will face significantly increased physical and economic risks.
In recent years extreme weather events such as deadly heatwaves, droughts, wildfires, tropical storms, and floods have increased in frequency and severity, resulting in massive loss of life and economic loss. Even if we manage to keep global temperatures to 1.5°C, lives and livelihoods across the planet will be profoundly impacted.
Swiss RE Institute estimates the global economy could lose up to 14% of total economic value by mid-century if temperature increases remain on the current trajectory. The Middle East and Africa will suffer economic loss between 14% and 22% in the most likely scenario. South Africa is particularly vulnerable and without further mitigation, could lose up to 18% of GDP by mid-century and even up to 23% in some scenarios.
It is expected that South Africa will experience a temperature increase twice the global rate of 1.5C. This means an average 3°C increase in the next 10 to 20 years. We have already suffered a prolonged drought and other disruptions to ecosystems and food crops. A 3°C temperature increase would be devastating.
Trade and transition risk
With 80% of South Africa’s electricity currently generated via coal plants, our electricity system is highly carbon intensive.
From a trade perspective, most of our exports come from carbon-intensive sectors like mining and manufacturing. These exports will become less competitive as the world decarbonises and South Africa’s economy will face mounting trade pressure as its trading partners make and implement net-zero commitments and take steps to enable their net-zero carbon growth trajectories.
The R131bn deal that South Africa struck with the US, UK, France, Germany, and the EU at COP26 is certainly a bright ray of hope. It will help SA accelerate its shift away from coal towards renewables while supporting coal workers and coal communities. This is the essence of a ‘just transition’.
Whilst the trade and transition risk are real and complex, they also present investment opportunities into the productive capacity to effect the necessary changes. By actively participating in the required investment, South African investment institutions would provide the much-needed leadership that would catalyse foreign institutional investors to invest alongside them and bring much needed global capital to help make South Africa’s transition just and drive real world outcomes.