Transition plans should sit at the heart of investment and capital allocation strategies to kick start what should be a decade of exponential change to green all sectors of the economy.
What is clear from all climate change scenario pathways to 1.5°C (e.g., IEA Net Zero Emissions, DNV Pathway to Net Zero) is that there needs to be an urgent and steep transition within all sectors of the economy. These scenarios imply a radical transformation of the energy sector characterised by multiple fold increase in solar and wind, in low-carbon hydrogen production, in CCS build-out as well as significant investments into power grids and energy efficiency measures. The key message is that we need exponential change and not an incremental fine-tuning of current trends. And this scale of change needs to be well underway within this decade.
Delaying this change to later decades would potentially mean that we significantly overshoot the remaining carbon budget to limit warming to 1.5°C. Many 1.5°C scenarios assume an initial overshoot of the budget with subsequent negative emissions to counter that. However, this approach is based on linear assumptions which does not account for the potential of irreversible climate feedbacks. Hence, the global ambition to 2030 matters.
The focus for governments, investors and companies, therefore, needs to be on setting clear targets to 2030 with the objective of reducing global carbon dioxide emissions by around 45% in 2030 compared to 2010 level (IPCC Special report, 2015). On our current trajectory, we are heading towards a 16% increase in CO2 emissions compared to 2010 level (UNFCC synthesis report).
Steering away from this trajectory requires a rewiring of finance as, fundamentally, addressing climate change is a capital allocation or reallocation problem. This means greening investment portfolios by transitioning existing carbon-intensive assets/products and, by financing green products and services – a contrapuntal motion of greening finance and financing green.
An encouraging step is the Mark Carney-led coalition of financial companies representing USD 130 trillion of capital which committed to net zero targets by 2050. Such pledges need to be backed by clear targets within this decade (e.g., 2025 and 2030 targets) given the scale and speed of the transition required.
Currently, there is still a wide gap between ambition and action of financial and corporate actors:
- The TCFD 2021 Status report found that ‘significant work remains to mainstream consideration of climate-related issues within financial decision-making’. One of the key areas where improvement is required is ’amount of expenditure / capital investment to be deployed to meet targets for addressing climate risks and opportunities’.
- The Carbon Tracker report (Sept 2021) assessed the financial reporting of 107 publicly listed carbon intensive firms. One of the key findings was that there is a lack of consideration of material, climate-related matters in the financials.
At its heart, the lack of consideration of climate related matters in financials is primarily driven by two factors a) a misalignment of temporal horizons – i.e., short investment / strategy horizon of asset managers and company boards compared to the multidecadal climate change horizon – and b) by a market failure to effectively price the cost of carbon, leading to asset mispricing.
Given that the pricing of an asset is based on its expected future cash flows, it is fundamental that the impact of climate risks and opportunities are considered in asset valuation as these may lead to asset impairment, affect its ability to access capital, impact on its revenues due to shift in demand, require additional investments or increase operating costs.
For investors to effectively price those risks and opportunities, they need information at an asset or company level. Companies need, therefore, to assess their climate risk exposure in the context of potential pathways that limit warming to 1.5°C. This should culminate in companies developing credible detailed transition plans that set out:
- how they are going to mitigate and capitalise on the risks / opportunities of the unfolding transition,
- how they are going to decarbonise their full life-cycle operations (scopes 1, 2 and 3 emissions) with clear definition of targets and timelines, and
- how the risks/opportunities and decarbonisation targets are reflected in their forecast capital expenditures (CAPEX).
The plans need to set out short and medium-term 1.5°C aligned metrics and targets up to 2030 with details on how the plans would be reflected in the real economy. These can be based on developing CAPEX plans for unconditional CAPEX investments (i.e., projects that are economically viable based on current policies and business models) and for conditional CAPEX investments (projects that require new policy levers or new business models to be economically viable).
By incorporating details of future unconditional and conditional investments into transition plans, those plans can have a catalytic effect in terms of:
- realigning financial flows - the plans will allow for better asset pricing by investors thereby supporting informed capital allocation decisions.
- influencing government policies – by identifying areas where new policy tools and/or business models (e.g., carbon tax, carbon border adjustment mechanisms, etc.) can unlock investments, companies and investors can effectively build a strong coalition to push for action by governments.
The plans will also facilitate the reporting and disclosure requirements for both investors and companies in the context of an increasingly stringent regulatory landscape.
And transition plans will also provide investors with visibility on alignment of their portfolios with a 1.5°C target. By aggregating the emissions from each asset within their funds, investors can assess and monitor their current emissions intensity and forecast their portfolio emissions trajectory based on the transition plans of the companies within their various funds.
Where companies have not submitted transition plans, investors should actively push for such plans to be developed as part of their engagement strategy with companies. This is particularly relevant for investments in carbon-intensive companies where, instead of an immediate divestment strategy, equity investors and lenders can steer such companies to develop credible transition plans based on clear milestones backed by potential future divestment or increased financing costs if targets are not met.
With regulators looking to legislate for transition plans, companies can get ahead and lead the way in developing these plans. This will be instrumental in effecting the scale of change required given that we cannot afford to wait any longer and we need to pick up the pace of the transition now or we risk 1.5°C slipping from our grasp. Given that, at its core, this is fundamentally a problem of capital allocation, investors and companies have a massive role to play in accelerating the steep downwards correction required in our current emissions pathway.
And transition plans should sit at the heart of this transformation to kick start this decade of exponential change.