Investors and corporations will arrive in Dubai for COP28 later this month, and the world is depending on them to recognize and address a paradox: ordinary net zero 2050 commitments are one of the biggest threats to achieving net zero carbon emissions in 2050.

While paradoxical, this is quite simple to understand. On their own, net-zero commitments reward divestment, and that merely changes the ownership of dirty assets, not emissions into the atmosphere. We will only lessen emissions in the atmosphere by long-term investors and companies owning and cleaning dirty assets.

We have to clean up our mess, not hide it.

Take it from Ontario Teachers’ Pension Plan. Jonathan Hausman, executive managing director of global investment strategy, recently remarked, “We need to use the levers of investment that we have to make an impact well beyond the portfolio footprint of Ontario Teachers, and that is something that we call ‘high carbon intensity transition assets’.”

Ontario Teachers’ intends to allocate around C$5 billion to such assets – high-emitting companies with credible decarbonisation plans that can be accelerated via capital and expertise. OTPP is doing this in the context of its net zero 2050 commitment and interim targets, and this effort to decarbonise, rather than divest, is what makes their commitment practical and meaningful.

The hard part is actually cleaning up dirty assets.

Long-term investors and companies see private markets as offering a special pathway to success. Private ownership is more concentrated, long duration, and prepared for this type of risk compared to the diffuse, high-turnover, and volatility-sensitive shareholders in public markets. All of these are advantages when the investment strategy depends on a big transition like decarbonisation.

Still, the work is hard, in part because limited partners (LPs) have deep concerns about allocating to general partners’ (GPs) transition strategies. LP concerns can range from greenwashing on the impact portion of the strategy to concessionary performance on the financial portion of the strategy.

We know this because long-term investors brought these realities to us in the larger context of FCLTGlobal’s effort to develop tools that allow LPs and GPs commit together to grey-to-green strategies.

Fee provisions are an example of these tools. In the course of this effort, LPs and GPs together identified sample fee and expense terms, such as including an emission-reduction target in the hurdle rate, putting carbon performance targets into the carry, and expensing offsets out of the management fee for any carbon underperformance.

And fees are just one example. Mandate terms are the centerpiece of any relationship between clients and managers and, in a deeper toolkit for top-down portfolio decarbonization, a similar group of owners and managers offer carbon-related mandate provisions for benchmarking, contract term, redemptions, projections, and reporting.

Long-term investors can come to COP28 ready to talk about how they are putting tools like these to work. Hausman continued, “We have one [high carbon transition asset] that we’ve worked on already, but we want to do more at a bigger scale.”

OTPP is in good company with this approach to decarbonisation. CDPQ has allocated C$10 billion to decarbonisation investments, and AIMCo is doing similarly, as chief executive Evan Siddall has stated explicitly: “We’re a long-term investor, so unlike public markets that tend to operate quarter to quarter with much shorter-term horizons, we can look to a transition into 2030 and see the path to earning a return on decarbonisation.”

There are limits to this sort of strategy, of course, just as there are for any investment. Two are particularly relevant to climate.

Transition strategies require trust. For asset owners, the sponsor has to trust that the fund can handle the usual financial aspects of an investment while simultaneously pulling off a highly-technical, scientific transition. For asset managers, the same trust is required from their clients. Trust is earned before it is applied, so the only agents in a position to accept this opportunity cost are those that have prepared their principals for it well in advance.

Relatedly, transition strategies test investors’ willingness to tolerate a bumpy ride. Ordinary net zero 2050 commitments with interim targets are appealing in part because they promise a smooth and foreseeable path to a clear destination. Transition strategies promise that the investor’s carbon footprint will get worse before it gets better. Emissions will go up every time the investor brings a dirty asset onto the books, it will take years for each to decarbonise, and the exact moment when those results begin to appear is very uncertain.

OTPP, CDPQ, AIMCo, and other long-term investors are committing to transition strategies nonetheless because they have the tools, they understand the long-term financial appeal, and that this is what it will take to get to planetary net zero 2050. That is what COP is about, and all of us are depending on this approach scaling at COP28.

Matthew Leatherman is managing director, research strategist at FCLTGlobal.

The world is shifting from a regime where climate change is viewed as a shared burden or a hot potato to pass around, to one where it is a “business opportunity that everyone should be scrambling to make money from,” according to University of Oxford Professor J. Doyne Farmer, citing probabilistic assessments by his team.

Drawing from complexity and systems theory, Farmer pointed to the growing deployment of technologies like solar energy, P2X fuel and batteries, and the falling cost of their usage over a long period of time.

“We have batteries coming down in cost quickly, we have windmills coming down in cost quickly, we have hydrogen-based fuels coming down quickly,” Farmer said. “So we have the technologies we really need dropping in price just when we really need them to deal with climate change.”

Technological change is “very inertial,” Farmer said. “Once a technology starts improving at a certain rate, it’s likely to keep improving at that rate for a long time.”

Professor J. Doyne Farmer is the director of the Complexity Economics programme at the Institute for New Economic Thinking at the Oxford Martin School, Baillie Gifford Professor in the Mathematical Institute at the University of Oxford, and an external professor at the Santa Fe Institute. 

He was speaking with Stephen Kotkin, senior fellow at Stanford’s Freeman Spogli Institute for International Studies, and the Kleinheinz Senior Fellow at the Hoover Institution, at the Sustainability in Practice conference held at the University of Oxford this month, organised by Top1000funds.com. 

The topic of the discussion was empirically validated probabilistic forecasts of energy technology costs, and the trillions of net savings that could result in a rapid green energy transition.

A range of predictions about technological change have turned out to be true, Farmer noted. Moore’s law from 1965 predicted computers would improve exponentially through time. Another observation from Theodore Wright from 1936 was that airplanes from a given factory drop in cost of production by about 20% every time the cumulative production of the factory doubles. 

“This law turns out to be true for lots of technologies and not just at the level of factories, it turns out to be true globally as well,” Farmer said.

These laws can be used to predict the future behaviour and performance of technologies, “even if you can’t predict the innovations that will enhance future performance,” Farmer said.

Drawing from these findings, Farmer and his team developed a probabilistic method for forecasting technology costs based on historical data, by collecting data on 50 technologies, “pretending we were at some point in the past and making 6000 forecasts for different points in the future.”

They then applied their findings to three different scenarios for the green energy transition: one scenario being business as usual, one being a slow transition, and one being a fast transition. 

Despite roadblocks such as political hurdles and land use issues, “greener energy will be widespread and substantially cheaper than energy has ever been in 20 years, with reasonable likelihood,” Farmer said.

“So this will bring us a lot of benefits. We’re going to have cheaper energy than we’ve ever had. We’re going to have lower volatility for energy prices. We’re going to have better energy security. We’re going to have low pollution. We’re going to have lower environmental impact and better sustainability. And most of all, no or minimal greenhouse gas emissions.”

By contrast, the “mainstream” way of doing forecasts practiced by the International Energy Agency and “integrated assessment modellers” has proved consistently wrong over time, Farmer said. “They just consistently were too pessimistic about how quickly the cost of renewables will drop and pessimistic about how quickly they would be deployed, even though the historical data should have been screaming at them.”

Net zero emission targets may cover most of the global economy, but the world is not going to deliver on its net zero promises, warned Oxford University’s Cameron Hepburn, speaking at Sustainability in Practice.

Hepburn, who is Battcock Professor of Environmental Economics and  director of the Economics of Sustainability Programme at Oxford’s Institute of New Economic Thinking, said there is not enough accountability or transparency to hold governments and corporations to their net zero promises.

“We are not holding each other to account,” he said, adding that if the world stopped burning coal, invested in renewables and electrified heating and transport systems, it would be possible to cap warming although 1.5 degrees is now “a huge stretch.”

The scale of the problem

Hepburn said it was difficult to electrify an entire economy. It requires trillions of capital not only going into renewable energy production but also industries like plastics, and food systems. Society also needs to tackle legacy emissions, taking carbon out of the atmosphere not just by planting trees and natural solutions but also putting carbon into depleted oil wells, for example.

Indeed, Hepburn flagged that consideration of electricity storage lags, and society has not understood the “storage challenge.”

Investment in the transition is also complicated because the dynamics are not linear and investment can trigger unexpected events. It involves understanding where the tipping points are in the system, and where investors have the opportunity to make a difference. The explosion in solar energy shows that progress is rarely linear.

“Solar is no longer an expensive joke,” he said.  He said to expect similar leaps forward in diet as the world moves from a traditional food system.

He warned that investors are holding stranded assets, and that assets are mispriced. “It is important that we have an orderly transition and start pricing assets correctly for financial stability.” He said an orderly transition is within our control, diversification is possible to prevent value being destroyed and urged for a tighter connection between climate and science.

Hepburn said change was dependent on leadership. He said it would be possible to run the entire UK economy on wind and solar.

Change is possible

When change happens, the global system will move into a new dynamic. This could see billions of market capitalization wiped out, and financial shifts moving large amounts of value around the market. Beliefs, incentives, and new laws will also start to move capital and systems, he said.

“Beliefs will change the status quo because if enough people believe it can happen it will be self fulfilling,” he said. He said the way technology and beliefs penetrate a system can cause sudden changes and shifts.

He stressed the urgency of new policies. But said in the absence of policy, investors should use their heft to put pressure on regulators to move the needle on policies. These policies will then allow investors to tap climate alpha when they invest in solutions. “The door will slide opend as the government becomes more amenable and moves the needle on the regulatory side.”

He said moving forward requires credible targets and corporates are floundering on how to make progress. “I hear board after board ask how do we make money with doing what we know we have to do?”

He called for more granular modelling in the financial system and said many of the today’s tools are ill-equipped, warning that often data doesn’t say anything useful

He said that if nuclear is to have a significant role it needs to come down the cost structure and deliver cheaper power.

Some 150 countries now have a net zero target. Of those Hepburn estimated 20 per cent have enshrined those targets into law resulting in governments getting punished if they fail to deliver. “Laws can be changed, but it gives a sign of strong confidence,” he said. “Countries that don’t have this as their baseline scenario don’t know what they are doing. We are just at the starting point where this takes off.”

He said that nature-based solutions are not permanent solutions. Nature based solutions involving managing the land and reducing biodiversity loss can deliver a great deal but they really only “buy time.” “They are very valuable because time is valuable, but they are not solving the problem in one go – they are storing it up for others to deal with.”

 

 

 

The world is shifting from having very few centralised power stations feeding electricity into the grid, to a more dynamic market with abundant opportunities for investors, according to Alex Brierley, co-head, Octopus Energy Generation, a specialist renewable energy and energy transition manager with about £6 billion worth of assets under management.

The opportunity set now includes rooftop solar generation, the decarbonisation of heat, energy storage and electric vehicle charging, green hydrogen and many other facets, Brierley said, in a panel session at the Sustainability in Practice forum, organised by Top1000funds.com and held at Oxford University.

“These are big new investment areas that I think investors should engage with,” Brierley said, in a session looking at the European energy market over the past three years and the opportunities in renewable energy assets.

Energy investors are looking for diversification and low correlation with their listed equities and fixed income portfolios, along with predictable yield and inflation protection, when they look to infrastructure including renewable energy infrastructure, Brierley said.

These expectations have been tested over the last three years, with events such as the onset of Covid-19 and the invasion of Ukraine causing massive fluctuations in energy and commodities prices. Now the fighting in Gaza threatens the path of oil and gas into Asia if Iran moves to shut the Strait of Hormuz. 

Despite the turmoil, renewable assets have largely performed as investors hoped, “and that I hope encourages many investors in this room to keep on investing in the incredibly important job that these assets are doing,” Brierley said.

Green hydrogen is unlikely to play a part in decarbonising heating in homes through the existing gas network, as ground source and air source heat pumps are far more efficient, and less dangerous, Brierley said. However green hydrogen could play a role in decarbonising big industry, he said. 

Green hydrogen is also the likely answer to power storage in a world dominated by solar and wind assets, he said, as “when there’s low wind for four or five weeks in a cold winter, short-term batteries just can’t cut it.”

Increasingly engaged consumers are also playing a role by buying electric vehicles at scale, plugging them in, and “allowing power companies like ours to actually determine when to charge those vehicles or not to charge those vehicles,” he said.

“We now have about 100,000 electric vehicles under the control of Octopus, we decide when they charge and when they discharge,” Brierley said. “What that essentially means is that we have about 550 megawatts of dispatchable capacity, which is basically just a really, really big battery and it’s extremely efficient.”

A table discussion asked audience participants–predominantly global institutional asset owners–what was holding them back from further investment in the energy transition, drawing a range of varied responses.

One participant said the rise in interest rates, and corresponding cash flow management issues,  had reduced demand for higher-yielding, illiquid infrastructure assets. Others were concerned about the economic sustainability of some parts of the renewable energy ecosystem with some major players in wind generation experiencing problems. 

Another investor said there were bigger priorities than the energy transition, such as water security. Another pointed to the difficulty of portfolio design with climate opportunities often falling between different asset classes, and challenges building internal expertise to recognise and move on opportunities.

Modern portfolio theory is useful in a world where the future is just like the past. But when it comes to climate change, the future is likely to be dramatically different requiring a new framework for decision-useful climate scenarios.

Speaking at Sustainability in Practice at Oxford University, Mark Cliffe, Visiting Fellow at Global Systems Institute, University of Exeter said that long-term scenarios looking years into the future are not necessarily decision-useful. They don’t reflect the volatility ahead and official scenarios underestimate the risk and opportunities arising from climate change, he told delegates, adding the challenge of pricing and modelling portfolio risk is finding predictable activity.

Cliffe explained that key “chronic” risk analysis is missing in modern portfolio scenarios which omit, for example, the impact of tipping points, natural capital loss, and the impact of war.

Scenario drivers include policy, geopolitics, the state of economies and technological change. “You have to factor this into scenarios,” he told the audience of institutional investors, asset managers and fellow academics. Elsewhere, he warned that the actions of NGOs and shareholders also needs to be integrated into a base for transition planning.

The challenge for investors is finding a balance that integrates the financial materiality in line with these risks and a fiduciary duty and legal obligation to reduce risk. However, he said “investors don’t have legal obligations to the planet.” Engagement is a high impact strategy and it is possible for investors to pressure companies to take responsibility for their externalities although he said “persuading people to do things they don’t want to do is hard work.”

He noted that divestment allows investors to hit carbon targets by offloading assets but “doesn’t help the world.” Alternatively, investors can line their portfolios with transition assets, and ride the transition.

Fellow panellist Mirko Cardinale, head of investment strategy at USS, explained how the United Kingdom’s largest pension fund has introduced a new approach to climate analysis. Traditional scenario analysis, he said, often left the investor with more questions than answers and omits uncertainty around physical risk and the interaction between physical risk, inflation and tipping points. [See USS outlines new  climate scenarios for improved investment decision making.]

The investor has focused its analysis on key objectives including the integration of climate science; a focus on short-term scenarios in a bid to make the information decision-useful, a focus on volatility, moving away from benchmark-relative to holistic performance assessment and introducing a new governance framework. Cardinale said it involves a change of mindset in terms of how to approach asset allocation.

“It’s much harder to incorporate this complexity into portfolio,” he said.

Cardinale explained that the approach involves embracing a multi-faceted view of risk and moving away from strategic asset allocation with clearly defined parameters and reference portfolios.

He said that at USS the process remains a work in progress. “We don’t have firm conclusions and can’t say which assets to buy and sell.”

Going forward, the process will help shape scenarios that include new, challenging views on assets that will inform and change the nature of mandates and set different asset allocations. He continued that analysis involves quantitative and qualitative assessments.

“You need a process that has the flexibility to be top down and bottom up, allowing the different design of mandates for equity and infrastructure.” He added: “factoring in resilience to climate and inflation may be more important than the change in asset allocation.”

He said that climate is a clear financial risk and doesn’t conflict with fiduciary duty and told delegates that USS has been able to explore this new approach because of a change in governance.

Fellow panellist Mike Clark, founder of Ario Advisory and the Institute and Faculty of Actuaries representative on the global advisory council of the Sustainable Finance Programme at the University of Oxford’s Smith School of Enterprise and the Environment said it is important to get finance closer to science.

He said that the strategic risk around climate is mispriced; investors are not managing systemic risk or engaging with policy makers. He added that modern portfolio theory doesn’t work because of explosive materiality – for example changes in the food system and different growing seasons in Europe.

“There are things out there that finance isn’t thinking about, we are approaching tipping points and how are we going to reprice risk?”

 

The world is on the cusp of entering a new labour market. As western economies grapple with demographic shifts and labour mismatches, a new set of opportunities and risks have appeared for investors. PGIM thematic research group director Jakob Wilhelmus outlines what they should look out for in this new world order.

The world is on the cusp off entering a new labour market as western economies grapple with demographic shifts – ageing populations, shrinking workforces, labour mismatches and the rise of new technology.

Dealing with the first issue, many countries continue to treat Japan as the classic case study of dealing with an ageing workforce. However, investors have been warned that the country’s macroeconomic experience was, in fact, an “outlier”.

In a podcast interview for Top1000funds.com, Jakob Wilhelmus, PGIM’s thematic research group director, said he’s concerned that Japan has become a “distraction” for investors.

His latest Megatrend research paper, The Transformation of Labour Markets, identified declining working-age population and labour mismatches as two main elements behind the world’s changing workforce. For most countries, Wilhelmus said these two factors would mean higher inflationary pressures, which was not the case in Japan.

“There are really two reasons for that [increasing inflationary pressures]. One is the fact that a decrease in available workers will increase wages, which in turn will lead to higher price inflation,” he said.

“And second… the growth of that [retiree] segment of society will lead to more consumption, higher fiscal spending and less production.

“This was very unlike the experience that Japan had two-three decades ago, and that is because it took choices that maximised the disinflationary impact by deciding against immigration, and instead started to outsource its production.

“But when you look at the realities of today, countries are facing a very different situation where labour is becoming scarce almost everywhere.”

Industries on notice

Labour mismatch refers to the structural imbalance between labour demand and supply and, according to Wilhelmus, often gets mistaken as short-term cyclical shortages.

He pointed to the example of China, the country with the most STEM graduates in the world. Despite abundant talents, the country’s youth unemployment rate is over 20 per cent in 2023. Wilhelmus attributed the phenomenon to a discrepancy between China’s main economic activity (manufacturing) and its worker’s sophisticated skills.

“The situation is very similar here in the US, Australia or Europe. There is a big gap between the demands of the job market and the skills the workforce possesses or can offer. In certain advanced economies, it’s particularly around vocational jobs like nurses and electricians.”

When it comes to potential solutions for the mismatch, Wilhelmus said policy choices will play an important part.

“On the one hand, it is immigration, which is a very loaded topic. But realistically, almost every country will have to figure out how to track global talent in a world where most countries will be competing for the same pool.

“On the other hand, its participation rates… because the reality is that while many countries have come a long way, the female participation rate is too low, and finding ways to increase that can increase economic output significantly.”

Investors’ role

The lesson for investors from these insights, Wilhelmus said, is to think twice before buying into the new labour market’s hype, of which generative AI is a prime example.

“It’s in some way very similar to the early days of the internet. AOL and Netscape looked like earlier winners, but those are two names that few investors want to remember,” he said.

“It’s really about the infrastructure to run those services and the underlying models, and not so much about the applications. That means investments in data centres – both the providers and the actual real estate – as well as chip manufacturers.”

He also suggested that investors based their analysis more on countries, and less on asset classes. As countries face different demographic stages, they will have different growth rates.

While advanced economies are already struggling with inflationary pressures, emerging markets such as Asia and Latin America may be less threatened, while South Asia and Sub-Saharan Africa regions are just seeing the benefits of a young and growing population.

“But here the challenge is that demographics alone do not guarantee economic growth… because most of the countries in those latter two regions really lacked the high levels of human capital and institutions that are needed to unlock the economic prosperity that can come from a growing workforce.

“It is really about a holistic assessment of the turning point in global labour markets and working through all of its implications.”