investment viewpoints

The two sides of climate change: mitigation and adaptation

The two sides of climate change: mitigation and adaptation
Christopher Kaminker, PhD - Group Head of Sustainable Investment Research, Strategy & Stewardship

Christopher Kaminker, PhD

Group Head of Sustainable Investment Research, Strategy & Stewardship
Thomas Höhne-Sparborth, PhD - Head of Sustainability Research

Thomas Höhne-Sparborth, PhD

Head of Sustainability Research

The global climate is changing due to human activity. Anthropological greenhouse gas emissions - GHGs - have been steadily rising since the pre-industrial era. Since 1970, there has been a 90% increase in carbon emissions resulting from the use of fossil fuels, with average temperatures already having increased by 0.8°C compared to pre-industrial levels.

The all-too-real effects of climate change have become increasingly noticeable. According to data from NASA, the world’s five warmest years on record have all taken place in the period since 2014, and 2019 is expected to join this list, having featured deadly heatwaves across Europe and Asia. The Okjökull glacier in Iceland recently became the first to disappear entirely as a result of rising global temperatures, with large spans of ice shelfs in Antarctica and Greenland now at threat of collapse. In 2019, wildfires in the Arctic and Amazon (both from natural causes and for land clearance) and were the topic of fierce political debate during the G-7 in France.

In 2009, the Potsdam Institute for Climate Impact Research introduced the concept of planetary boundaries based around processes critical to the stability of the planet, along with quantitative limits within which human development can safely develop. Of the nine processes the researchers identified, four of these – including climate change and the integrity of our biosphere – have now been breached, posing dangerous and possibly irreversible risks to the Earth’s system.

Worse is likely to come. Global warming is likely to reach 1.5°C between 2030 and 2052, according to the Intergovernmental Panel on Climate Change’s (IPCC) special report on global warming, and concerted action would be required to limit the rise to less than 2°C by 2100. Any such increase will exacerbate the effects of climate change already seen. Under a 2°C scenario, the IPCC expects a rise in sea levels of up to one meter this century, possibly putting at risk as many as 145 million people living at near-sea level.

According to a new report by a UN environmental body, even this seemingly moderate increase is expected to put 5% of the world’s species at risk of extinction. With hundreds of species already gone extinct, as many as one million others are threatened with extinction, placing current extinction rates up to hundreds of times of higher than the average over the last 10 million years.

Limiting the rise in temperatures to no more than 2°C was adopted as the central goal of the 2015 Paris Agreement. Yet, lacklustre commitment and follow-through has increasingly given the target the appearance of a best-case scenario - not aided by the US decision to withdraw from the accord in 2017.

At higher temperature scenarios, including three or four degree increases, the possible effects on eco- and economic systems become progressively more difficult to predict. Tipping points include increases in temperature that would lead to a rapid acceleration in the loss of ice sheets of Greenland as well as the West Antarctic ice sheet. This loss would trigger higher sea levels and reduce the amount of reflected sunlight, accelerating heating. Many other trigger points may exist but remain poorly understood, such as the risk a sudden dispersal of climate-cooling stratocumulus clouds as highlighted in a recent study published in Nature. The IPCC recognises the likelihood of tipping points that may trigger irreversible changes that may lead to a catastrophic rise in temperatures.


The Economic Cost

With incidences and scale of cyclones, flooding, drought, wildfires and other weather events on the rise, economic losses resulting from these events has similarly increased. Major storms such as Hurricanes Katrina (2005) and Harvey (2017) are each estimated to have caused around $125 billion in economic damage, according to the US National Oceanic and Atmospheric Administration (NOAA).

Climate change has a direct impact on the probability and severity of such events. In the case of Hurricane Harvey, it's estimated that climate change increased its precipitation 38% and its likelihood sixfold. In a study of the effects of Hurricane Sandy (2012), Lloyd’s, a leading insurance provider, estimates that a 20cm increase in sea levels around Manhattan increased the losses by 30%.

The annual Weather, Climate & Catastrophe Insight report estimates that over the years 2010-2018, median annual losses due to weather events reached $215 billion, up from $115 billion in the previous decade. 2017 and 2018 were the costliest back-to-back years in history, with total damages from weather events having amounted to $653 billion. As high as these figures are, they do scant justice to the underlying cost to human life and local ecosystems.

In economic terms, the IPCC estimates that the combined effects from a 1.5°C increase would be expected to result in economic damages of $54 trillion by 2100. Such damage includes the results of physical risks from flooding and extreme weather events, as well as the cost of discontinued and displaced economic activities. These costs would increase to $69 trillion under a higher 2°C scenario. The social and environmental impact of higher-temperature could amount to substantial economic damage, with one set of researchers estimating losses in a 4°C scenario at $23 trillion annually.

Climate action thereby is not only an environmental imperative but a financial and economic necessity. To investors, understanding a company`s exposure to climate change and its level of preparedness is an essential risk management component. Effective climate action will require substantial investments in infrastructure, clean energy, transport electrification, more efficient production processes, sustainable supply chains, and other green technologies.


Responding to climate change

Investing in climate change does not need to detract from the pursuit of economic growth. The OECD has shown that structural reforms and proactive fiscal policies more than offset any negative economic effects that might result from climate policies. One report suggests that such policies, aimed at a decisive transition to a decarbonised economy, would increase output by 3% across the G20 a countries compared with current policies by 2050. On the other hand, inaction or delayed action will be costly. Any delays would necessitate the more rapid and stringent implementation of climate policies when they are eventually put in place, and any high-carbon infrastructure invested in until then would incur additional costs in the form of decommissioning and stranded assets.

According to estimates by the International Renewable Energy Agency limiting temperature increases to 2°C will require annual investments of $3.5 trillion from public and private sources, with current investments falling short by approximately $800 billion per year. This presents investors with a substantial opportunity to finance potential solutions that generate positive returns in sectors with strong business models, while reducing long-term risks and supporting the transition to a more sustainable economy.

Response efforts on climate change fall into two distinct camps – mitigation and adaptation. On the one hand, mitigation is concerned with actions that help avoid or reduce the process of climate change, including global warming. This may include investment in technologies and products that result in a reduction in greenhouse gas emissions, or actions that contribute to the capture and long-term storage of CO2, for instance through reforestation. On the other hand, adaptation actions serve to limit the adverse effects of climate change, for instance through the construction of more resilient buildings, the improvement of flood defences and the strengthening of critical infrastructure.

Both types of actions are considered complementary. For instance, the EU Action Plan on Sustainable Finance considers both mitigation and adaption as eligible activities within its draft classification (`taxonomy`) of sustainable activities, with a working group having been formed to advise on the specific activities that can make a meaningful contribution to these dual goals. 

The LO Funds – Global Climate Bond portfolio adopts a complementary approach in keeping with this dual focus on mitigation and adaptation. Albeit projects focused on mitigation account for the majority of projects covered by the portfolio, it recognises the essential role of adaptation activities with the share of such activities having expanded. A smaller proportion of the portfolio – around 4% in 2018 – is given over to financing social activities.


The nature of mitigation activities

The World Meteorological Organization (WMO) estimates that concentrations of carbon dioxide have increased nearly 150% from pre-industrial times, reaching a seasonal peak of 414.7 parts per million in May 2019. Carbon dioxide is considered to be the most important greenhouse gas that absorb and re-radiate the energy from the Sun and contribute to the warming of the planet. The WMO suggests that even since 1990, the warming of the planet from such greenhouse gases has increased by 41%, with these trends at the heart of the expected increase in average temperatures during this century.

The IPCC has stated that to limit the rise in temperature to 1.5°C over the course of this century, net emissions of carbon dioxide will have to fall to zero by 2050, through a transition to carbon-neutral technologies, or through the offsetting of emissions by other activities that lead to the capture (sequestration) of carbon. Activities that contribute to these goals are referred to as mitigating activities.

Mitigating activities come in a wide variety of forms. First, mitigation-oriented activities may focus on improving efficiency of buildings and production processes to reduce demand for energy and thereby contribute to a lower overall carbon footprint. Second, activities may focus on the development of new products and technologies such as wind turbines, solar energy and electric vehicles – each of which offer a greener profile than the alternatives that they seek to replace. Finally, activities may also include efforts to increase the storage capacity for greenhouse gases, with forests, crops and other natural resources acting as natural carbon sinks.  


Investing in mitigation projects

Mitigation is the focus of approximately 81% of projects supported by the LO Funds – Global Climate Bond portfolio.  Mitigation-orientated projects in the portfolio focus on investment in renewable energy generation, and in efficient infrastructure, such as green buildings and low carbon transport solutions.

On a portfolio-weighted basis, energy is the most significant sector represented in the fund. Clean transport is the second most significant, followed by green buildings. In its 2018 report, the IPCC identified the energy sector as the single most important contributor of greenhouse gases and using a 1980s baseline period, accounted for as much as 57% of the human-induced warming through such emissions. According to the Global Carbon Budget 2018, coal, oil and gas are the three primary sources of emissions from fossil fuels, accounting for 40%, 35% and 20% respectively.

Energy projects account for 33% of the portfolio, largely taking the form of decarbonising and managing energy supply, with a significant focus on renewable energy. Renewables-based energy generation has grown in popularity in recent years and, by the end of 2018, accounted for more than 25% of global power output. The International Energy Agency (IEA) anticipates this share rising to 40% by 2040, due to a combination of falling costs and supportive government policies. Bloomberg New Energy Finance forecasts that electricity demand will attract a total of $13.3 trillion in new investment to 2050, with wind energy accounting for $5.3 trillion of this total and solar energy for $4.2 trillion.

The bulk of renewable energy projects supported by the fund are wind-powered generation. Once instance is a project in Italy which saw the installation of a 10MW capacity onshore wind farm in the municipality of Bisaccia. The five turbines each have a 2MW energy capacity and are connected to the national grid. This will lead to the mitigation of 7,997 t in GHG emissions each year.

Through this and other projects, the fund provides direct support to mitigation activities that contribute to reducing greenhouse emissions and limiting global warming and associated effects on climate change. Minimising the rise in global temperatures through mitigation strategies is deemed the preferred strategy for managing climate change and this is reflected in the heavy weighting of the fund towards this type of action.


Adapting to a warmer climate

Notwithstanding the vital importance of mitigation efforts such as the ones described above, it has become increasingly clear that such actions may limit global warming, but will not be sufficient to halt the impact of climate change altogether. Companies and investors, along the world as a whole, must therefore face up to the reality that climate risks are likely to intensify, with increased likelihood of extreme weather events, higher average temperatures, shifts in rainfall and weather patterns, and higher sea levels. These, in turn, may contribute to wider changes, including damage to life and property, water shortages and scarcity of food and resources.

Responding to this new and changing environment will require active adaptation. Like mitigation actions, adaptation actions can take many forms. Starting early and integrating climate resilience from an early stage into infrastructural and construction projects is a key step. This would involve, for instance, more careful location mapping to reduce exposure to flood risk, or more stringent building controls to increase preparedness, through simple interventions such as the raising of lower floor levels or using tiles and other waterproof materials to facilitate clean-up and repair operations after a severe weather event.

Adaptation projects may also include more ambitious infrastructure, such as the construction of flood gates, perimeters, dykes, reservoirs and other water defences that may provide protection to population zones, as well as infrastructural projects – such as protection of power networks by placing cables underground, or the upgrading of a city`s waste and sewage system.


Investing in adaptation projects

Investing in projects such as these may stave off greater costs in the future, with government spending on improving resilience on average estimated to reduce future losses at a factor of five to one for every dollar spent.

Despite this strong investment case, only 5% of all climate change investment worldwide is currently spent on adaptation efforts. More is needed, with the United Nations Environmental Programme (UNEP) having estimated that globally as much as $500bn a year will be required. To this end, the World Bank Group (WBG) has announced it would be elevating adaptation to be on an equal footing with mitigation actions, as part of its 2025 Climate Change Targets.

This growing focus on adaptation is reflected in the portfolio. In 2018, adaptation-focussed activities represented 14% of the portfolio, up from 8% in 2017. Through engagement, Affirmative Investment Management (AIM) seeks to encourage greater investment in adaptation, such as in water management systems, flood management controls, climate-smart and resilient infrastructure, and hazard warning systems.

One of the adaptation projects the portfolio supported in 2018 reflects the risk climate change presents to food security, and the effect it has on extreme weather patterns. The project in question was based in Fuijan, which is heavily affected by typhoons by every year. Through an International Bank of Reconstruction and Development Green Bond, the fund backed a series of adaptation projects, including upgrading ports, necessary preparations against seasonal storms, and improving emergency response systems. Scheduled infrastructure upgrades include breakwaters, docks, seawalls, and sheltered water areas.


The Road Ahead

Through the IPCC, a clear scientific consensus has emerged as to the nature, causes and consequences of climate change. There is no doubt that climate change will play an increasingly dominant role in shaping the way we live, produce, and consume. To maintain relevance in this evolving environment, a proactive strategy will be essential, with climate denialism likely to prove a failing, and even suicidal strategy, for governments and businesses alike. 

Finance plays an important role in facilitating these solutions. Through initiatives such as the Climate Bonds Initiative and the EU Framework on Sustainable Finance, sustainability will increasingly become an integral part of companies` performance, reporting and attractiveness to investors. With demand for green finance opportunities on the rise, new products will be required to enable investors to help finance these activities.

The LO Funds – Global Climate Bond portfolio adopts a forward-looking and responsible strategy, based around the complementary approaches of mitigating actions and adaption, focusing on key sectors where the impact of climate change is most immediately felt. It takes the view that climate change has immediate economic and financial implications and is here to stay – and we must be responsive to it.

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