COP26: 7 key takeaways for investors

The Glasgow Financial Alliance for Net Zero (GFANZ) sees 450 financial institutions with USD 130 trillion in assets committing to the transition to net zero. This does not reflect a new flow of capital to be invested in green solutions (the first GFANZ priority) but rather the stock of capital for which its owners and managers recognise the need to decarbonise underlying, invested assets (the second priority).

The challenge is, of course, vast. One issue concerns the fact that not all net-zero targets set by companies are equal, with many lacking clear plans for implementation. The UN Secretary General Antonio Guterres is set to launch an expert group to propose clearer standards to measure and analyse net-zero commitments within the private sector. In parallel, a newly merged International Sustainability Standards Board (ISSB) will aim to create disclosure standards to help investors make informed decisions about corporate climate performance.

 

The current state of net-zero alignment

Taking the credibility of commitments into account, Lombard Odier estimates that only 25% of large caps today are aligned to keeping warming below 2°C, and only 6% are on track to keeping warming below 1.5°C. For net-zero minded investors, this means that the challenge may be less about pouring capital into that small subset of the economy that is already aligned, but more about bending the curve of emissions in the remainder of the economy – where the greatest impact will be made and potentially the most attractive transition opportunities will be found.

The CDP has estimated that of 16,500 investment funds, less than 1% are aligned to keeping warming below 2°C. Given the observation above, this is perhaps not surprising, given the small percentage of investable assets that we believe is already aligned. Moreover, a fund that is currently aligned to 1.5°C is investing in companies that are already on the right track, but it is also imperative to invest in companies that need to get on the right track, supported by investment and engagement policies.  

Fossil fuels are explicitly addressed in the Pact, marking another first in climate communiques achieved at COP26. Verbal acrobatics near the end of the summit’s 24-hour extension led to calls for a phasing out of coal to become a “phasedown” of “unabated” coal, allowing room for carbon capture and storage technology to be used. Similarly, a phaseout of fossil-fuel subsidies was similarly caveated to focus only on “inefficient” subsidies. This leaves much room for the imagination.

In parallel with the Pact, a separate coal pledge seeks to phase out coal in the 2030s for major economies and 2040s for poorer nations – “or as soon as possible thereafter” – and end investment in new coal-power generation domestically and internationally. More than 40 countries signed the Pact, including heavy coal-users Poland, Indonesia, and Vietnam. This pledge, too, leaves plenty of manoeuvring room, but if successful could phase out 40GW of coal power across 20 countries.

Financial incentives, however, will likely be vital. Over USD 20 billion will be made available to support this, including USD 10 billion in philanthropy-led financing set aside to support clean technology deployment in developing countries. There is also USD 8.5 billion allocated for the South Africa Just Energy Transition Partnership, which is a multilateral effort that could serve as a model enabling other developing nations to ditch carbon-intensive forms of power.

Beyond coal, a group of 20 countries, has committed to stop financing foreign fossil fuels project by end of 2022.  More than 100 countries have also signed the Global Methane Pledge, committing to cut methane emissions – many linked to fossil-fuel supply chains – by 30% by 2030. This is accompanied by legislative measures and a proposed $1,500/tonne methane levy in the US for oil and gas producers. There is still leeway, but commitments to wean the economy off its reliance on fossil fuels are being stepped up.

Evidently, over the past decade, Goldman Sachs has seen a rising cost of capital for fossil-fuel producers while renewable-energy generation has become ever cheaper to finance (see figure 1). As this trend continues, an unprecedented shift in capital allocation will happen as more energy investment is channelled into renewable energy.

 

FIG. 1. Cost of capital: fossil fuels vs renewable energy

 

 

 

 

 

 

 

 

 

 

Source: Goldman Sachs as at November 2021

COP26 was always focused on climate change, but the interconnectedness of environmental challenges put nature firmly on the agenda. Indeed, at Lombard Odier, we recognise that climate change is one of nine planetary boundaries, of which humanity has breached at least four: climate, biodiversity, land use and biogeochemical flows.

The main text of the Pact recognises the need to protect, conserve and restore “nature and ecosystems…including through forests and other terrestrial and marine ecosystems”. The preservation and harnessing of nature’s regenerative powers not only represent an important goal, but will also be an essential lever in halting climate change given that our oceans, forests and other vegetation act as important carbon sinks. When these ecosystems are destroyed, stored carbon is released into the atmosphere. Reforestation reverses that trend and may contribute to carbon removal.

The End Deforestation Pledge, signed by countries with over 85% of the world’s forests, seeks to halt and reverse forest loss and land degradation by 2030. Although the pledge is effectively a relaunch of an earlier 2014 declaration, it seeks to deliver more meaningful results by committing to specific overseas development financing to boost forest protection and restoration. It also focuses on the role of sustainable trading in commodities most at risk from deforestation. The pledge is also supported by a separate commitment by 30 financial institutions – including Lombard Odier – with total assets of USD 8.7 trillion seeking to eliminate deforestation risks from their portfolios by 2025 or earlier.

Critics have questioned the credibility and commitment of governments in some of the countries most exposed to deforestation. Other challenges – relating to accounting processes, verification, and data availability – also remain. Despite this, the pledge could spur the voluntary carbon-offset market, as avoided deforestation, reforestation, afforestation and more sustainable forest management may be one of the lowest cost, highest impact levers available to accelerate the transition to net zero and a more nature-positive economy.

Technological innovation will most likely be a key catalyst for the transition and help fuel the ambitions governments will commit to in future negotiations. Widespread cleantech adoption is thereby somewhat of a chicken-and-egg problem, with supportive policies and private-sector investment reinforcing one another in an ongoing cycle.

Recognising the role of technology in the transition, the Glasgow Breakthroughs involve 40 countries that are committing to cleantech deployment to ensure multiple goals by 2030. These include:

• Ensuring clean power as the most economical option across regions
• Making zero-emission vehicles the norm
• Promoting near-zero emission steel as the preferred choice
• Making green hydrogen affordable globally
• Driving the uptake of climate-resilient, sustainable forms of agriculture

 

The drive for EVs

In the COP26 Transport Declaration, a group of countries, cities, auto manufacturers and financiers announced a further commitment to “work towards all sales of new cars and vans being zero emission…globally by 2040 and by no later than 2035 in leading markets”. Signatories largely comprised countries that already have phaseout policies for fossil fuels, but the initiative creates a benchmark for others to follow. Companies operating in countries that are not yet promoting these policies, where electric vehicles remain broadly unaffordable, and where electricity grids remain dependent on high-carbon power, abstained from the commitment.

As the market monitored developments at COP26, cleantech stocks experienced a small rally while pure-play electric vehicle firms surged. Tesla’s market cap passed USD 1 trillion just before COP26, surpassing the combined valuation of the next nine largest automakers. Rivian went public, valued over USD 100 billion, making it the largest US IPO since 2014 despite only having started producing electric vehicles this year.

 

FIG. 2. Building portfolios back better: medium-term performance of stocks positively exposed to decarbonisation

 

 

Source: Bloomberg as at November 2021

Under Article 6 of the Paris Agreement, a carbon trading and market mechanism was envisioned to enable faster and cheaper carbon reduction among country or corporate counterparties.

A simple example of the mechanism in action is as follows. If it is easier to reduce emissions in country B than in country A, country A might offer to pay for country B’s abatement. If that reduction would not have happened in the absence of A’s support, A would be permitted to claim B’s reduction.

Article 6, now part of the Pact, is a comprehensive set of accounting rules and inventories that require countries to make “corresponding adjustments”. Through this mechanism, the country selling the reduction adjusts its emissions level upwards, while the buyer adjusts its emissions downwards, thereby preventing double counting.

To implement this, a new credit mechanism has been created, replacing the Clean Development Mechanism (CDM) negotiated as part of the Kyoto Protocol in 1992. Key differences in the new mechanism are its move away from purely enabling carbon offsets and accrediting reductions between the buying and selling countries, rather than the buyer alone. In addition, 5% of the credits transacted must be committed to an adaptation fund to finance stronger resilience to the physical impacts of climate change.

For companies, the use of carbon credits would be governed by their respective countries’ emission-trading schemes. With increased clarity about these accounting systems, international credits could be used more widely.

 

Price surge

The carbon market is responding to COP26’s signal. Consensus about the likely scarcity of carbon allowances in the future is emerging amid a rapidly dwindling carbon budget intended to keep 1.5°C in sight. Accordingly, the European carbon price jumped to an all-time high of more than EUR 66 per tonne at the conclusion of the summit.

 

FIG. 3. Carbon prices rise to record after climate agreement in Glasgow

 

 

Source: Bloomberg as at November 2021

For the worst-affected and most vulnerable nations, climate change creates severe environmental, economic and societal risks. Many cannot afford adaptation measures and must rely on global decarbonisation efforts. From their perspective, any temperature commitment that is not 1.5°C or below is disastrous – and unfortunately, COP26 has not delivered this.

The Paris Agreement promised USD 100 billion per year of climate finance from developed countries to the global south by 2020. Six years later, the target has resoundingly been missed and delayed for another two years, casting doubts on promises made by industrialised economies. Several requests have also been made to further increase the funding, with the Pact acknowledging the necessity of “significantly increasing” investment beyond the original amount but not agreeing a specific figure.

Some progress has, however, been made in providing adaptation finance. Industrialised countries committed to doubling their contributions to the global south to USD 40 billion each year by 2025. In a breakthrough, the pact addresses “loss and damage” to focus on the unavoidable impacts of climate change that cannot be mitigated or adapted to. This implicitly acknowledges richer nations’ accountability through historical emissions, and COP26 offered the first contribution to the fund. But at GBP 2 million, the amount is symbolic at best.