This article was originally published in June 2020.
According to the IPCC, we have about 10 years – at current emission rates – before the planet hits the CO2 budget limit consistent with giving us a fair chance of avoiding an average temperature increase of 1.5°C. Beyond that increase, climate scientists fear non-linear environmental and economic changes.
Estimates of the investment required to avoid that outcome are around $1tn per annum. And most of the IPCC simulation models now demonstrate that some form of carbon sequestration or circular carbon economy will be needed to achieve the target.
The reason? Most of the increase in emissions over coming decades will not come from high income economies. Population growth combined with increases in income per capita in low and middle income economies will drive the bulk of the increase in future emissions.
This represents a real challenge to global policy making institutions like the UN and World Bank. On the one hand the number one objective of the UN Development Goals is the eradication of poverty. On the other hand, using current energy technologies, the eradication of poverty will drive emissions beyond the carbon budget limit. Moving beyond the carbon budget will have climate impacts that hit low income economies the most. Damned if you do and damned if you don’t.
High income per head economies have used up the bulk of the carbon budget to date. If we think about the carbon budget as a common global good – an odd way to think about it perhaps – then low and middle income economies have a strong case to make that they have a proportionate claim on using it. There isn’t sufficient emissions space for them to develop owing to the historic development of wealth countries.
If a transformative solution that made economic activity clean was found the problem would disappear. History tells us that novel energy systems take decades to be broadly adopted. So, even if we developed fusion energy sources in the next five years it may take too long to put the capacity in place.
The onus, then, is on high income economies to do two things; reduce emissions as fast as possible, and find economically viable ways to sequester carbon already in the system.
The only effective way to enact such a crash change in our economic system is a combination of government taxation and subsidy, regulatory change and private sector action
The response in wealthy economies has been modest, to be generous, when set against the scale and urgency of the job at hand.
The only effective way to enact such a crash change in our economic system is a combination of government taxation and subsidy, regulatory change and private sector action. The finance sector would play a key role in both funding the new investment and in pricing, trading and hedging the instruments involved in forcing the change. The real estate sector would play a key role in putting that money to work.
Government is unlikely at the national or international level to provide the impetus for change fast enough for a several reasons. Frustration with the pace of official change has generated private sector voluntary activity; green bonds, ESG investing, and voluntary carbon offsets.
Sadly, none of them are likely to be effective in the time frame required. Of more concern is that ESG and carbon offsets end up being seen as a fad from which the providers make money while the investors bask in a warm, but erroneous, glow of “job done”.
Investors have a choice; invest in ESG trackers or invest in managed ESG funds that aim to engage with firms to effect change. Cynics might see fast growing active ESG AUM as the asset management industry’s bulwark against the continued rise of passive investing. Active stock selection and engagement garners traditional fees, while passive trackers have turned into a race to the bottom on costs.
The problem for the investor is how to think about the trade off between measurable, quantitative financial returns and opaque, qualitative ESG metrics. Without knowing how to do that how can they measure the additional impact of the asset manager in effecting ESG change in return for higher fees?
It is also becoming more apparent that combining E, S and G in one investment style leads to several problems – they are not always compatible targets at the individual company level, there are a variety of underlying data sources for each and it is not clear how to score the three objectives relatively to come up with an overall ranking – how do you rate excellent governance versus poor environmental credentials? In any event it is not common across jurisdictions for companies to be required to produce audited reports on their E, S or G credentials. The scope for bias to play a role is substantial.
Corporate management and asset owners have fiduciary responsibilities. In most jurisdictions those responsibilities are normally seen as maximising share holder and investor value. In order to force these players to change behaviour a large minority of shareholders would need to agree to increase investment in green technologies or to vote down management proposals and compensation packages. Engagement at the level of individual ESG funds is unlikely to produce substantial additional changes to corporate behaviour beyond what is already planned owing to social and consumer pressures. Strategically building up large stakes in high emission firms with the scope to change would be the more effective strategy but so far that has been rare. Such guerrilla investment tactics are likely to become more common in the future.
Additionality is a key problem for voluntary carbon offset markets as well. Projects must demonstrate that the carbon reduction would not have happened in the absence of the offset funding. For example, switching to efficient lighting is likely to happen in any event, and so you would struggle to get approval for such a scheme as a real reduction in net emissions. As you might imagine there is a lot of argument about what is and what isn’t additional. According to a report for the European Commission only 7% of offset projects would pass the strict additionality test the authors used.
Voluntary offsets have so far been something of a cottage industry. Cottage industries tend to be inefficient and expensive – estimates suggest that only a relatively small amount of every offset dollar gets to the final project. Commonly offset projects are bundled with co-benefits that reflect the UN Development Goals and so as a result they tend to be situated in low income economies. Those economies tend to be have low CO2 emissions in any event.
But, with large companies (e.g. Microsoft) and industry associations (e.g. the airline industry) announcing a desire to offset current as well as historic emissions demand is set to grow substantially.
Supply and oversight will need to grow and costs fall as a result. The current market will need a substantial overhaul, including an increase in initial project funding, selective easing of some of the gold standard restrictions on additionality, and focusing on emission reductions rather than the co-benefits.
It seems a simple idea to target emission reduction projects in high income/high emission economies. For example retro fitting social housing with electric boilers, triple glazing and insulation while subsidizing the ongoing energy cost increases would result in measurable and long-lived reductions. Doing so via carbon offsets would allow councils and local authorities to access a novel form of funding – it would not be treated as debt – that doesn’t come from additional local taxes or central government. One could imagine street level projects with local surveyor and architect support (if they had the requisite new professional qualifications) being bundled up as fungible and liquid offset notes. Small and medium sized manufacturing and services companies could do the same thing, perhaps through their professional associations.
In reality, of course, the best thing emitting companies can do is reduce their own emissions before looking to offset what they cannot address internally. For emitters, who to be frank, probably see carbon offset as partially a public relations expense, these local projects would provide substantial benefits but at a higher cost than projects in low income economies. It will be a real test of the strength of commitment if the cost of offsets rose from the current low levels.
Climate change is going to be a central topic for the bulk of our lives. The private sector – finance and real estate in particular – have a key role to play in the changes that are coming. At present ESG and the carbon offset market are unlikely to provide the changes required (future reputational risks seems likely),
