Have we ever seen a banker wearing a mask and a cape?
03 November 2021 Cop26
Unless reminded with taxpayers money bailouts in the aftermath of the 2007-08 financial crises or regular trading losses due to poor risk management, the finance industry generally likes to be associated with big numbers. And COP 26 offered them one: $130 trn. Indeed, asset owners are reported to have committed to reaching net zero (carbon) by 2050, investing the above-mentioned $130 trn. In essence, this means that all the investments made on behalf of their clients (aka “assets under management” or AUM) should be compatible with the Paris Agreement’s 1.5 degree objective.
As a reminder, 3 sectors desperately need to decarbonise if we are to reach net zero by 2050:
- Power (the rise of renewable energy, phasing out of coal then eventually natural gas)
- Transportation (shift to battery electric, fuel cell hydrogen, renewable fuels etc… )
- Critical yet emission-intensive industries (steel, cement, chemicals)
Notably, the IEA published in its net zero reference paper that $4 trn of annual investments in energy and energy infrastructure are required by 2030. So there is a decent hope that the large asset managers of this world would disproportionately invest in the companies and sectors that truly need to be transformed to move towards this greener future.
Well, the iShares MSCI World Paris-Aligned Climate UCITS ETF is invested, as of today, at 1.98% in the broad power sector (utilities and energy) and 1.63% in materials (are wind turbines made of bamboo? will future roads be gravel?). Information technology and Communication account for 33% of this ETF (including the usual suspects such as Microsoft, Apple, Alphabet and Meta in the top 10 holdings). Besides, according to Carbon4 Research, the broad tech sector (including internet, software, hardware, media and telecommunication) was only responsible for 3.6% of world GHG emissions in 2020 and emissions have increased at a pace of 6.2% a year over the past 7 years, which is far from impressive. So in a nutshell, 33% of the money invested in a Paris-aligned strategy is directed towards companies that in aggregate account for a growing, yet small share of global CO2 emissions. Is this how $130 trn is going to be spent? Research by Scientific Beta dove into the flaws of net-zero strategies, which mostly fail to invest where it matters, starting with clean energy.
One other mechanism genuinely emphasised by the finance industry is the cost of capital divergence. Investment people love to use arcane phrasing to impress their audience and give the impression they are smarter (hopefully, we don’t do this). But don’t worry, the concept of financing cost is fairly easy to understand. The entire argument is based on the fact that Company A involved in green, sustainable businesses (think of an offshore wind farm developer) should be able to finance their activities more cheaply relative to Company B that is involved in a dirty business (think of coal mining activities) to facilitate its future growth. Laudable.
The cost of capital is influenced by the capital structure of the company (equity vs. debt) and the expected returns on each asset class (typically, the safer the business operations, the lower my expected returns). Let’s continue with our hypothetical example. Company A can take more debt – let’s say 50% (it’s green and safe), cost of equity around 5%, cost of debt at 0 (thank you green bonds). Company A’s cost of capital is 2.5%. Conversely, Company B, which engages in bad activities will be able to carry very little debt – let’s say 10% (it’s risky and dirty), the cost of debt will be fairly high (8%), and cost of equity will be through the roof (15%). Company B’s cost of capital is a staggering 14.3%. Success right? It is worth keeping in mind that investors do not starve listed polluters off financing by selling their stocks. Ultimately though, a stock that is out of favour tends to see its cost of financing rise and the mechanism described above starts applying to that company.
Wait a minute. If our societies still require coal that Company B produces and the supply of coal is restrained by the lack of access to capital, what happens to the price of coal? It goes up. This in turn enables Company B to generate much more cash from operations, eventually pay down debt, and nicely reward its faithful shareholders via dividend payments. On the other side, Company A can only develop a handful of offshore wind projects at a time (demand and in-house capabilities), no matter how cheap and abundant funding has become.
Some may say that it takes one greenwasher to call out other greenwashers. Is this the underlying message delivered by Larry Fink, BlackRock CEO? Dumping fossil fuels or stopping funding them doesn’t solve the problem. It just becomes someone else’s problem. Equally not allocating investments in the right sectors is unlikely to play in the planet’s favour.
But as long as the big numbers are safe, then we should be all.