Climate change mitigation: plugging investment and engagement gaps

The latest IPCC Working Group III (WGIII) report carried a strong message that the current policy environment implies an increasing likelihood of disorderly transition, which LGIM’s Destination@Risk model suggests is the highest climate risk scenario for investors.

Emissions growth has slowed since the 2000s but remains stubbornly positive at +1.3% per annum as demand growth outpaces intensity reductions. There remains an ambition gap, an implementation gap and an investment gap between the status quo and scenarios that result in below 2°C of warming by 2100.

However, there is some hope that pathways are economically possible with minimal GDP impacts as ‘learning curves’ can create cost-effective abatement options to accelerate decarbonisation over the mid to long term.

Temperature alignment and engaging on decarbonisation

A warming outcome of 2.8°C by 2100 is implied by pre-COP26 country commitments in the WGIII report, but policy lags commitments. Policies implemented by the end of 2020 imply an outcome of 3.2°C. LGIM’s Destination@Risk model finds the carbon-weighted temperature alignment of the 12,000 companies in our dataset is about 2.75°C.

From a decarbonisation perspective, the report finds that, globally, 27% and 48% reductions in global CO2 emissions are required respectively by 2030 to be consistent with <2°C pathways and 1.5°C pathways, with peak emissions by 2025 in a 1.5°C scenario.

Emissions trends in our companies dataset that integrate probability-adjusted decarbonisation targets predict the aggregate emissions, including utilities, will reduce scope 1 emissions from 14.81GT per year to 14.77GT per year in 2030, a reduction of about 0.2% over the decade.

We believe there is a significant way to go on company ambition and action. We will continue to push for an increase in both, through our direct and collaborative engagements and through the tools we have available to take companies with us in our net-zero commitments, not least our Climate Impact Pledge.

Unlocking capital flows

The report finds that annual investment in the transition is three to six times below the level needed by 2030 to limit warming to below 2°C; this is reflective of underinvestment in the energy system generally.

To unlock capital flows, we believe investors need to be active in financial innovation to find the right allocation of risks between stakeholders and meet risk/return hurdle rates and environmental, social and governance (ESG) objectives. Policy has a role to play in mitigating technology risk concerns, jurisdiction risks and ESG risks; the finance industry may also need to examine its perception and pricing of those risks for projects.

From a technology pathway perspective, the working group highlighted five key Illustrative Mitigation Pathways, leaving the door open for hydrogen, biofuels, nuclear, batteries and alternative energy carriers to play an expanded role in the transition in the longer term. The group also noted the reliance on policy, and the cost curve as well as local considerations, regulatory environments and the ability to develop supply chains.

As investors, the report is a clear message that we do not yet know the end-state of the transition. There is a need for diversification across technologies and geographies, a need to look deeper at supply chains and dependencies to find investment opportunities. As ever, there is also a need for strong fundamentals and caution as we remember the Chinese solar crystalline silicon PV scale-up, where the cost curve beat the chemistry. This proved immensely valuable for the climate, but proved a challenging environment for investors to achieve returns.

We were heartened by the identification of high-impact, low-cost transition-abatement options between now and 2030 in renewables, energy efficiency, methane abatement, nature-based carbon removal solutions and the built environment.

In addition, we were struck by the finding that 3GT per annum of CO2 removal from nature-based solutions and agriculture could be achieved by 2030 at a cost of $20 per tonne. Investors aligning to net zero may seek to move into new asset classes such as this as the transition progresses, to meet net-zero commitments. LGIM sees investors with long time horizons and strong governance frameworks as potential owners of these types of assets in the future. Mitigation options and costs analysed are shown on page 51 of the summary.

Cross-industry collaboration

What is clear is the need for strong dialogue across the asset management industry. LGIM is committed to this through representation and involvement in initiatives such as the Transition Plan Taskforce, the Glasgow Financial Alliance for Net Zero and the Net Zero Asset Manager’s Initiative.