An Investor’s Perspective on Corporate Climate Action - Paul Bodnar Flashcards
An Investor’s Perspective on Corporate Climate Action
Paul Bodnar, Director of Sustainable Finance, Industry, and Diplomacy, Bezos Earth Fund, and former Global Head of Sustainable Investing at BlackRock.
I think if you look at it from an asset manager perspective, originally, ESG was the category of information additional to that which you would find in financial statements. So it used to be the case that if you were a stock picker on Wall Street, back in the ’50s and ’60s. you’d review information about companies based on their financials, you might read the news. And eventually folks figured out that there was this category of extra financial information that was nonetheless financially material for affecting security selection decisions in an investing context.
30/08/23
14/02/24
And that got to be lumped together under this strange combination of terms called environmental, social and governance. And the purpose of using this information was to make better investment decisions, better risk adjusted performance, not to think about necessarily social or environmental objectives, but just investors like to have as much information as they can about the companies that they’re thinking about investing in. And lo and behold, if you’re thinking about investing in a services company, you might want to know whether its employees are happy or not. If you’re investing in an industry that uses a lot of water, you might want to know whether a company is water intensive or not. And any company, you might want to know how well governed it is relative to best practices. So this information is originally used to improve risk adjusted return.
But as sustainability became a rising concern in society and in the minds of individual investors, it got conflated a little bit with the quite different objective of trying to advance sustainability outcomes through one’s investing practices.
So as the topic of sustainability became more complicated, more important, the data sources more available, these terms like ESG and sustainability began to be conflated in ways that legitimately caused concern. And I would say the market began to sort itself out a little bit better in the last few years. But of course, as you would expect, there began to be more regulatory attention to this and clean up on both sides of the Atlantic, for example, in quite different ways.
And then about a year and a half ago, ESG also became a political artifact, and in that process it became disconnected from these market-based debates about terminology and fund labels and how do you use ESG data. It became more of a part of a broader polarized political dialogue, in the United States. So, in all of this, the role of climate risk became more and more apparent in the financial sector because just to state it simply, climate risk will reshape the global economy, whether it’s managed successfully or not. If it’s not managed successfully, then we’re going to have accelerating climate impacts, which will reshape the economy and portfolios regardless of what portfolio you have. If it is managed successfully, it will be because we have remade the global economy through a project of unprecedented scale and scope and speed.
Either way, if you’re an investor, climate risk is going to change your portfolio and the way you think about things. So investors came to understand climate in particular as a matter of science and economics, not as a matter of values or ideology. I think you’ll find that most financial institutions, including asset managers are very firm in their understanding of climate risk, but other environmental or social issues, not as far along in being nailed down as financially material investment factors.
And so when we talk about risk, climate risk, a lot of times you hear it broken down into transition risk and physical risk, is that the breakdown that you use as an asset manager and an advisor to clients and your colleagues?
Yes. That’s generally how the industry and its primary standard setting efforts like the TCFD, the Task Force on Climate-related Financial Disclosures, have thought about it. So, as I mentioned, there’s physical risk, which is the impact of climate on the economy, and then there’s transition risk, which is the impact of the economy on the climate and particularly efforts to respond to mitigate climate change on the economy. So if you are in a carbon intensive business like oil and gas, or previously automotive, and the world is trying to push beyond fossil fuels, then that will materially affect your business, and that’s transition risk. There’s been a little bit of a disconnect between the goals that the world has set for decarbonization and net-zero by 2050 on the one hand, and the scenarios that folks are creating to guide investment decisions that relate to physical risk.
In a way they are partial substitutes in the sense that the more governments respond by imposing phase-outs on fossil fuels like bans on internal combustion engine vehicles or pricing carbon through carbon taxes or cap and trade or other type of technology forcing regulations, the more that society moves in that direction, some of that sting of the physical risk will be somewhat diminished. I think we’re well past the time where anyone thinks we can avoid physical risk. So there is already some sense of this partial substitution, the more transition risk we actually encourage through mitigation policies, a bit less severe physical challenges we’ll face. But it sounds like you’re noting there’s other disconnects beyond people’s failure to recognize even that or are you going in different direction?
You’re absolutely right. However, there is a significant time lag. So if you look out the window and see the climate impacts of today, what you’re seeing is the emissions of 1990 or 1995. There’s a significant time delay built into the climatological system. That means that action we take today is not necessarily going to have an impact until one or more decades in the future. And some impacts like seawater temperature increase will continue for hundreds or thousands of years. But you’re absolutely right that the actions we take today on the mitigation side can reduce the physical risk that we face tomorrow.
But what I would say is that the world’s obviously very focused on trying to achieve net-zero by 2050 in line with a goal of holding warming to 1.5 degrees centigrade above pre-industrial levels. And that is the right goal in scientific terms, but we are not making nearly enough progress towards that goal. And if you look at the graphs that show you the rate of decrease that we would need to achieve on an annual basis in global emissions in order to stay below 1.5 degrees in terms of the carbon budget that’s implied that we have left to work with, you’ll see this discontinuity between the current path we’re on and the path we need to be on.
And that discontinuity grows sharper every year. If we had started this project in earnest 20 years ago, reducing global emissions, we might’ve gotten away with a couple percentage points of annual decline. But because we didn’t, we now need to achieve something like 8% or more annual decreases in CO2 emissions in order to hold 1.5 degrees within reasonable probable reach. And by comparison, global emissions fell by something like 6% in 2020, a year in which we put the global economy in an induced coma due to COVID.
And yet everybody is rightly focused on trying to hold that goal within reach. But if you are an investor and you have a big portfolio and you have invested in climate analytics and you’re trying to understand the most likely pathway for emission reductions, you need to have a model that links up a model of the transition with a model of physical risk. And the problem we have today is that investors generally don’t have these tools. If you look at the most commonly cited scenarios that even the financial sector uses on decarbonization, they’re organized around the attainment of a temperature goal, meaning, the International Energy Agency has produced a net-zero, 1.5 degree compliant scenario.
They will tell you in great detail exactly what needs to be true in 2025 or 2030 or ‘35 in order for the world to be on track for 1.5 degrees. The problem is that normative model, a model of the world as it should be gets easily confused with a forecast and it is not a forecast.
If you’re using that kind of a model to guide your investment decisions on the transition side, you’d better be using a different model on the physical risk side because actually we’re not headed to 1.5 degrees, we’re headed to well north of 2 degrees at the moment, if not closer to 3 degrees. And so what the financial sector’s learning right now is that it’s got to be able to have transition risk and physical risk models that talk to each other as opposed to the current practice, which is where they’re largely disconnected.
And the lack of those models seems widespread. It’s not just an investor’s perspective, it’s also operating company’s perspectives where they have to make, in some cases, some long-term R&D bets about what the world will look like both from a carbon pricing perspective and from a physical risk perspective. And as I talk to more managers in those roles, it’s increasingly clear to me that they lack the tools that they need to make smart decisions too. So, despite all of this big data revolution and a lot of interesting AI tools coming out, there’s still lots of work that needs to be done to really put these models into action and really track things in a way that creates error bars narrow enough to actually make some decisions.
If you’re looking at a climate scenario or emissions model, ask yourself always, is this a model of the world as it SHOULD BE or a model of the world as it’s LIKELY TO BE? And if you’re finding yourself looking at the latter, you’re in luck, because as you say, there aren’t a lot of them available. There’s a great project called the Inevitable Policy Response, charmingly titled, which is one of the very few publicly available scenario tools that tries to look at the difference between what ought to be true if we’re on track for climate goals that the world has agreed on and what is currently likely to happen and shows you in fine detail the difference between those two.
In other words, if you were to enumerate the top 10 or 20 specific variables that determined whether the world was or wasn’t on track to 1.5 degrees, what would those be? They would include things like the date of Chinese coal phase out or the track record of tropical forest management or internal combustion passenger vehicle phase out dates. And they do a great job of illustrating the difference between what’s currently on track, let’s say in the G20 on something like the internal combustion phase out versus what would need to be true if we were on track for 1.5 degrees. And sometimes the difference is stark and sometimes it’s surprisingly small, which is encouraging because that means we can push a little bit harder and get on track in that particular area.
How does that lead asset managers to actually make credible claims that they’re working in this space? Are they basically technology bets? And when you’re thinking about a company, for example, in an automotive, you’re thinking, well, who’s doing a lot of work to make sure that their vehicles and the technology behind their vehicles will be successful in a wide range of scenarios where we’re seeing some phase outs of internal combustion engines policies announced in Europe and even in the US, but perhaps not in other parts of the world. There’s a great uncertainty about how quickly charging infrastructure will be deployed, especially in rural places and especially in poorer places around the world. How is an investor to think about sorting through different automotive companies, just as an example, to try and fix ideas? Let’s choose an industry.
First is that investor interested in simply tracking the likely pace of change in that particular sector and getting it right, or is that investor trying to accelerate the pace of change in that sector? What is their underlying objective? This is what we talked about earlier, having clarity on what your investment objective is. So you could have an impact investor who wants to invest in the automotive value chain with a view to both making money, but also to accelerating the rate of decarbonization in that sector. Or they could just be saying, look, I invest in the automotive sector and the automotive sector is going through the largest structural change in a hundred years and I just need to get it right. I just need to know whether the companies that do it faster are going to be more profitable or less profitable, all else equal.
That is when you hear about transition metrics or transition investing, that’s mostly what folks are talking about is they’re constructing measures or proxies for the speed of decarbonization and assessing whether a company is or is not doing its share or what folks think that company should be doing. So, that’s useful information, but ultimately what investors are interested in is not just climate performance but financial performance.
If auto company X commits to no longer invest in new internal combustion vehicle architectures starting in 2030, and another one commits to stop working on internal combustion engine innovation today, which of those two companies is going to be more profitable? That’s what investors want to know, and they can just be very hard headed about that without thinking about the climate performance normative aspect. They can say, well, I think that this company actually that’s going faster is going to win greater market share.
I think that that company is correctly betting on the availability of charging infrastructure, whereas the slower company is being too cautious and it’s going to lose market share. So these two measures of climate performance and financial performance, I think sometimes they’re looked at separately, but the really sophisticated investment managers will start to try to combine those data sets so that when you have a new piece of information like blue chip company X decides to dramatically accelerate its rate of decarbonization, your portfolio management software will be able to tell you whether its stock is under or overvalued depending on how you crunch all the numbers and variables that I just described.
What’s interesting to see is the auto companies have shifted, at least what they’re saying publicly to agree to phase outs of internal combustion engines, at least in some cases and at least in some sectors, which suggests to me that they are going to also shift some of their political conversations to try and make sure that the infrastructure gets subsidized and gets built.
This is an increasing focus for especially activist investors to understand and call for the disclosure of lobbying activities by companies. This is a common subject of shareholder resolutions. And if you look at an initiative like Climate Action 100+, which is a joint initiative of a number of nonprofits and investors to try to focus on the climate performance, I would say for more of some of the largest and most significant carbon emitters in the market, this is definitely one of the areas of focus. So if you had to pick a few variables to track as a shareholder of the company that you’re invested in, this would be one of them, right? Which is no matter what the company is saying, what is it actually doing to influence its operating environment on the policy side, because we all know that climate action is so policy dependent in most sectors.
Another variable that’s increasingly in focus is compensation and whether executive compensation in these companies is linked to climate or sustainability goals. And the ultimate one I would say for a sector like automotive or oil and gas is not what the company says it’s going to do, but tracking its capital expenditure. Most of the assets in the global economy that emit carbon are long life capital assets, whether you’re talking about power plants or cement plants or automobiles or container ships or airplanes.
And part of the problem that we have in driving towards 1.5 degrees is that these are sticky assets that are designed to be in service for a long time. And if we just did the math on how long the existing capital stock in the economy can be in service, we would discover that we need to retire a whole lot of it early. We would also discover that rate of capital stock turnover for industries like cement or chemicals or steel implies a rate of investment that these companies cannot finance through free cash flow alone. So take a simple example like cement, cement plants, let’s say last an average of 40 years, that means in a given decade, you’re turning over a quarter of the fleet.
If you’re trying to reduce greenhouse gas emissions by 45-50% this decade, you’re implying double the rate of replacement of cement plants and not with incrementally better technologies, but with a completely different production process. And that’s what’s happening for automotive, right? You’re ripping out the powertrain and replacing it with electric systems. You’d have to do the same for cement and steel and chemicals and aluminum.
That is a hugely capital intensive process, and your clue as to whether these companies are taking it seriously is to look at the share of their annual capital expenditure and see how much of it they’re investing in these new technologies. This has become particularly controversial for oil and gas because even some of the oil majors that profess to be most focused on climate change still spend a relatively tiny percentage of their annual CapEx on alternative energy.
And every time they’re spending CapEx on traditional oil and gas, again, they’re locking in potentially new long life capital assets that will then need to be wound down. Just to give one final example, going back to the automotive case, you can stop selling new internal combustion vehicles in 2030 or 2035, but that is not the year in which the internal combustion fleet is off the road because vehicles last 15 to 20 years, and if they are no longer demanded in the United States, let’s say they can get shipped to other countries and used there. So we have to stop thinking only in terms of the flows of green investment, we need to think of the stock of fleets, coal plant fleets, vehicle fleets, fleets of jets, and other emitting assets in the economy.
So, who would you think of as producing some well-researched reports to keep track of all this? Are asset managers doing this work on their own? Are they relying on consultants or academics or government reports? How does one get up to speed on these types of issues?
You can be sure that there’s a lot of great proprietary research happening inside these institutions, but we do have the benefit of a lot of good publicly available work. I think the International Energy Agency’s work in the last five years or so has just become dramatically better and more detailed when it comes to the energy transition. And then you have some initiatives like the Energy Transitions Commission that produce fantastic work. So it’s increasingly easier to keep track of this even though some of the most granular data as you would expect can sometimes be entirely proprietary or hidden behind paywalls as you would expect. One organization that does an amazing job in tracking this is Bloomberg New Energy Finance, but of course you have to get a subscription to access that data
Here we have portfolios that are marketing themselves as net-zero. Is that to attract some of these impact investors or is that to attract these ESG materiality concerned investors or both? Or is it trying to attract employees to their firm to have a portfolio that might be useful in recruiting in the fairly competitive marketplace for labor?
It’s hard to speak generally about all asset managers, especially when you think about the pretty significant regional differences between Europe and the United States, for example, where financial institutions are subject to very different regulatory requirements and have different kinds of client bases.
So think of a university endowment, which the folks who manage the Harvard endowment like to be unconstrained and are targeting maximum returns. They don’t necessarily want to be told that they can or cannot invest in x or y, but it may come to pass that the discussion on campus creates a mandate on certain investment managers not to invest in fossil fuels. Is that because of risk adjusted return? No. Is it because of impact? Not necessarily, it’s just a mandate. I think in general, asset managers and pension funds and other asset owners are all struggling with the role that they should be playing in this story, and what can they do and what can’t they do?
So fiduciary asset managers, their North Star is fiduciary duty. And in the United States, fiduciary duty is not defined as looking at the interests of your clients on aggregate and taking actions as a company, as an asset manager in furtherance of a societally defined goal. This is not our money, this is our client’s money, and if our clients choose to invest it this way, we will help them to invest it this way. But if we are a shareholder of an oil and gas company on behalf of a million people who hold tiny shares in an ETF, we can’t presume that they want us to push that oil company to align its business strategy with 1.5 degrees, unless that strategy is also the one that’s going to generate the most long-term shareholder value.
And so this struggle to figure out how you can play your part as a financial institution in the journey to net-zero while also being a fiduciary whose actions are determined ultimately by your clients, especially if you have these big aggregated products that are owned by millions of firefighters and nurses and people on the coasts and people in the heartland, and they don’t have the same view about ESG, and you have one vote at the shareholder meeting of carbon intensive company X, how are you going to cast that vote? These are actually pretty serious dilemmas.
One interesting development I would highlight is that some of the pension funds that have done the best job of scrubbing the carbon out of their portfolios, their finance emissions as the metric is sometimes called. So if you look at a pension fund’s holdings and you look at the carbon emissions of all those companies and you multiply it by the percentage shareholding that the pension fund has in each of those companies, you get the simplest calculation of that pension fund’s own emissions’ footprint.
So a lot of pension funds and other institutional investors have been trying to reduce that footprint over time. The problem they’ve realized, though, is that’s easy to do by, you can just sell your shares in oil and gas companies, someone else is going to buy those shares, but you yourself don’t hold those shares anymore. The problem with that is that if you’re doing that faster than the rate at which the actual economy is decarbonizing, then you may have scrubbed it out of your own portfolio, but that doesn’t mean that you’ve actually caused anything good to happen except some marginal decrease in the price of that stock to a third party.
And so some of these funds are adding back the ability to invest in carbon intensive companies to circumvent their own carbon reduction goals because they realize that they’ve lost the leverage as a shareholder to really have an impact on those companies. So they need to get back in the game of being the shareholder of carbon intensive companies and being an active shareholder that’s trying to guide these companies towards net-zero. So it’s just an example, to some extent, unforeseen side effect of being really good on climate.
This reminds me a lot of the divestment movement conversations and the responses by administrations including at Harvard in the face of student pressure and some alumni pressure to divest from fossil fuels. And the initial response, one was, we don’t want to take politics into our investment perspective, we want to just focus on financial returns. And then another response was, well, exactly as you described, if we sell off our holdings, then it robs us of the opportunity to engage and try and convince them to see the future the way we see the future.
There is an allegation that that’s a greenwashing defense to continue holding carbon intensive investments. And eventually, as you noted, Harvard and some other companies are increasingly getting away from fossil fuel investments.
There are two ways to come up with a net-zero portfolio or to decarbonize your portfolio. One is through the selection process, what you buy and what you sell. And then the other way, which of course is complimentary, is more of an influence strategy.
We’ve seen more recently some activist shareholders getting surprisingly high votes on some of the shareholder activist proposals that they bring to annual shareholder meetings to ensure that companies are being a bit more transparent about their climate strategy, for example, or even in some cases, to try and lobby against some of the governance decisions, including who serves on the boards and who should serve on the board. And I think it’s been quite interesting to see this transition of actual more people getting on board with these movements that are challenging management in the highest way possible, the most visible way possible, which is at the annual shareholder meeting.
What’s been interesting is I think asset managers who represent their clients in the shareholding have also learned more and more about this difference that I mentioned earlier between the world as it should be, and the world as it’s likely to be as an outlook.
So, again, if you are representing millions of small shareholders in an oil and gas company who have holdings in an index fund, can you decide, question, that the world needs to get to 1.5 degrees, and therefore, you’re going to boot out the directors of that company unless they change course, stop drilling for oil, and have a business strategy that’s consistent with 1.5 degrees? That question is particularly sharp for oil and gas companies. It’s a little bit easier when you get to derivative industries that are not actually in the business of making hydrocarbons, but it’s a very difficult question. And again, if you are representing a broad group of shareholders who don’t all have the same degree of enthusiasm for climate action, for example, the question that you need to ask as a fiduciary in the US context is, does this company have a strategy that will generate the maximum long-term shareholder value? And that question is not necessarily the same as will it be compliant with 1.5 degrees or any other temperature goal?
It’s more like a version of, is this company’s strategy designed to maximize its performance in the most likely operating environment in which it will find itself? And that question is about forecasts. So, it was interesting a few weeks ago, and I might be getting the details of this slightly wrong, but in the BP annual general meeting, there was a shareholder resolution called on BP to reverse its recent decisions to effectively weaken its climate targets, which BP did. And one of the two service providers that advises shareholders on how to vote called Glass Lewis recommended that shareholders not support this resolution criticizing BP for its climate targets, because that was a financially sound strategy for BP to pursue - to weaken its targets - because the world was not on track to net-zero by 2050.
And so why should BP’s business strategy be on track to 2050 if the world isn’t, because that’s the market that BP sells into. And of course the whole thing is recursive and self-fulfilling when it comes to big oil companies, but I just thought it illustrated this point really clearly that folks are struggling to distinguish between the fact that this is a collective action problem and we all need to be working on it, and we all need to do the things that are necessary to make that future true. And yet when we’re looking at individual investment decisions in the context of US law and fiduciary duty, we might not be able to make those decisions.
And so one question that arises might be one for your colleagues at the law school to look at is do we have the correct interpretation of fiduciary duty?
If an asset manager looks at the world with its considerable research capabilities, and says, “Gee, if the world doesn’t manage climate risk, then there’s going to be a very significant erosion in economic growth, and those circumstances are going to have a material negative financial consequence for our clients on aggregate.” If they conclude that, is there a form of fiduciary duty that flows from that conclusion, a fiduciary duty to clients on aggregate rather than just individual shareholders and individual companies showing up at individual annual general meetings? That I think is one of the most important specific legal questions related to net-zero in the US today.
Even if hypothetically they found that there were, the problem still strikes me about discounting and the time horizons, and that suppose the answer is yes, but the vast majority of those consequences will really hit the economy in 30, 40, 50 years, and you have a normal discounting model. Those years get rounded to zero in current analyses. And so that’s a whole other level of problem.
It’s a very tricky question because one of the headwinds that sustainable investing faced in the last few years was the huge boost in traditional oil and gas and coal markets as a result of the post initial COVID supply shock augmented by Russia’s invasion of Ukraine. And if you were a trader or a portfolio manager and you had under weighted oil and gas in your portfolio, either because it was an impact play or because you thought that these companies were going to underperform in the long term, you were losing out relative to colleagues who would’ve doubled down on these stocks. And so the vibe and understanding on Wall Street was very much in favor of conventional energy because you could make more money by holding it than you could by letting it go at that point.
I want to take advantage of the fact that you’ve worked in so many different sectors. You’ve worked in the nonprofit sector, in the private sector, in the government sector, and all the while in different dimensions of climate finance. And I wonder if you can summarize your experience on the different lenses you’ve been able to apply to climate finance and what led you from one sector to the other.
