Chapter 3: Environmental Factors Flashcards
(87 cards)
1
Q
According to an update by the Stockholm Resilience Centre from 2017, four of nine planetary boundaries have already been crossed as a result of human activity:
A
▶ climate change;
▶ loss of biosphere integrity;
▶ land-system change; and
▶ altered biogeochemical cycles (phosphorus and nitrogen loading).
2
Q
Climate change
A
Climate change is defined as a change of climate, directly or indirectly attributed to human activity, that alters the composition of the global atmosphere and which is, in addition to natural climate variability, observed over comparable time periods. It is one of the most complex issues facing us today and involves many different dimensions, including: ▶ science; ▶ economics; ▶ society; ▶ politics; and ▶ moral and ethical questions.
It is an issue with local manifestations (e.g. extreme weather events, such as more frequent and/or more intense tropical cyclones) and global impacts (e.g. rising global average temperatures and sea levels), which are estimated to increase in severity over time.
The main man-made driver of the warming of the planet is rising emissions of greenhouse gases (GHGs). They form a layer in the atmosphere that prevents increasing amounts of the heat reaching the Earth from the Sun from being radiated back into space. Carbon dioxide (CO2) is the most significant contributor to the warming effect, because of its higher concentration in the atmosphere, which is at levels not seen since before Homo sapiens first appeared.
3
Q
Greenhouse gases
A
The main man-made driver of the warming of the planet is rising emissions of greenhouse gases (GHGs). They form a layer in the atmosphere that prevents increasing amounts of the heat reaching the Earth from the Sun from being radiated back into space. Carbon dioxide (CO2) is the most significant contributor to the warming effect, because of its higher concentration in the atmosphere, which is at levels not seen since before Homo sapiens first appeared.
Other important GHGs include methane, nitrous oxide and other fluorinated gases. Although the average lifetime in the atmosphere of such gases is shorter than that of carbon dioxide, they tend to “compensate” by having a higher ‘warming potential’ – 30 times stronger, in the case of methane, and over 23,000 times stronger
for sulphur hexafluoride, when compared over a century.
Emissions of GHGs primarily come from energy, industry, transport, agriculture and changes in land-use (such as deforestation), with CO2 resulting from the burning of fossil fuels (e.g. in power plants, gas boilers and vehicles) comprising the highest share – around two-thirds - of all GHGs.
4
Q
Tipping points
A
▶ The melting of the permafrost – frozen ground in the Northern hemisphere, the thawing of which would release the vast amounts of carbon it currently holds, thereby further accelerating climate change.
▶ The disintegration of the West Antarctic ice sheet – this holds enough ice to raise global sea levels by over three metres.
▶ The ‘dieback’ of the Amazon rainforest – changes in temperature and deforestation that would render the forest unable to sustain itself, making one of the world’s largest natural stores of carbon emit more carbon than it absorbs.
▶ Melting Arctic ice sheets, causing a shutdown in the system of currents in the Atlantic Ocean that brings warm water up to Europe, which, among other consequences, may lead to ‘widespread cessation of arable farming’ in the UK and parts of Europe.
5
Q
climate economist Martin Weitzman’s dismal theorem
A
suggests that standard cost-benefit analysis is inadequate to deal with the potential downside losses from climate change. However small their probability, as long as we cannot completely rule out scenarios of climate-induced civilisational collapse, their expected value must be properly understood as being equivalent to negative
infinity
6
Q
Responding to climate change is usually presented in terms of two main approaches:
A
- reducing and stabilising the levels of heat-trapping GHGs in the atmosphere (climate change mitigation); or
- adapting to the climate change already taking place (climate change adaptation) and increasing climate change resilience.
However, this is not a binary option; some of the most effective climate policies pursue both objectives simultaneously.
7
Q
Climate change mitigation
A
Climate change mitigation is a human intervention that involves reducing the sources of GHG emissions (for example, the burning of fossil fuels for electricity, heat or transport) or enhancing the sinks that store these gases (such as forests, oceans and soil) in an attempt to slow down the process of climate change. The goal of
mitigation is to:
▶ avoid significant human interference with the climate system;
▶ stabilise GHG levels in a timeframe sufficient to allow ecosystems to adapt naturally to climate change;
▶ ensure that food production is not threatened; and
▶ enable economic development to proceed in a sustainable manner
8
Q
The aim of the international Paris Agreement on climate change
A
To hold “the increase in the global average temperature to well below 2°C (3.6°F) above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5°C (2.7°F) above pre-industrial levels” by the end of the century.
9
Q
Climate change adaptation and resilience
A
Researchers have observed that some of the most effective climate policies (such as the protection of coastal wetlands or the promotion of sustainable agroforestry) contribute to both adaptation and
mitigation simultaneously.
Cities and municipalities in particular are at the frontline of adaptation and resilience due to their high concentration of people, assets and economic activities. Representing 80% of global gross domestic product (GDP), cities are heavily exposed to climate change risks in the forms of:
▶ sea level rise;
▶ extreme weather events, such as flooding and drought; and
▶ increase in the spread of tropical diseases.
All of these will have an economic and social cost to cities’ inhabitants, infrastructure, businesses and the built environment. At the same time, cities are a major contributor of GHG emissions, mainly from transport and buildings. Useful best practices of various cities’ climate adaptation strategies include:
▶ incorporating flood risk into building designs (in New York) and planning for enhanced water absorption rates into city infrastructure (‘sponge cities’ like Wuhan);
▶ modelling the impact of natural disasters on energy supply (in Yokohama); and
▶ analysing the resiliency to disruption of food supply systems (in Los Angeles and Paris).
10
Q
Natural resources
A
▶ fresh water;
▶ biodiversity loss;
▶ land use; and
▶ forestry and marine resources.
Natural resources also include non-renewable resources (such as fossil fuels, minerals and metals), which cannot be replenished quickly enough to keep up with their consumption.
11
Q
Governments and businesses are having to deal with increased pressure on natural resources, caused by:
A
▶ population growth;
▶ health improvements leading to people living longer;
▶ economic growth; and
▶ the accompanying increased consumption in developed and emerging economies.
12
Q
Biodiversity
A
The “variability among living organisms from all sources including, among other things, terrestrial, marine and other aquatic ecosystems and the ecological complexes of which they are part; this includes diversity within species, between species and of ecosystems”.
13
Q
Ecosystem services
A
Biodiversity underpins ecosystem services, provides natural resources and constitutes our ‘natural capital’. Some of these ecosystem services include:
▶ food; ▶ clean water; ▶ genetic resources; ▶ flood protection; ▶ nutrient cycling; and ▶ climate regulation, amongst many others.
14
Q
Natural capital
A
“the world’s stocks of natural assets which include geology, soil, air, water and all living things. It is from this natural capital that humans derive a wide range of services, often called ecosystem services, which make human life possible.”
15
Q
Companies with exposure to deforestation in their supply chains may face material financial risks, such as:
A
▶ supply disruption;
▶ cost volatility; and
▶ reputational damage.
16
Q
Shifting business practices to adopt more sustainable land management approaches contributes to:
A
▶ agricultural and economic development, both locally and globally;
▶ the health and stability of forests and ecosystems, and the continued provision of ecosystem services at an increasing scale; and
▶ the reduction of GHG emissions from deforestation and degradation.
17
Q
The blue economy
A
The “sustainable use of ocean resources for economic growth, improved livelihoods, and jobs while preserving the health of ocean
ecosystem”
18
Q
Circular economy
A
The circular economy is an economic model that aims to avoid waste and to preserve the value of resources (raw materials, energy and water) for as long as possible. It is an effective model for companies to assess and manage their operations and resource management as it is an alternative approach to the usemake-dispose economy.
The circular economy is based on three principles:
- design out waste and pollution;
- keep products and materials in use; and
- regenerate natural systems.
19
Q
Physical risks
A
These are risks resulting from extreme weather events, either acute or related risks chronic risks from longer-term shifts in climate patterns, for example, higher temperatures.
20
Q
Transition risk
A
Transition risk relates to risks that result from changes in climate and energy policies, a shift to low-carbon technologies and liability issues.
Transition risks are multiple in nature, including:
▶ policy risks – such as increased emissions regulation and environmental standards;
▶ legal risks – such as lawsuits claiming damages from entities (corporations or sovereign states) believed to be liable for their contribution to climate change; and
▶ technology risks – such as low-carbon innovations disrupting established industries.
These risks are interlocking in nature and potentially have far-reaching impacts, which underscore their systemic relationship to business and financial activities.
21
Q
Direct impact
A
An organisation’s activities directly affecting biodiversity. For example, when:
» degraded land is converted for the benefit of production activities;
» surface water is used for irrigation purposes;
» toxic materials are released; or
» local species are disturbed through the noise and light produced at a processing site.
22
Q
Indirect impact
A
The impact is caused by parties in an organisation’s supply chain(s). For example, when an organisation imports fruits and vegetables, produces cotton shirts, sells construction materials or publishes
books, the production of the inputs for these goods will have indirect impacts on biodiversity.
Indirect impacts can also include those from activities that have been triggered by the operations of the organisation. For example, a road constructed to transport products from a forestry operation can have the indirect effect of stimulating the migration of workers to an unsettled region and encouraging new commercial development along the road.
Indirect impacts may be relatively difficult to predict and manage, but they can be as significant as direct impacts and can easily affect an organisation. Impacts on biodiversity can be either:
▶ negative (degrading the quality or quantity of biodiversity); or
▶ positive (creating a net contribution to the quality or quantity of biodiversity).
23
Q
Examples of sectors that rely significantly on natural resources and ecosystem services, with the potential to negatively affect biodiversity
A
▶ agriculture, aquaculture, fisheries and food production;
▶ extractives, infrastructure and activities or projects involving large-scale construction work;
▶ fast-moving consumer goods (FMCG) companies – primarily through the sourcing of raw materials in products;
▶ forestry;
▶ pharmaceutical (in some cases);
▶ tourism and hospitality (in some cases); and
▶ utilities, including those involved in hydropower or open-cycle power plants generating significant thermal discharges.
24
Q
Environmental impacts from direct operations can include
A
▶ toxic waste; ▶ water pollution; ▶ loss of biodiversity; ▶ deforestation; ▶ long-term damage to ecosystems; ▶ water scarcity; ▶ hazardous air emissions and high GHG emissions; and ▶ energy use.
Failure to address these challenges will expose businesses to additional risks, while working on solutions presents a business opportunity to develop climate-resilient business strategies. The circular economy is a useful model for companies to assess and manage their operations and resource management.
25
Circular Economy Action Plan
In March 2019, the EU Commission adopted an ambitious Circular Economy Action Plan to address the challenges of climate change and pressures on natural resources as well as ecosystems. This was followed by EU guidelines under the Non-Financial Reporting Directive which introduced the concept of ‘double materiality’
– in other words, asking companies to report both the impact of climate change on their activities as well as, conversely, the impact of a company’s activities on climate change and the environment, stipulating that ‘companies should consider their whole value chain, both upstream in the supply-chain and downstream’.
26
Supply chain sustainability
Supply chain sustainability is the management of ESG impacts and practices beyond the factory gates, looking at the broader lifecycle of goods and services, particularly with regards to the sourcing of raw materials and components.
Supply chains are complex to understand due to the fact that they are heavily interdependent. As such, the relationships between products and services and environmental risk factors are intertwined across sectors and throughout every level of the supply chain.
Companies are increasingly expected to understand, manage and disclose their exposure to supply chain ESG risks or be left exposed to reputational, operational and financial risks. As such, it is becoming increasingly important for investors to factor into their due
diligence and active stewardship a stronger understanding of the supply chain management of their portfolio companies.
27
Traceability
Traceability is a useful practice to identify and trace the history, distribution, location and application of products, parts and materials. This ensures the reliability of sustainability claims in the areas of human rights, labour (including health and safety), the environment and anti-corruption.
Investors should assess whether a company in their portfolio has policies and systems in place which:
(i) clearly explain the environmental (and social) requirements that suppliers are expected to meet via a procurement policy (such as a supplier code of conduct); and
(ii) enable it to assess environmental (and social) risks throughout its supply chain and discuss whether it has a mechanism in place to improve poor practices.
Achieving full transparency and traceability across all stages in a supply chain in order to undertake a complete assessment of a company’s environmental risks is often complex. This is a result of multiple actors involved with different systems and requirements in a supply chain that are required to produce an end-product, often across international borders.
Despite these challenges, attempting to conduct this full value chain analysis is important for investors to obtain an accurate picture of investee companies, and for companies to ensure that their own policies are not undermined by actions taken elsewhere in their supply chain.
28
Examples of sectors with particularly complex and/or high-risk supply chains include:
```
▶ oil and gas;
▶ mining;
▶ beef;
▶ cocoa;
▶ cotton;
▶ fisheries;
▶ leather;
▶ palm oil;
▶ agriculture; and
▶ forestry.
```
29
Some of the main environmental risks in the supply chain include:
```
▶ material toxicity and chemicals;
▶ raw material use;
▶ recyclability and end-of-life products;
▶ GHG emissions;
▶ energy use;
▶ water use and wastewater treatment;
▶ air pollution;
▶ biodiversity; and
▶ deforestation.
```
30
Not-for-profit organisations offer measurement frameworks and tools that can help trace critical sustainability issues in company supply chains. These include:
▶ The Sustainability Consortium (TSC), which has built a set of performance indicators and a reporting system that highlights sustainability hotspots for more than 110 consumer-product categories, covering 80–90% of the impact of consumer products.
▶ The WWF offers more than 50 performance indicators for measuring the supply-chain risks associated with the production of a range of commodities, as well as the probability and severity of those risks.
▶ CDP and the GRI have created standards and metrics for comparing different types of sustainability impact.
▶ The Sustainability Accounting Standards Board (SASB) has developed standards that help public companies across eleven sectors, including consumer goods, to give investors material information about corporate sustainability performance along the value chain.
▶ The EU Taxonomy for Sustainable Activities and the Climate Bonds Sector Criteria provide sector-specific metrics and indicators to assess if assets, projects and activities across energy, transport, buildings, industry, agriculture and forestry, water and waste management, etc., are compliant with the goals of the Paris Agreement.
▶ The Transparency for Sustainable Economies tool (TRASE), a partnership between the Stockholm Environment Institute and Global Canopy.
▶ The Exploring Natural Capital Opportunities, Risks and Exposure (ENCORE) tool, an initiative of the UN Environmental Program World Conservation Monitoring Center (WCMC), UNEP Finance Initiative and Global Canopy
▶ The Terra Carta (Earth Charter), an initiative under the patronage of the Prince of Wales, providing a roadmap for business action on climate change and biodiversity.
31
Examples of global traceability schemes include:
▶ the Forest Stewardship Council (FSC);
▶ the Marine Stewardship Council (MSC);
▶ Roundtable for Sustainable Palm Oil (RSPO); and
▶ the Fairtrade Labelling Organizations International (FLO).
32
Kyoto Protocol (2005) - main GHGs
1. CO2;
2. methane (CH4);
3. nitrous oxide (N2O);
4. hydrofluorocarbons (HFCs);
5. perfluorocarbons (PFCs);
6. sulphur hexafluoride (SF6); and
7. nitrogen trifluoride (NF3).
33
Kyoto Protocol (2005)
The Kyoto Protocol was adopted in 1997 and became effective in 2005. It was the first international convention
to set targets for emissions of the main GHGs.
It established top-down, binding targets, but only for developed nations, recognising the historical links
between industrialisation, economic development and GHG emissions. The protocol’s first commitment period
began in 2008 and ended in 2012, but was subsequently extended to 2020. Negotiations on the measures to be
taken after the second commitment period ends in 2020 resulted in the adoption of the Paris Agreement.
34
Paris Agreement (2015)
At the 21st Conference of the Parties to the UN Framework Convention on Climate Change (UNFCCC) in Paris in 2015 (COP21), a landmark agreement was reached to mobilise a global response to the threat of climate change in the form of the Paris Agreement.
The agreement’s long-term goal is to keep the increase in global average temperature to well below 2°C (3.6°F) above pre-industrial levels, and to limit the increase to 1.5°C (2.7°F), since this would substantially reduce the
risks and effects of climate change.
Although the Paris Agreement is not legally binding under international law, it serves as a significant landmark in tackling climate change on a global scale.
35
Nationally determined contributions (NDCs)
Instead of top-down imposed contributions, they capture voluntary efforts by each country to reduce national emissions and adapt to the impacts of climate change, and require every signatory (both developed and developing nations) to determine, plan and report on its NDCs, with updates to commitments every five years.
While commitments vary, they tend to fall in the 25–30% range of GHG emissions relative to 2005 by 2030. Unfortunately, many countries are not on track to achieving their targets, with existing NDCs estimated to be aligned with a dangerous trajectory of around 3°C (5.4°F).
36
UN SDGs
The UN SDGs are a set of 17 global goals set in 2015 by the UN General Assembly seeking to address key global
challenges such as poverty, inequality and climate change. Although primarily intended as a framework
for government action, the SDGs are now regularly cited by corporate and investment actors as material
to their business planning and operations. SDGs 7 (affordable and clean energy), 11 (sustainable cities and
communities), 12 (responsible consumption and production), 13 (climate action), 14 (life below water) and 15
(life on land) are some of the most directly relevant to the environmental debate.
37
Kigali Amendment to the Montreal Protocol
The Kigali Amendment to the Montreal Protocol of 2016 is a global agreement to phase out the manufacture of hydrofluorocarbons (HFCs). These gases were used in an attempt to replace ozone-depleting chemicals, but
have the downside of causing a potent warming effect on the planet.
38
International Maritime Organization (IMO) 2020 Regulation
The International Maritime Organization (IMO) 2020 Regulation caps the maximum sulphur content in the
fuel oil used by ships. Limiting sulphur oxide emissions, which contribute to air pollution and acid rain is estimated to have a very positive impact on human health and the environment.
39
‘Corsia’ (Carbon Offsetting and Reduction Scheme for International Aviation)
‘Corsia’ (Carbon Offsetting and Reduction Scheme for International Aviation) is a UN mechanism designed
by the UN International Civil Aviation Organization (ICAO) designed to help the aviation industry reach its aspirational goal to make all growth in international flights after 2020 carbon neutral, with airlines required
to offset their emissions. The scheme is important as domestic aviation emissions are covered by the Paris
Agreement, but international flights – which are responsible for around two-thirds of the CO2 emissions from aviation – are under the remit of ICAO.
40
European Green Deal
A plan to make the EU economy climate-neutral by 2050 by boosting the efficient use of resources, restoring biodiversity and cutting pollution. As part of this programme, it has renewed its strategy focused on sustainable finance, whose main ambitions are:
▶ to reorient capital flows by establishing the following:
• a classification system (taxonomy) for sustainable activities, and
• standards and labels for green bonds, benchmarks and other financial products; and
» increasing EU funding for sustainable projects.
▶ to mainstream sustainability into risk management by efforts to incorporate sustainability into financial advice, credit ratings and market research, as well as more technical proposals on the treatment of ‘green’ assets in the capital requirements of banks and insurers (the so-called ‘green supporting factor’).
▶ to foster transparency and long-term thinking by strengthening the disclosure requirements relating to sustainability (on both the financial industry and companies more broadly).
These developments are intended to embed sustainability across the entire investment chain – from the owners of capital (such as pension funds and insurance companies) to the beneficiaries of capital (such as investee companies), as well as key intermediaries (banks, asset managers, financial advisors and consultants, credit rating agencies).
41
EU taxonomy
Approved by the EU Parliament in June 2020, it aims to significantly reduce (perhaps even remove altogether) the risk of green-washing financial products by providing a classification system to determine whether an economic activity is environmentally sustainable. Inclusion in the taxonomy is restricted to activities that contribute to at least one of the six environmental objectives:
1. climate change mitigation;
2. climate change adaptation;
3. sustainable use of protection of water and marine resources;
4. transition to a circular economy, waste prevention and recycling;
5. pollution prevention and control; and
6. protection of healthy ecosystems.
Under the taxonomy regulation, institutional investors and asset managers offering investment products as environmentally sustainable would need to explain whether and how they have used the taxonomy criteria. This forms a part of the growing disclosure requirements for investors relating to sustainability.
42
Sustainability disclosures
Sustainable Finance Disclosure Regulation (SFDR)
| Non-Financial Reporting Directive (NFRD)
43
Sustainable Finance Disclosure Regulation (SFDR)
Under SFDR, investors will be required to provide more transparency around:
▶ how the impacts of sustainability risks on their financial products are being systematically assessed (e.g. integrated into due diligence and research processes);
▶ how asset managers consider – and seek to address – the potentially negative implications of investment activities on sustainability factors; and
▶ products labelled with an explicit ESG focus.
44
Non-Financial Reporting Directive (NFRD)
Under NFRD, companies, including corporates, insurers and banks, are expected to report on the policies they have in relation to environmental protection and a range of other social and governance factors. The original Directive is currently under review. In 2019, it was supplemented by guidelines on climate reporting which introduce the concept of ‘double materiality’, i.e. the two-way impacts between companies and climate change.
45
Climate benchmarks
These play an important role in investments, serving as a comparator to measure the performance of investments (in the case of actively managed funds), or as a target for the construction of investment solutions, which aim to replicate (or
‘track’) the composition of certain widely used benchmarks (e.g. stock market indices like the FTSE 100 or S&P 500, in the case of so-called ‘passive’ or index funds).
However, the most widely used benchmarks are primarily based on company size (at least for equities) and thus do not directly reflect low-carbon considerations in their methodologies. This raises the possibility that
a significant and, given the rising share of assets managed under index strategies, growing portion of the investment universe might be pursuing environmentally unsustainable investment strategies. In fact, some research suggests that “current benchmarks are likely to be more aligned with a ‘business-as-usual’ scenario, where temperature rises range from 4°C to 6°C (7.2°F to 10.8°F), leading to catastrophic damage to the Earth”.
Therefore, the EU have developed two types of climate benchmarks for equities and corporate bonds that aim to start with lower associated carbon emissions intensity relative to their investable universe, and then continually cut emissions thresholds each year by at least 7%, in line with IPCC estimates for annual reductions necessary for a 1.5°C (2.7°F) temperature scenario.
46
Two main categories of benchmarks are:
1. EU Paris-Aligned Benchmarks (EU PABs), which must:
» reduce carbon emissions intensity by at least 50% in their starting year;
» have a four-to-one ratio of ‘green’ to ‘brown’ investments relative to the investable universe; and
» not invest in fossil fuels.
2. EU Climate Transition Benchmarks (EU CTBs), which require a 30% intensity reduction in starting year and at least an equal ‘green’ to ‘brown’ ratio, but permit fossil fuel investments as part of a transition process.
Further progress on developments from the EU Commission’s Sustainable Action Plan will continue to play a pivotal role in the development of EU and global markets towards greater harmonisation through the International Platform on Sustainable Finance (IPSF), thereby influencing policy.
47
Task Force on Climate-related Financial Disclosures
The TCFD was launched in 2015 following a request from the G20 countries’ finance ministers and central bank governors for the Financial Stability Board – the organisation which coordinates the work of national financial supervisors and international standard setting bodies – to investigate the risks of climate change on the stability of the financial system and the appropriate response.
The TCFD set out to provide a set of recommendations and a framework for companies and financial institutions to provide better information to support investors, lenders, insurers and other financial stakeholders to identify, build and quantify climate-related risks and opportunities into their decisions. The TCFD also took the view that better information will help investors engage with companies on the resilience of their strategies and capital spending, including more efficient allocation of capital, which should help to promote a smooth transition to a more sustainable, low-carbon economy.
In July 2017, the TCFD published its final recommendations for how companies should report, structured around four thematic areas:
1. governance: The organisation’s governance around climate-related risks and opportunities.
2. strategy: The actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy and financial planning.
3. risk management: The processes used by the organisation to identify, assess and manage climate-related risks.
4. metrics and targets: The metrics and targets used to assess and manage relevant climate-related risks and opportunities.
48
Network for Greening the Financial System
Comprising over 70 central banks and financial supervisors. It was set up to strengthen the global response required to meet the goals of the Paris Agreement, and to enhance the role of the financial system to manage risks and to mobilise capital for green and low-carbon investments in the broader context of environmentally sustainable development. The NGFS has developed technical guidance – including publishing a set of climate scenarios – for the regulatory supervision of climate risks
49
Emission trading system
An ETS is a system based on the exchange of permits for emission units, where actors who exceed their emissions limits are required to buy permits from those that have emitted less. The overall quantity of emissions is fixed, and market mechanisms are used to set their price.
In theory, this creates an economic incentive for emissions reductions to occur at the point of least cost; rather than mandating similar levels of reductions for all actors, price discovery helps reward those that can afford to reduce more.
The effectiveness in practice, however, depends crucially on the design of the ETS. If the scheme is too restrictive, it may encourage the offshoring of industries into jurisdictions with fewer constraints (a phenomenon known as
‘carbon leakage’), and thus fail to reduce emissions. As a result, free allocation of allowances (to give industry an initial ‘buffer’) has been a widely used feature of ETSs, although in some cases, overallocation resulted in the price of an emissions unit being too low to properly incentivise decarbonisation.
50
Carbon taxation
Carbon taxation directly sets an explicit price on GHG emissions (e.g. per
tonne of CO2). This has the advantage of predictability, although the carbon tax rate, alongside the elasticity of demand for different products and the extent to which companies can pass on the carbon costs to their end consumers, will be key determinants of effectiveness. It has been estimated that an explicit global carbon price of US$40 to US$80 (£29 to £58) per tCO2 in the 2020s, more than doubling to US$50 to US$100 (£36 to £72) per tCO2 by 2030, is required to meet the goals of the Paris Agreement. This is substantially higher than the
current global average price, which the International Monetary Fund (IMF) estimates is US$2 (£1.4) per tCO2.
51
Internal/ shadow carbon pricing
An internal or shadow price on carbon creates a theoretical or assumed cost per ton of carbon emissions. For example, the major oil company, BP, uses a price assumption of a US$100 (£72) per tonne of CO2 by 2030 to better understand the potential impact of future climate regulation on the profitability of a project, a new business model or an investment. Its use reveals hidden risks and enables businesses to build this factor into future valuations and estimates of capital expenditure. In addition, when emissions bear a cost in profit-and-loss statements, it helps to uncover inefficiencies and incentivise low carbon innovation within departments, cutting a company’s energy use and carbon pollution.
Some governments are using internal carbon pricing as a tool in their procurement process, policy design and project assessments in relation to climate change impacts. More recently, financial institutions have also begun
using internal carbon pricing to assess their project portfolio. In 2019, circa 1,600 companies – including more than 100 Fortune Global 500 companies with a total annual revenue of about US$7tn (£5tn) – reported that they are currently using an internal price on carbon or plan to do so in the next two years.
52
International Finance Corporation’s (IFC) Equator Principles
At a project finance level, when assessing project infrastructure initiatives, the International Finance
Corporation’s (IFC) Equator Principles, which are based on IFC’s Performance Standards, have become a globally recognised risk management framework, and are adopted by financial institutions for determining, assessing and managing environmental and social risk in project finance. They set out performance standards that address environmental factors (such as resource efficiency, biodiversity and land resettlement) as well as other social-oriented standards.
53
Public finance
Public finance is a key policy instrument to both incentivise and enable the transition to green growth.
Domestically, governments are a significant economic actor – commissioning new buildings, roads and other forms of infrastructure, for example – highlighting the importance of aligning public procurement and sustainability. Governments also contribute to international development, with public sector financing often blended with funding from multilateral development finance institutions in developing countries and disbursed through investment vehicles, such as:
▶ green infrastructure funds (e.g. the Association of Southeast Asian Nations (ASEAN) Catalytic Green Finance Facility under the ASEAN Infrastructure Fund);
▶ specialised banks (e.g. Asian Infrastructure Investment Bank); and
▶ funding platforms (e.g. the Tropical Landscapes Finance Facility).
A variety of financing initiatives leveraging public sector and development finance for sustainable agriculture, biodiversity conservation and the blue economy are also emerging, particularly targeting more vulnerable and developing economies.
54
G20 Green Finance Study
According to a G20 Green Finance Study, financial institutions need to combine two types of approaches to assess environmental risks:
1. understanding environmental factors that may pose risks to financial assets and liabilities (for example, the wrong pricing of a pollution liability or natural disaster insurance policy could be a risk to liability, if the event probability is underestimated), and how such risks may evolve over time; and
2. translating environmental risk factors into quantitative measures of financial risk that can, in turn, inform firms’ risk management and investment decisions.
55
The types of risk analysis tools and associated metrics depend upon
The types of risk analysis tools and associated metrics primarily depend upon the asset classes and risk types financial institutions are exposed to (for instance, a fixed income analyst may be most interested in credit risk).
Similarly, the choice of approach depends on the type of direct or indirect exposure to an environmental risk factor. For example, the probability of physical risks from flooding will have to be incorporated differently than
transition risks stemming from the transition to a low-carbon economy due to policy change. Depending on the investment strategy and objectives, different levels of analysis will likely be performed: at the individual asset
level, portfolio level, and at the macroeconomic or systemic level.
It is important to analyse the extent to which environmental and climate-related impacts could affect a company’s value chain – supply chain, operation and assets, logistics and market – which would have an
impact on financial performance.
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Levels of environmental analysis
Environmental risk assessments are conducted along with social and governance assessments at:
A. company or project level;
B. sector level;
C. country level, or
D. market level.
57
Approaches that are used by investors to
| assess material environmental risks (and opportunities):
A. carbon footprinting and other carbon metrics;
B. natural capital approach; and
C. climate scenario analysis.
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Carbon footprinting and other carbon metrics
Carbon footprinting is one of the most common approaches used by companies and investors. A portfolio carbon footprint effectively measures carbon emissions and intensity associated with operations of the companies in a portfolio. Measuring the carbon footprint of a portfolio means that an investor can:
▶ compare it to global benchmarks;
▶ identify priority areas and actions for reducing emissions; and
▶ track progress in making those reductions.
The use of carbon footprinting applies the international accounting tool of the GHG Protocol Standards. While Scopes 1 and 2 cover direct emissions sources (such as the fuel used in company vehicles and purchased electricity), Scope 3 emissions cover all indirect emissions arising from the activities of an organisation.
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Benefits and challenges of carbon footprinting
The benefits of carbon footprinting include the potential to aggregate emissions across industries and value chains, for countries and portfolios, enabling comparisons between companies or portfolios, across sectors
and geographies, and to focus the analysis on emissions intensity. However, the analysis has its limitations and challenges as a risk measure, and is increasingly seen as too backward-looking or static.
Some of the main challenges of carbon footprinting include:
▶ the lack of disclosure for unlisted or private assets;
▶ Scope 3 emissions are rarely being included, thus failing to capture companies’ full value chain;
▶ ‘double-counting’ (a metallurgical coal miners’ Scope 3 emissions can be a steel-makers’ Scope 1 emissions);
▶ the use of different estimation methodologies; and
▶ it does not measure potential investment risks related to the physical impacts of climate change.
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Total carbon emissions
Depending on objectives, carbon footprinting can be an absolute or relative metric. It can be used to assess, for example, the total carbon emissions associated with a given investee company or portfolio. This recognises
that investments that may be seen to have a disproportionately high contribution to global emissions may have a higher exposure to future policy interventions on carbon emissions.
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Calculation:
Sum of (current value of investment/ issuer's market capitalisation) x issuer's Scope 1 and 2 emissions
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WEIGHTED CARBON EMISSIONS
investors may wish to track carbon emissions intensity (e.g. emissions scaled in relation to a particular metric such as a company’s revenues). The TCFD recommends that asset owners and managers report the weighted average carbon intensity associated with their investments.
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Weighted average carbon intensity:
Sum of (current value of investment/current portfolio value) x (initial issuer’s Scope 1 and 2 emissions/ initial issuer’s US$m of revenue)
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This can provide a measure of how carbon-efficient companies are, allowing for an element of comparability between companies of different sizes, and recognising that high levels of carbon emissions are not a perfect proxy for high climate risks. A coal-burning power plant and a coal-burning steel plant may have very similar levels of emissions. But renewable energy can much more easily – and, for two-thirds of the world’s population, more cheaply – replace the use of coal for generating electricity, whereas cleaner and economic alternatives to coal for steelmaking are not as widespread.
As such, the policy focus and future profitability profile of the two plants may look radically different. A useful starting point is to consider companies’ announced emissions targets and related environmental ambitions, also in relation to carbon pricing in different climate scenarios.
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Net zero
Companies are increasingly adopting net zero targets. However, there is significant variation among these targets, as they can:
▶ be absolute or relative targets;
▶ cover different scopes of emissions (just operational (Scope 1 and 2) or include some or all of the value chain (Scope 3) and different types of emissions (just carbon dioxide or all GHGs);
▶ focus on differing or multiple timeframes; or
▶ rely on offsets.
This can make it difficult for investors to accurately measure and benchmark their carbon emission reduction objectives.
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Science-based targets (SBT)
Targets underpinned by the latest climate science and evaluated by the Science-Based Target initiative (SBTi), a partnership between several environmental institutions, which provides independent certifications of the strength of companies’ targets.
It has produced decarbonisation guidance in different sectors, including power, apparel and footwear, and information and communication technology, and more recently for the financial sector. Over 1,000 companies
have set targets through the SBTi.
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Emissions trajectories
Emissions trajectories can be used to assess the required reductions to reach a stated goal (for example, net zero carbon by 2050) and compare the pathways implied by corporate commitments, policies or individual assets (for example, proposed refurbishments to a building to improve its energy efficiency). For instance, the Transition Pathway Initiative is an asset-owner-led collaboration, which has developed a publicly available tool that aims to assess companies’ preparedness for the low-carbon transition.
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Temperature alignment
This seeks to compare the climate profiles of companies, sectors or portfolios against a benchmark of global temperature. As global ‘carbon budgets’ impose constraints on the amount of emissions that are compatible with maintaining a reasonable chance of global temperatures not exceeding certain levels, this allows a degree of quantification of the implied future temperature levels associated with a company or portfolio. For example, Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, estimates its portfolio of equities and bonds are aligned with a warming trajectory of around 3°C (5.4°F).
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How the UN Principles for Responsible Investment (PRI), UNEP Finance
Initiative and the Institutional Investor Group on Climate Change are developing frameworks to help benchmark investors’ transition to net zero.
Emissions trajectories;
Temperature alignment;
Capital expenditures, ‘green’ revenues and research and development
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Capital expenditures, ‘green’ revenues and research and development
A different approach looks in more detail at companies’ level of ‘green’ capital expenditures, revenue streams and R&D to gauge the direction of travel for their business models.
For the oil and gas sector, the Carbon Tracker Initiative have created a framework to assess companies’ potential capital expenditures on new oil and gas projects, compared against their cost of production, associated emissions and demand levels in different climate scenarios.
An alternative is to consider existing revenues. Data providers including FTSE Russell and HSBC have compiled proprietary databases to assess the sales companies generate from over 100 low-carbon products and
services.
Several data providers have constructed methodologies to analyse the patents for low-carbon technologies filed by companies. R&D is a potentially useful indicator; however, the mere accumulation of patents need not
imply strategic commitment – for example, Kodak engineers invented and patented the digital camera that would eventually render its company’s main business obsolete.
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Natural capital approach
A term often used to describe the relationship between nature and measuring and valuing nature’s role in decision-making is natural capital. Natural capital helps businesses identify, measure, value and prioritise their
impacts and dependencies on biodiversity and the ecosystem, which ultimately give businesses new insight into their risks and opportunities.
Understanding the value of both natural capital impacts and dependencies
helps business and financial decision-makers assess the significance of these issues to their institution, and therefore make more informed decisions.
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Natural Capital Protocol (NCP)
Assessing environmental factors using the Natural Capital Protocol (NCP), a decision-making framework, enables organisations to identify, measure and value the direct and indirect impacts and dependencies of companies on natural capital. It currently provides guidance for the apparel sector, food and beverage sector and forest products sector.
The protocol aims to allow companies to measure, value and integrate natural capital impacts and dependencies into existing business processes such as risk mitigation, sourcing, supply chain management and product design.
Recognising the need for increased consideration of natural capital issues by financial decision-makers, an initiative to establish a Task Force on Nature-related Financial Disclosures (TNFD) was announced in mid- 2020, a collaboration between UN-affiliated institutions, Global Canopy and WWF, supported by financial institutions and governments.
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Natural resource risk assessment tools for investors and policymakers
Integrated Biodiversity Assessment Tool (IBAT) for Business, developed by the International Union for Conservation of Nature (IUCN), is a central global biodiversity database, which includes key biodiversity areas and legally protected areas. Through an interactive mapping tool, decision makers
can easily access and use this up-to-date information to identify biodiversity risks and opportunities within a project boundary.
Enabling a Natural Capital Approach (ENCA) is a policy tool and guidance developed by the UK Department for Environment, Food & Rural Affairs.
CERES and WWF have developed water risk assessment tools, targeted at investors, lenders and policymakers:
▶ CERES Aqua Gauge: A Comprehensive Assessment Tool for Evaluating Corporate Management or Water Risk. Developed by CERES and CDP.
▶ WWF Water Risk Filter.
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Climate scenario analysis
Scenario analysis is an approach for the forward-looking assessment of risks and opportunities. Scenario analysis describes a process of evaluating how an organisation, sector, country or portfolio might perform in different future states, in order to understand its key drivers and possible outcomes.
Climate-related risk has been identified as one of the most complex macro-existential risks, which is least understood and hardest to quantify. The TCFD recommends that companies and financial institutions:
“Describe the resilience of the organisation’s strategy, taking into consideration different climate-related scenarios, including a 2°C (3.6°F) or lower scenario and, where relevant to the organisation, scenarios consistent with increased physical climate-related risks.”
In the current landscape, there is no common set of scenario analysis methodology used by investors. Instead, the types of approaches and models will depend largely on the objectives and scope of the work.
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Institutional Investors Group on Climate Change (IIGCC) - Objectives of undertaking scenario analysis
The Institutional Investors Group on Climate Change (IIGCC) published a practical investor guide, which provides a useful framework in which to approach climate-related scenario analysis. The guide sets out two objectives of undertaking scenario analysis:
1. Financial impact: the use of scenario analysis enables the assessment and pricing of climate-related risks and opportunities.
2. Alignment: aligning the portfolio(s) with a 2°C (3.6°F) or lower future. This is typically driven by a set of investment beliefs.
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INVESTOR FRAMEWORK FOR CLIMATE-RELATED SCENARIO ANALYSIS
1. Establish objectives – alignment of values or financial materiality and internal governance in place
2. Understand & select scenarios - understand types of climate scenarios and how these can be translated into parameters to guide investment analysis
3. Apply scenario analysis to investments - Top-down mapping to identify main areas of risk or bottom-up in depth analysis to better understand magnitude of risk
4. Review findings and consider actions - Iterative process involving a range of actions including further analysis and information gathering
5. Disclose - Reporting and communication; internally to portfolio managers,
Investment Committee, Trustees; and externally to clients, regulators, and other stakeholders.
6. Ongoing active monitoring - Key parameters identified, to be monitored over time
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EU's NFRD (non-financial reporting directive)
The EU’s NFRD, which helps analysts and investors to evaluate the non-financial performance of large companies, sums up the most effective and recommended approach. This involves:
▶ taking a set of transparent and credible data sources and assumptions, which can be quantitative or qualitative;
▶ applying recognisable, accepted methodologies, which will probably have the backing of an industry body, government department or multilateral institution;
▶ focusing on materiality – looking in particular at business models, operations and financial performance; and
▶ generating a set of outputs which can be measured in terms of key performance indicators.
In order for the financial system to achieve a better appreciation of climate change risks (and opportunities), there is a need for more data, greater disclosure, better analytical toolkits, advanced scenario analysis and new risk management techniques.
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Apply material environmental factors to financial modelling, ratio analysis and risk assessment.
Approach to shortlist environmental factors for which the potential impact
of environmental risk on infrastructure financials can be demonstrated:
1. A longlist of widely recognised environmental factors was derived. The longlist was reduced to a shortlist of environmental factors that are typically among those considered key to an environmental assessment in the context of infrastructure.
2. If, and to what extent, any of the selected environmental factors has a material impact on the infrastructure asset will be revealed by the asset-specific ESG due diligence process.
Approach to assess the implications of environmental risk on financial ratios and models - determine the potential impact pathways from the selected environmental factors to specific financial ratios or inputs into financial models (i.e. environmental factor > risk considered > financial ratio or factor impact > impact of the risk)
E.g. GHG emissions > Client demand for lower-carbon products and services (e.g. cleaner electricity in the case of a utility company) > revenues > decrease in revenues from high-carbon activities
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OPPORTUNITIES RELATING TO CLIMATE CHANGE AND ENVIRONMENTAL ISSUES
A. the circular economy;
B. clean and technological innovation;
C. green and ESG-related products; and
D. the blue economy
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Circular economy
In a circular economy, products and materials are repaired, reused and recycled rather than thrown away, ensuring that waste from one industrial process becomes a valued input into another. The circular economy concept is now a core component of both the EU’s 2050 Long-Term Strategy to achieve a climate-neutral Europe and of China’s five-year plans.
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Clean and technological innovation
The term cleantech is an umbrella term “encompassing the investment asset class, technology, and business sectors which include clean energy, environmental, and sustainable or green, products and services”
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Green and ESG-related products
Financial products that have emerged include:
▶ a range of green, sustainability and ESG indices;
▶ green bonds and loans, sustainability funds and ETFs;
▶ retail and institutional deposit or savings products; and
▶ crowdfunding investments
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Green bonds, loans and other labelled ESG-related products
Green bonds were created to fund projects that have positive environmental and/or climate benefits. The majority are green ‘use of proceeds’ or asset-linked bonds.
While clean energy and low-carbon building investment continues to dominate allocations, funding for low-carbon transport has increased dramatically and issuers from the information and communications technology (ICT) and manufacturing sectors have entered the green bond market.
In addition to green bonds, which focus closely on climate-change solutions, there has been increased issuance in other labelled debt, primarily green and sustainability loans, where the financing terms are linked to climate
or environmental performance indicators (for example, investors may receive an increase in the bond’s coupon if the company fails to meet certain targets).
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Considerations when assessing green or ESG-related products
▶ the eligibility of assets and criteria to meeting their green, ESG or SDG-related objectives;
▶ the use of proceeds effectively allocated to eligible projects;
▶ the transparency and reporting requirements and key measures of impacts; and
▶ the issuer or borrower has a clear sustainability and ESG strategy
There will continue to be a proliferation of ‘green’ financial products in the marketplace. The important consideration to note is that the quality and transparency of environmental and climate-related data and disclosure will need to improve in order to avoid ‘greenwashing’.
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Green Bond Principles (GBP)
The International Capital Markets Association (ICMA) sets out voluntary guidelines called the Green Bond Principles (GBP), which were established in 2014 by a consortium of investment banks to promote the integrity of the green bond market by recommending transparency, disclosure and reporting. As part of ensuring the integrity of the use of proceeds, external review is obtained through a second party opinion provider who will track and report on whether proceeds are used as promised.
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Climate Bonds Initiative
The Climate Bonds Initiative has regular information about the state of the green bond market. The Climate Bonds Taxonomy and sector-specific criteria have been scientifically developed to meet the object of the Paris Agreement of keeping global warming under 2°C (3.6°F), and the range of
sector criteria keeps expanding. More recently, the NGO has started focusing on transition and published a framework for delineating green and transition finance.
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Green Loan Principles (GLP)
In 2018, the Green Loan Principles (GLP) were established by the UK and Asia Pacific Loan Market Association (APLMA). The four pillars of the GLP are:
1. There is clear green use of loan proceeds.
2. The project’s sustainability objectives have been clearly evaluated and communicated to lenders.
3. Loan proceeds are strictly managed through project accounts.
4. Detailed and strict reporting is mandated.
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Blue economy
The World Bank defines blue economy as the “sustainable use of ocean resources for economic growth, improved livelihoods, and jobs while preserving the health of ocean ecosystem”. All other definitions of the
term essentially relate to a broader perspective on sustainable economic and social activity associated with the world’s oceans and coastal areas.
The blue economy has more recently begun to gather more attention and has climbed the policy agenda. As covered in the previous section on oceans as a natural resource, it is clear that the ocean is already under stress from over-exploitation, pollution, declining biodiversity and climate change.
Investors and policymakers are now beginning to recognise:
▶ the growth prospects for the ocean economy;
▶ its capacity for future employment creation and innovation; and
▶ its role in addressing global challenges
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Blue economy - Three priority areas for action
1. approaches that produce win–win outcomes for ocean business and the ocean environment across a range of marine and maritime applications;
2. the creation of ocean-economy innovation networks; and
3. initiatives to improve the measurement of the ocean economy via satellite accounts of national accounting systems.
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Blue Economy Development Framework
The World Bank and the European Commission have launched the Blue Economy Development Framework (BEDF), which is a new step in the area of international ocean governance. It helps (developing) coastal states transition to diverse and sustainable blue economies while building resilience to climate change.
The BEDF aims to create a roadmap that assists governments to:
▶ prepare policy, fiscal, and administrative reforms;
▶ identify value creation opportunities from blue economy sectors; and
▶ identify strategic financial investments.
The BEDF intends to help coastal countries and regions to develop evidence-based investment and policy reform plans for its coastal and ocean resources.
