Building blocks for a low carbon economy: A guide for climate-aware investors

• We need to accelerate our efforts to tackle climate change - without transitioning to a low carbon economy, we won’t have sustainable economic growth
• Carbon offsetting, carbon pricing and carbon taxes can all play a part in the energy transition but much more needs to be done
• There are growing opportunities to invest in green assets and new technologies helping drive the transition

2021 was one of the warmest years on record – and the seventh consecutive year when the global temperature has been more than 1°C above pre-industrial levels.¹

This is worryingly close to the cap envisaged by the 2015 Paris Agreement, to limit global warming to +2°C (but ideally +1.5°C) above pre-industrial levels.² All the evidence suggests the reason we have edged ever closer to that proposed limit is the high and growing levels of carbon dioxide in the earth’s atmosphere.

Tackling carbon

In chemical terms, carbon dioxide is a compound made up of one carbon atom, and two oxygen atoms – CO2 – and in the atmosphere acts as a greenhouse gas (GHG). Carbon dioxide and methane, another GHG, are the primary sources of climate change. Together they cover the earth’s atmosphere, and trap heat. This is most obvious in rising average global temperatures, but also in increased instances of extreme weather events including drought, flooding and ever-greater storms.

The main sources of greenhouse gas emissions include, among others, transportation (combustion engines), electricity production, industry and agriculture, as well as commercial and residential buildings.

Fighting climate change

Climate change has been acknowledged as the greatest threat facing the planet and the urgency for action has markedly increased. The United Nations warned: “The science shows clearly that in order to avert the worst impacts of climate change and preserve a liveable planet, global temperature increase needs to be limited to 1.5°C above pre-industrial levels. Currently the Earth is already about 1.1°C warmer than it was in the late 1800s, and emissions continue to rise.”³

We need to bolster and accelerate our efforts to tackle climate change – emissions need to be reduced by 45% by 2030 and reach net zero by 2050. This means dramatically cutting our GHGs and moving the global energy sector away from fossil-based fuels, towards greener, renewable alternatives. If we don’t, we may jeopardise the global economy and the prospect of a prosperous future. 

Thankfully, many governments and organisations are stepping up to the challenge. More than one third of the world’s 2,000 largest public companies have net zero commitments, up from one fifth in 2020 while 91% of global GDP is now captured by national government net zero targets, up 68% over the same period.⁴ Industries such as automobile makers are transforming with Ford and Jaguar Land Rover having committed to having all-electric ranges in the next decade,⁵ while oil giants BP and Shell have set their own net zero targets.⁶

The carbon business

The battle against climate change – seen through efforts to cut carbon dioxide in the atmosphere – is big business. Carbon offsetting, carbon trading and carbon credits all have their part to play in cutting GHG emissions. We outline what you need to know below:

Carbon offsetting: The term ‘offset’ was first used in the late 1970s as part of the US Clean Air Act, in which new emissions in high-pollution areas were allowed only where other reductions were made to offset the increases. Carbon offsetting is all about reducing GHG emissions in one area in a bid to compensate for emissions made elsewhere. Essentially it is a way for organisations (or individuals) to make up for their CO2 emissions by supporting legitimate carbon-reducing projects.

Those projects absorb or reduce CO2 emissions or can even directly remove carbon from the atmosphere. Carbon offsets come in a variety of guises:

• There are nature-based solutions where projects protect existing forests, improve soil management, and restore damaged habitats, leading to reforestation and the implementation of climate-smart agriculture practices. They aim to absorb more CO2 from the atmosphere and can lead to the trading and sale of carbon credits (see below).
• They can be technology-related, such as Carbon Capture and Storage (CCS) facilities, or Carbon Capture Utilisation and Storage (CCUS), whereby CO2 from industrial processes is captured and stored, and in the case of CCUS, used. CCUS facilities around the world can currently capture and store around 40 million tonnes (Mt) per annum of CO2 whilst 830Mt of CO2 capture capacity would be needed annually by 2030 to meet the sustainable development scenario, and 5.6 gigatons by 2050, according to the International Energy Agency.⁷
• Carbon Dioxide Removal or DACCS (Direct Air Capture and Storage) is where CO2 is removed from the atmosphere and stored in geological or ocean reservoirs, or in products.

We believe the use of carbon offsetting should not help companies postpone necessary emission reduction measures. It should be viewed as an interim solution, to complement hard-to-abate emissions in the short term while transitioning to net zero, and only a permanent solution where a particular part of an industry, or industrial process, defies any practical decarbonisation pathway.

Carbon pricing puts a cost on the various environmental and social impacts caused by GHG emissions. These include, among many others, property destruction due to flooding as well as crop damage and healthcare costs that might be brought on by drought. Carbon pricing essentially internalises the cost of emitting CO2, thereby creating an economic case for reducing emissions.

According to the World Bank, 40 countries and over 20 cities, states and provinces already use carbon pricing mechanisms, with more planning to introduce them. In aggregate the carbon pricing schemes in place cover about half their emissions, which translates to about 13% of annual global greenhouse gas emissions.⁸

There are two primary types of carbon pricing: carbon taxes and carbon emissions trading systems (ETS).

Carbon ETS

Emissions trading is a way of getting companies to reduce their GHG emissions. An emissions trading system or scheme is a mechanism by which nations or organisations can emit greenhouse gases into the atmosphere but do so in a market where emissions allowances can be traded between themselves.

The goal is to incentivise firms to reduce emissions by setting a limit on the maximum level of emissions allowed and reducing that level over time. If a business earns ‘carbon credits’ by reducing emissions or producing GHG-free power for example, it can then sell those credits on the ETS to companies who have exceeded their allotment.

Through this process, a market-based carbon price can be achieved. Over time the supply of allowances is reduced, and the price will rise, thereby making it more and more unprofitable for businesses to avoid reducing their emissions.

Having a cap should ensure that overall emissions are kept down and encourage businesses to stay within their pre-allocated carbon budget. The European Union’s (EU) ETS is the world's first major carbon market and remains the largest globally.⁹

The bloc’s ETS applies not only to the EU members but also to the other three members of the European Economic Area – Norway, Iceland and Liechtenstein. It covers over 11,000 heavy energy-using installations – power stations and industrial plants – as well as airlines operating between these countries, which are collectively responsible for close to half of the EU's emissions of CO2 and 45% of its total greenhouse gas emissions.¹⁰

According to McKinsey & Company, it is estimated that the carbon credit market could be worth more than $50bn by 2030. Alongside carbon capture and storage, and carbon removal, nature-based solutions will be central to this. McKinsey Nature Analytics estimates there is the potential for nature-based projects to store an additional 6.7 gigatons of CO2 every year by 2030 – around 17% of global CO2 emissions in 2020.¹¹

Carbon taxes

Carbon taxes are set by a government, laying out the price companies must pay for their emissions. It is another way of incentivising firms to cut their GHG output by, say, switching to greener fuels or adopting more environmentally friendly technologies. Unlike ETS systems, the carbon tax price is defined from the outset. Carbon taxes essentially come in two guises. As the Center for Climate Energy Solutions explains: “An emissions tax, which is based on the quantity an entity produces; and a tax on goods or services that are generally greenhouse gas-intensive, such as a carbon tax on gasoline.” As of 2021, some 35 carbon tax programmes have been introduced worldwide.¹²

Why investors should care about carbon

Investors need to be aware of the risks of investing in businesses that will underperform because of their environmental footprint. In our view, delivering climate-aware investments is not something that challenges the primacy of financial objectives – it complements and enhances our understanding of those objectives. Fundamentally, it’s about better management of financial risk.

Thankfully, it is increasingly possible to use analysis, data, and portfolio construction techniques to align portfolios with the ambition of a net zero carbon world. When it comes to selecting securities, it is vital to assess how climate change could impact a particular business and its future profitability. How would a firm be impacted by flooding and other disruptive weather events? What would it mean for its operations, supply chains and workforce?

There are regulatory and fiscal risks too. Governments can increase taxation to address the impact of emissions. If companies are going to have to pay more to emit GHGs, then that will hit their profitability and, subsequently, investor returns. Consumers can vote with their feet too. They can reduce demand for a company’s goods and services if it is seen to be at risk from climate change or if it is contributing to rising emissions.

New opportunities

But it’s not just all about risks and exclusions – there is the opportunity to invest directly in green assets: Green bonds, green real estate, forestry and so on. Equally, the new technology being employed to help the transition to a cleaner economy may provide a series of opportunities for investors. This technology, that is both directly and indirectly related to the energy transition, is evolving rapidly. We are already seeing fairly mature developments in solar and wind and other renewable energy sources, but they still have to scale up massively to contribute fully to the fight against climate change.

At its heart this is about investors understanding and adapting to the risks that climate change poses for business models and to communities. Companies with poor environmental footprints and poorly thought-out carbon pathways may underperform, while at the extreme end we may well see stranded assets rendered un-investable by the pace of policy or consumer change.

It is widely agreed that climate change poses a huge threat to the world. We know that it is going to be very damaging to the environment. It will result in rising sea levels, extreme weather, societal disruption, the loss of economic activity and more.

Quite simply, without the transition to a low carbon economy, we won’t have sustainable economic growth, and that would mean we can’t have sustainable investment returns.