Climate Change -Part III
Humanity is waging war on nature. This is suicidal. Nature always strikes back. Making peace with nature is the defining task of the 21st century. It must be the top, top priority for everyone, everywhere.
António Guterres, UN Chief
During my twenties and early thirties, while living in central London, the thought of owning a car seemed like an unnecessary burden. Fast forward to my early forties. I had moved to the suburbs with two young kids on board, each with a very busy schedule of extra-curricular activities. Under those circumstances, the thought of having a car suddenly seemed like a lifesaver!
Therefore, in early 2015, my husband and I decided to purchase a car. Foremost on our minds was that the car should be eco-friendly. We took the decision, which we thought at the time was environmentally (and financially) sound, to buy a Volkswagen diesel car. But alas, not even a year after our purchase, the Dieselgate scandal came to light, and we realised we had been ‘walking naked’, just like Hans Christian Andersen’s emperor. Not only had we unknowingly been spitting out excessive levels of nitrogen oxide, but the re-sale value of our car had plunged with the announcement.
When making investments in climate change opportunities, there is no doubt that investors will be found to be ‘walking naked’ every once in a while. So, when creating a portfolio of climate change opportunities, it is crucial investors keep this at the forefront of their minds.
Given that the sources of greenhouse gas (GHG) emissions come from a wide array of sources, diversification in a climate change opportunities portfolio is key. In this paper we explore diversification by GHG emission source, category of solution and investment strategy. As discussed in Part I and Part II of this paper, there is an array of strategies available to investors keen on accessing climate change opportunities, including:
• public markets (Part I): Long-only equities (ETFs and mutual funds), green bonds, equity long/short funds and carbon emission trading;
• private markets (Part II): Private equity, venture capital, growth equity, infrastructure, real estate, afforestation & reforestation.
When determining how to allocate to these investment strategies (and solutions), I present three new portfolio construction ‘pillars’ which should be useful to investors when putting together a portfolio of climate change opportunities. Arguably, these pillars could be seen as a climate change lens through which the opportunity set is assessed.
When starting on this journey, investors need to determine what they mean by ‘climate change’ and being cognisant of the fact that our planet is a complex self-regulating system with interconnecting linkages.
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Sources of GHG emissions revisited
The portfolio construction process in any climate change portfolio should start from basics, i.e. what the sources of GHG emissions are. As discussed in Climate Change - from risk to opportunity, 73% of all GHGs come from energy. Its use within industry is the biggest contributor, but transportation and buildings (mostly heating or aircon) are big sinners as well. The other major GHG contributor is agriculture, forestry & land use (see Exhibit 1).
An important takeaway from Exhibit 1 is that GHGs come from a wide array of sources, and investments must be similarly diversified to tackle the crisis. However, given the vast amount of interconnectivity in Exhibit 1, particularly within energy, tackling the GHG crisis should probably start in the energy sector.
Allocating to climate change opportunities based on the sources of GHGs is a complex exercise, so to conceptually simplify the portfolio construction process, it is a useful exercise to align the sources of GHG emissions to six solutions to the climate crisis as shown in Exhibit 2.
Each of the strategies discussed in Part I and Part II of this paper fit into one or more of the six climate change solutions in Exhibit 2. The most easily accessible and versatile route to invest in climate change opportunities is through GHG Reduction Technologies (see Exhibit 3). Some climate change solutions are more limited in the number of investment strategies underpinning them. See for example Stranded Assets, which consists of just one strategy – equity long/short funds, which allows for shorting of assets which are stranded as a result of the green transition.
I have now evaluated all the relevant investment strategies (see Part I and Part II of our Climate Change strategy paper) and mapped them to the wider solutions as outlined above. The next step is to determine how much to allocate to each.
Portfolio construction framework – three new pillars
Harry Markowitz won the Nobel Prize in Economics on the back of the work he completed on Modern Portfolio Theory in 1952. This still forms the basis of most portfolio construction today. However, for climate change portfolios, three new pillars should be considered (see Exhibit 4). These pillars are intrinsically interconnected with risk and returns and are arguably another lens through which the opportunity set from climate change should be assessed.
Pillar 1: Contribution to climate change solution
How much could this strategy, once fully developed and deployed, contribute to solving the climate crisis? Planting trees is a good example. As discussed already in Part II, Bill Gates argues in How to Avoid a Climate Disaster that you would need to plant more than 16 billion acres of trees, roughly half the landmass of the world, just to neutralise the emissions of the United States (and China’s emissions are more than twice the size of US emissions).
It is therefore unrealistic that by planting trees alone, a climate crisis could be averted. Investors allocating to afforestation & reforestation strategies, should take this into consideration when determining how much to allocate to those investment strategies. Having said that, afforestation & reforestation strategies still deserve a role in a climate change portfolio, with forests absorbing close to 7.6 billion tonnes of CO2 annually (source: Global Forest Watch).
On the other hand, if carbon capture and storage (CCS) is deployed all over the world, it could potentially, single-handedly, contribute significantly to keeping the world within the Paris Agreement parameters. So, following the argument of this first pillar, CCS should constitute a significant allocation in a climate change portfolio.
Pillar 2: Technology phase
Here is where the second pillar enters the equation. CCS is complex with technological developments taking a long time to develop, particularly at scale. Billions of dollars have already been spent on carbon capture R&D in North America with rosy predictions for CCS repeated year after year. However, today, over 20 years after they began to work on CCS, it has not yet proven to be the ‘holy grail’ that was expected. So, the second ‘new’ pillar that should not be overlooked by investors when constructing a portfolio of climate change opportunities, should be the technology behind the solution.
A good indicator for investors to use when determining where a technology is within its longer-term journey is its cost, particularly in relation to competing technologies. Exhibit 5 shows that an additional $60 per ton cost for carbon capture makes coal mines with CCS technologies incorporated unable to compete with wind and solar. So, if you take the second pillar into consideration, the allocation to CCS is significantly reduced.
It is important to note that the technological assessment of a potential solution includes not only new breakthroughs but also the deployment and scaling-up of existing technologies, resulting in further improved efficiencies and lower costs.
One should also consider solutions which are not necessarily technological in nature, for instance the growth of carbon trading. See Part I for a discussion on carbon trading. Likewise, it is important to be aware of government support and subsidies to further certain solutions as it may speed up the pace of development.
Pillar 3: Time value of carbon
There is an urgency underlying the climate crisis. Scientific studies suggest that an increase in temperatures beyond certain levels increases the risk of feedback loops. This may again result in irreversible changes. Potential tipping points in the climate system include the disintegration of polar ice sheets and deforestation in the Amazon.
Climate change is therefore an issue that needs to be addressed sooner rather than later. The concept of Time Value of Carbon, i.e. GHG emissions cut today are worth more than identical cuts made (or promised) tomorrow, is an important consideration when putting a portfolio of climate opportunities together.
An example of incorporating the time value of carbon into the portfolio construction process would be to give a larger allocation than otherwise to strategies which focus on the reduction of short-lived GHG emissions. Methane, for instance, typically breaks down in the atmosphere after only 10-12 years, while CO2’s atmospheric lifetime is in the range of 50 to 200 years (not to mention the fact that the global warming potential of methane is over 80 times stronger than CO2 over a 20-year period).
So, reducing methane emissions would have a positive impact on the environment sooner, which is important given the increased risk of feedback loops and tipping points mentioned earlier. This is part of the rationale for the pledge from 105 countries at COP26 to cut methane emissions by 30% by 2030 compared to 2020 levels.
The time value of carbon also reinforces the second pillar, the technology phase, where technologies which are operative today should arguably be given a larger allocation than technologies which may still be at the conceptual stage.
What does climate change mean to you?
Investors in climate change opportunities will need to precisely determine what they mean by ‘climate change’. The United Nations defines climate change as:
… long-term shifts in temperatures and weather patterns. These shifts may be natural, such as through variations in the solar cycle. But since the 1800s, human activities have been the main driver of climate change, primarily due to burning fossil fuels.
However, climate change is just one of various issues that investors who are concerned about the health of our planet should be addressing. The Stockholm Resilience Centre has conducted some interesting research, where it has identified nine processes which “regulate the stability and resilience of the Earth system” (see Exhibit 6).
The scientists also came up with planetary boundaries within which “humanity can continue to develop and thrive for generations to come”. However, “crossing these boundaries increases the risk of generating large-scale abrupt or irreversible environmental changes”.
Exhibit 6 does not do for good bedtime reading, though, with four of the systems surpassing the boundary and a number of them in close proximity. Ultimately, investors need to decide if they want to zoom in on strategies solely focused on the strict definition of climate change (i.e. investment strategies which focus on GHGs) or more generally on the overall health of our planet.
Johan Rockstrom of the Stockholm Resilience Centre insightfully states that “the planet is a complex self-regulating system” and that the nine systems identified “behave like the 3 musketeers: one for all, all for one”. For instance, when forests are degraded and the planetary boundary for land is breached, the ability of the climate system to remain stable is also being undermined. Given these embedded linkages in our ecosystem, a wider remit focusing on the health of the planet would be advisable.
Another important (and related) consideration is whether there are any particular United Nations’ Sustainable Development Goals that investors specifically want to target in addition to climate action. Exhibit 7 shows some other SDGs which relate to Climate Change.
Putting it all together in practice
Investors looking to put a climate change portfolio together should:
• consider the sources of GHG emissions;
• acknowledge the fact that GHG emissions come from a wide array of sources, i.e. in order for the risk/return characteristics to improve, be prepared to allocate across the spectrum;
• include the three portfolio construction pillars discussed above, although they shouldn’t allow them to replace Markowitz’s MPT but rather use them as a compliment to it; and
• think of this approach as another lens through which they can view the opportunity set in more detail, for example:
i. the magnitude of the contribution to the climate change solution;
ii. the technology underpinning the solution; and
iii. the time value of carbon, i.e. the awareness that GHG emissions cut today are worth more than identical cuts made tomorrow.
The resulting climate change portfolio will vary from investor to investor, dictated by individual preferences and constraints, some of which are depicted in Exhibit 8. Exhibits 9-10 show how one could allocate to different climate change solutions, assuming you are an investor with no liquidity nor any capacity constraints, targeting mid-teens or higher long-term returns.
Given the wide opportunity set and sources of GHGs, the largest allocation by solution is GHG Reduction Technologies followed by Carbon Sequestration Technologies and Practices and Circular Economy. The breakdown by specific solution is very diversified, with EV & Related Mobility, Renewables, Battery Storage and Green Fuels being amongst the larger allocations (see Exhibit 10).
Strategy-wise, the allocation is quite diversified (see Exhibit 11). Most has been allocated to private equity and venture capital, driven in part by the opportunity set for climate solutions in PE and VC being quite extensive (see Part II). The high potential for enacting positive change and innovation has led to a relatively high allocation to infrastructure and equity long/short as well.
In Exhibit 11, we have allocated by investment strategy. Note that we haven’t allocated much to long-only equity, which includes ETFs. This results in our illustrative portfolio being quite different from that of many investors, who simply allocate to the space by investing in the latest climate-aware ETF.
Geographically, we allocate more than half to North America in our model portfolio. Europe accounts for the second largest allocation followed by the Rest of the World (see Exhibit 12).
Investors need to be very cognisant of the complex, dynamic and uncertain nature of climate change and the effectiveness (or lack thereof) of climate change solutions. It is therefore imperative that, while managing and overseeing a climate change portfolio, investors adapt their views and portfolio as the effects and solutions develop and are better understood.
There is no doubt that investors in climate change opportunities will face many unexpected surprises, but it will be worth experiencing a few Dieselgate-like moments, if this is what it takes for investors to participate in what we would consider the greatest investment and impact opportunity in the decades to come.
Alison Major Lépine
19 November 2021