“Taking climate change into account is prudent risk management,” Janet Yellen, US Treasury Secretary, said recently. Yet asset managers across private and public markets who look to follow that maxim face a dilemma. They flick the pages of a target company’s Annual Report and peruse its plans to reduce its carbon footprint. They could choose to invest on that basis. But fund managers also have a financial responsibility to maximise returns for their investors. Following that mandate can lead to a completely different set of portfolio choices.
To make sense of this dilemma, we need to separate two concepts that are easily confused: carbon accounting, and climate economics. These approaches point in different directions.
Consider two hypothetical companies: the first provides satellite data for oil and gas installations, the second operates mines extracting nickel and other minerals. It’s easy to understand that the nickel miner is the more polluting. Mining’s Scope 1 and 2 emissions are severe – mining vehicles run on diesel and thus pollute directly (Scope 1 emissions), and the site runs on electricity derived from coal or gas (Scope 2 emissions). Sulphur in its supply chain is a further concern. Indeed, for every kilogram of nickel produced, around 13kg of CO2e enter the atmosphere. By contrast, the direct, or Scope 1, emissions of the satellite data company are non-existent, and its Scope 2 and 3 emissions are minor. From a carbon accounting perspective, it’s easy to call the score.
But climate economics works differently. It starts with a simple truth: our planet will have to decarbonise, sooner or later, and as it does so many industries will become untenable, while others will enjoy a huge growth tailwind. Indeed, as the transition to a net zero economy takes hold, potentially trillions of dollars of assets, from oil wells to coastal real estate, will become liabilities, requiring ever more capital to maintain. Of all the investing megatrends of the coming decades, the climate transition may well be the biggest. It is undoubtedly the most predictable.
So let’s go back to our two hypothetical companies. The software company is wholly exposed to an industry – oil and gas – that is stagnating and will soon start to decline. Investors price assets on the net present value of their future cashflows, and the cashflow outlook here is poor, no matter what the carbon metrics may show. On the flip side, the nickel mine, for all its faults, is positively exposed to the transition. Nickel is used across the gamut of clean energy technologies, from solar panels to electric cars. To be sure, the mine will need to decarbonise its own operations over time. But a savvy climate investor should consider its prospects favourably.
Evaluations like these are complex and frequently counter-intuitive. To find out more about how Dovetail can help you, get in touch.