Debates around the investor role in tackling climate change and how to mobilise private finance were high on the agenda in Glasgow during COP26. Shifting financial flows is an essential part of the decarbonisation process and there is no solution that won’t involve the financial sector deploying large amounts of capital to support the transition. 

That’s because, in addition to moving away from fossil fuels, our reliance on a stable climate depends on climate solutions being unleashed at scale, which requires unprecedented amounts of capital in a concentrated period. 

For investors, this presents a significant investment opportunity across nearly all asset classes, regions, and timeframes, in Australian Ethical’s opinion.
 

Identifying climate winners

Although decarbonising the economy will produce plenty of winners and losers, how can investors pick the winners from the losers? 

Six years after the Paris Agreement, more than three-quarters of the global economy is now covered by net-zero targets of various kinds, and yet investors still need clarity – including interim targets, policy guidance and industry strategies. 

The reality is that climate remains an incredibly complex topic. Many difficult questions still need answering such as what kind of emissions to focus on, how to address avoided emissions and carbon offsets. 

And yet while there is no common framework for allocating capital with a net-zero emissions mindset, investors do not need to wait for data to be perfected or legislation to be put in place. 
 

Portfolio response

There are two common approaches they can follow to adjust their portfolios in response to climate change. 

The first is based on reducing investment risk associated with climate change by avoiding exposure to companies that are less likely to do well in a world that is getting hotter. Those might include oil and gas companies, or those heavily exposed to coal or more highly polluting industries. 

The second is to consider climate change as an investment opportunity and look for companies that will aid or benefit from the transition to a low carbon economy. 

In other words, minimising allocations to companies most negatively affected by climate change should help to mitigate the downside risk, while increasing exposure to companies with climate-smart business models and offerings may maximise the upside opportunity.
 

Sector winners

There are some key sectors that are truly racing ahead towards net zero, such as electric cars. They are already cheaper to own and run in many places – and when the purchase prices equal those of fossil-fuelled vehicles in the next few years, a runaway tipping point will be reached. 

Other sectors are more established, such as renewable energy. Electricity from renewables is now the cheapest form of power in places, sometimes even cheaper than continuing to run existing coal plants. And while there’s a long way to go to meet the world’s huge energy demand, the plummeting costs of batteries and other storage technologies bodes well for investors in the sector.

But perhaps the most important step investors should start with is learning more about the economics of climate change to better understand the implications of a heating world on their portfolios. 

Winners and losers in the transition to net-zero will come from a wide variety of sectors. And so, investors should seek to understand how the physical and transition risks brought on by climate change will affect the companies in which they invest. 

Some of these risks are slowly growing threats while others have already emerged. Investors should look for what strategic steps each company has or has not taken to mitigate these risks.
 

Assessing climate risk

At Australian Ethical, we have long seen it as part of our fiduciary duty to reduce climate-related financial exposure for our customers. Our investment approach helps us to distinguish climate leaders from climate laggards and to determine whether an investment is part of a path to a better future for people and the planet.

This means understanding what a company does and how it contributes to the transition. The actions taken in the next decade by companies and by investors will be critical for a net-zero pathway.

For example, historically we have had a limited investment in the building materials sector as it is a major contributor to global carbon emissions. But as new technologies are being developed and the sector pathway to climate alignment is becoming clearer, we are now investing selectively in those companies that meet our science-based, sector-specific ethical requirements. 

As long-term stewards of capital, we see it as our responsibility to help the sector get to Paris alignment as quickly as possible. Transition can be accelerated through better collaboration to understand and remove barriers to a more efficient transition, and we can contribute by supporting the development, supply and uptake of transformational, low or zero-carbon products (such as green steel, low carbon cement and products made from recycled content). 

Ambitious transformational decarbonisation pathways exist but will only become more commercially viable as bold investors demonstrate leadership, driving technologies down the cost curve. By directing capital to climate solutions - such as renewables - and away from fossil fuels, responsible investors are supercharging efforts to bring down the cost of capital for companies that are critical for the transition, while also increasing the cost of capital for companies that need to limit their carbon-emitting activities. 

At Australian Ethical, we recently set a 2040 net-zero emissions target for our company and non-government sector investments, bringing forward the 2050 target we set in 2015. 

The world will need diverse successful zero-emissions businesses operating across the economy by 2040 to reach net-zero by 2050, and by setting a net-zero 2040 target, we’re helping drive capacity and innovation to make this a reality. 
 

Conclusion

Reserve Bank Deputy Governor Guy Debelle said recently that climate change is “first-order risk” for Australia and no matter the opinions of Australians towards the move to net zero, it is going to happen. 

Our experience shows there are businesses that are leading in the management of climate risk and there is the opportunity to create high-performing, low-emissions portfolios. 

In Australian Ethical’s opinion, now is the time to climate-proof portfolios or risk missing out on potentially good returns offered by the global transition to a zero-carbon economy.