Why investors (alone) can’t solve climate change

If the number of words written on 'ESG' in the past few years was directly linked to our ability to solve social and climate problems, we’d be well on the way to the ideal world that it envisages.

The fact that we’re not suggests there is something we’re not adequately addressing. Perhaps this is the basic question of 'who pays, and when?'

Transitions create winners and losers. Yet we seem to be trying to revolutionise our environmental practices (in particular) without first agreeing how we will mitigate the impact on individuals. Progress is being made, but addressing climate change is much harder when the political ground rules remain undecided.

This can be largely attributed to our inability to address the unequal impacts of moving to a post-fossil fuel world. The costs aren’t only financial: almost everyone is a fan of clean power until it means putting power lines through a natural beauty spot, fifty euros on a litre of petrol, or shutting down local employment.

Meanwhile the benefits are distant: carbon-reducing technologies won’t make an observable difference for at least a generation.

The task of creating incentives or penalties that drive behaviours, and of mitigating the costs for those on the wrong side of change, falls completely on the politicians we appoint to balance the interests of everyone.

Solutions with immediate costs but 50-year benefits are incompatible with five-year electoral cycles and voters who typically care more about the here and now. Politicians understand this, but may struggle to get (re)elected if they impose the implicit wealth transfers necessary to make change.

Solutions with immediate costs but 50-year benefits are incompatible with five-year electoral cycles

We might hope that corporate entities would take a longer view, but given the short-termism of most shareholders, they rarely do. In fact, many actively lobby against anything which might put a dent in their near-term profitability, even at long-term expense.

Caught between these two very different timelines, politicians have an unenviable task in executing detailed policy. Most rules so far have centred on emissions disclosures, in the hope that this will somehow transform consumer, and in turn corporate, behaviours. There is little evidence of that yet.

Our role as asset managers is to deliver investment returns within the rules set by politicians, and we have a fiduciary obligation not to entangle this with pursuing ESG goals unless our clients explicitly ask.

Slow progress on policymaking therefore makes it difficult to reconcile the pursuit of investment returns with delivering on net zero targets. Regulatory intervention is most valuable in the scaling phase.

Generally, prices come down sharply as new technologies mature. A slow ratcheting up of costs for old approaches with negative externalities can be combined with subsidies for new practices until a tipping point is reached where the new stands on its own.

The longer it takes for clear regulatory frameworks to materialise, the less likely it is that investors will commit capital at the scale required.

I recently read 'Chip Wars' by Chris Miller. It’s about how today’s astonishingly powerful microprocessors emerged. They didn’t just happen – for several years in the 1960s and 70s the companies pioneering them were heavily subsidised in the form of tax breaks or government procurement commitments. This allowed them to commit high amounts of capital to creating ever-better technologies, which then became ubiquitous and revolutionary.

The longer it takes for clear regulatory frameworks to materialise, the less likely it is that investors will commit capital at the scale required

How do we overcome our present dysfunction to achieve for climate goals what we achieved for processing power? The key difference perhaps is that the timescales are longer; so long that it’s tempting to give up.

We’re seeing some of that now, as the daunting entanglement of climate and social fairness swims into focus. These are trade-offs that the financial sector is in no position to arbitrate.

Complex issues can’t be reduced to simple metrics. Social improvements and creating technologies that will avoid emissions in the future while using resources now, require a nuanced assessment of progress and alternative pathways which you won’t find in an ESG dataset or one-size-fits-all voting policy.

We think the answer is 'many small ways'. Together, investors and governments can bring about constant incremental progress. Investors don’t make the rules, but are already deploying capital that will facilitate the energy revolution, in full expectation of strong returns.

Even cash-strapped governments are already offering incentives for companies that are tackling some of our biggest problems. We need much more of this. Investors and governments can work together to promote projects that would otherwise be deemed too risky or distant to compete for capital.

Engagement is key: with policymakers, companies, other investors and society at large. Institutional investors can help governments to nudge investment opportunities over the line in terms of expected returns.

Unfortunately, this creates a free-rider problem in the industry: the benefits of engagement accrue to shareholders and indeed to society, but the costs are borne only by a few. But that’s a topic for another article.

Stuart Dunbar, Partner, Baillie Gifford