The former Bank of England Governor poses a potentially dangerous vision for ESG, explains Nick Silver
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In his recent Reith Lecture, Mark Carney, the former Governor of the Bank of England, gave a passionate call to arms for the world to urgently transition to net zero carbon emissions. He articulated how finance will play a crucial part in the solution – by employing the three Rs – Reporting, Risk and Return.
Carney’s argument can be seen in the wider context of ESG investing – which, for most of my working life, has been marginal in finances, but now about 40% of investors profess to be “ESG Aligned”.
One view of ESG is that it captures non-financial risks and hence ensures an improved risk/return profile. However, Carney’s ambition for the 3 Rs – that they contribute to avoiding climate change – represent a marketing view of ESG, that it delivers returns whilst ‘doing good’. Both of these views are flawed, but the latter is more dangerous.
It is important to distinguish between our need to transition to net zero carbon emissions and other ESG issues. To get to net zero we broadly know what we have to do sector by sector; which will be a massive engineering and coordination task. This contrasts with other ESG themes which encompass a wide range of concerns requiring a diverse range of actions. Unfortunately to address climate change, Carney’s 3R strategy for finance is inadequate.
Carney describes the tragedy of the horizons, but baked into investment regulation is the tragedy of pensions investment horizons
The logic of the 3Rs is simple: when companies are fully Reporting on climate risks, it allows investors to assess these Risks on their portfolios and identifies climate-solving Returns on investments. Investors would then adjust their portfolios, which will align capital flows to a transition to a net zero economy.
Climate risk has 3 components: physical, transition and societal. An accurate analysis of physical risk does not drive a transition to net zero – examples of negatively impacted assets would be insurers, ports or Bangladesh government bonds. Selling these and buying tech stocks or newly ice-free Northern-passage Russian ports would not contribute to a transition.
The bigger play is transition risk and potential returns for investment in a zero-carbon economy; for an investor to optimise their risk/return, they would have to make a call on how the economy shifts and who will be the winners and losers. But society and governments may shift more slowly than anticipated – 3 Rs investment choices are purely reactive – a rapid rebalancing of the portfolio could only be justified by the belief in a rapid societal shift. Based on past performance, there is a risk for investors from moving too rapidly – investors will only achieve returns if they can accurately anticipate which way society will decide to move. If we had more Trumps and Bolsanaros, the world could easily move in a different direction.
Shifting portfolios does make a slight difference to the climate, but not of the scale required for the transition. The price of fossil fuel company equity, such as Exxon, has been hit recently (largely because of the fall in oil prices); the rise in the share price of clean tech companies, such as Tesla, has enabled them to ramp up production and development of electric vehicles. But there is still a great deal of investment in fossil fuel development, at a time when we need to stop all investment.
A 3R strategy is akin to a thematic investment. Like other themes such as tech, they might generate better returns for the investor, but this is not guaranteed. Carney advocates radical change for the rapid transition, but his thinking does not extend to the radical change in the way investment is done; the 3Rs are definitely not enough to ensure the rapid transition that Carney seeks – there is no reason to presume you will do good by making returns.
The premise of long-term investment such as pension investment, is that savings are invested in a way that the economy will sustainably grow over the long term, and this will generate the income to pay returns. If we are heading towards 3-4°C climate change this won’t be a viable system.
Carney describes the tragedy of the horizons, but baked into investment regulation is the tragedy of pensions investment horizons; regulation through mark-to-market accounting and equating risk with volatility ensures that supposedly long-term investors are incentivised to chase short term returns, instead of investing in the long-term interest of the economy or society, or stewarding the assets they are entrusted with.
Investment needs to be premised on an aggressive policy of achieving net zero, and that, incidentally, will generate investment returns. Such a climate investment strategy would have the following basic elements:
a) Equity: Investors could compel the companies they own to rapidly transition to net zero, with targets and punishment for non-compliance.
b) Bonds: Famously James Carville observed: “I would like to come back as the bond market. You can intimidate everybody”. Bond investors have not been intimidating governments on climate. As a minimum they should make it known to central banks and treasury that bondholders demand credible policy for a rapid net-zero transition.
c) Impact investment: Investors would allocate a minimum proportion of investments into cleantech innovation and development, and green infrastructure.
Investors could monitor their own portfolio’s track to ensure a net zero transition not through divestment but across an engaged portfolio.
Would this investment strategy negatively impact returns? Recent economic analysis has found that a rapid switch to a low carbon economy would have a limited impact on economic growth; so overall long-term returns are likely to remain unaffected, in the current negative interest rate environment investors could generate positive returns through mobilization of capital. Sure, some companies would do badly, but others would grow rapidly, which has net zero impact on universal investors. However, this would require investors and regulators to take a systemic view of the investment system; that the behaviour of the system is not the sum of its parts.
Investors could coordinate their action as they are already signed up to many initiatives. For example, PRI Principle 7 could be “we will use our asset ownership position to drive a rapid transition to a zero-carbon economy”, but that would require a step change in compliance with these principles; investors’ would need to understand that it is in their interest for everyone to comply – to avoid freeloading – so would need to introduce punishment for non-compliance.
Mark Carney’s lecture is a call for the radical transformation that we need to achieve net zero. Yet, when it comes to finance, his own backyard, his 3R strategy will make no difference. This is because, like ESG as a whole, it is based on two presumptions which are now wrong:
Firstly, ESG thinking developed when it was only a small proportion of the market. Now, it makes up a significant chunk of the market (and Carney suggests that all investors need to engage), so its ability to drive change is of a whole different order of magnitude.
Secondly, it is still tethered to a market fundamentalism world view – the market is making the wrong decisions because of the lack of accurate information (Reporting). This is the thinking that has put us on a 4°C pathway, along with too many other social ills that are all too obvious now. It is this that needs to be urgently changed.
Nick Silver is author of Finance, Society and Sustainability (Palgrave McMillan). He is Founder and Chairman of the Climate Bonds Initiative and Founder and Director of Radix, Think Tank of the Radical Centre. He is a senior visiting fellow at City University.