Investor Insight Newsletter: science-based stewardship - July 2024

Fossil fuel companies that are actively developing new oil, gas and coal projects and delaying the global transition by lobbying to lock-in demand for their products, are materially increasing the medium to long-term risk profile for all investors.

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As another proxy season draws to a close, we have seen strong demonstrations of investor stewardship. Most notably, Woodside received a 58.4% vote against its Climate Transition Action Plan, and following extensive shareholder engagement, Rio Tinto committed to improve its disclosure of plans to rein in emissions from iron ore processing.

However, there is no denying the overall results from this proxy season do not reflect the latest climate science and the risks posed to portfolios.

  • There is a high probability the world will overshoot 1.5°C warming before 2030 - a breach that will incur significant and exponential physical and financial costs globally.
  • Warming to date places five major Earth systems at risk of crossing tipping points, including the Greenland and West Antarctic ice sheets and warm-water coral reefs.
  • A tipping point is a threshold where a system abruptly shifts to a new, self-perpetuating and irreversible state. Whilst impacts can be catastrophic, tipping points are not reflected in climate projections and are often excluded from financial models used to assess the costs and risks of climate change.
  • The greater the overshoot of 1.5°C, the higher the likelihood of  triggering multiple tipping points. The collapse of the Atlantic Meridional Overturning Circulation (AMOC) combined with global warming could cause half of the global area for growing wheat and maize to be lost.
  • Rapid and deep cuts to emissions will limit warming and lessen - though not eliminate - the risk of triggering tipping points.

Recent research estimates that macroeconomic damages from climate change could be six times larger than previously thought. The research implied a social cost of carbon of $1,056 per ton of carbon dioxide - far higher than any carbon price in the voluntary or compliance markets today. Critically though, this research does not factor in the impacts or costs of reaching tipping points.

Fossil fuel companies that are actively developing new oil, gas and coal projects and delaying the global transition by lobbying to lock-in demand for their products, are materially increasing the medium to long-term risk profile for all investors.

Walkbacks on climate commitments, like we’ve recently seen from Glencore and Shell, only make financial sense if you assume overshooting 1.5°C warming has no consequence for the financial system upon which we rely.

When looking under the hood of companies still growing their fossil fuel portfolio, there’s lots that doesn’t add up. For example, we’ve run the numbers for Woodside’s unsanctioned oil and growth portfolio and found that Browse generates $3/tCO2e (including scope 3). If  carbon costs society over $1,056 CO2e, anyone with an investment horizon beyond five years should understand that this is a terrible risk / reward.

Science-based stewardship

Dr Dimitri Lafleur, ACCR Chief Scientist

What happened to 1.5°C?

Twelve months of record temperatures have brought us two years closer to breaching 1.5°C warming above pre-industrial levels. Measured as a long-term average, overshoot could now arrive as early as 2027. A growing body of research shows that the costs of limiting the overshoot as much as possible are much lower than the costs associated with higher temperature outcomes (see here, here and here). These insights should spark reviews of the current financial assessments of tail risks.

A call for investors to do their due diligence on scenario use by companies

In April, ACCR published Climate Science Insight: Woodside’s (mis)use of scenarios in its climate plan, outlining our concerns with the way Woodside uses scenarios in its latest Climate Action Transition Plan. In our view, problematic use of scenarios is industry-wide, with a range of fossil fuel companies using scenarios not to stress-test their strategies in a range of possible futures, but to overstate the resilience of their business models in lower warming pathways.

Scenarios have been designed to explore the effectiveness of possible mitigation strategies and the key uncertainties in possible futures. Four key things for investors to consider when looking at how a company uses scenarios include:

  • Understanding of assumptions is vital for meaningful use. Scenarios that lead to the same temperature outcome are built on a wide range of varying assumptions and interdependencies. For example, in scenarios that accommodate oil or gas growth, there are invariably unrealistic assumptions relating to declines in other fossil fuels or uptake in CO2 removal technologies.

  • Changes in climate policy around the world make certain scenarios more likely than others. Countries are generally ratcheting up their emission reduction policies in the spirit of the Paris Agreement. For example, while in 2015 the legislated policy scenario was considered to lead to 3.6°C warming, by 2023 that had dropped to 2.7-3°C. Current pledges and net-zero targets bring that further down.

  • Scenarios need to be up to date if they are meant to show possibilities from today onwards. The remaining 1.5°C carbon budget used in IPCC AR6 scenarios (published in 2022, with data from 2020) is more than twice what is now available.This means that assumptions can go bad quickly, exacerbated by geopolitical shifts. For example, the energy crisis in Europe has significantly accelerated the roll-out of renewable energy - changing a key assumption for the region. Notably, scenarios that incorporate recent data (e.g. IEA NZE, Network for Greening the Financial System (NGFS) phase 4, IRENA) all show a significant decline in oil, gas and coal towards 2030, for alignment with limiting global warming with 1.5°C in 2100.

  • Not all scenarios described as “Paris-aligned'' meet the same definition. There is no document that stipulates what a Paris-aligned scenario is. However, the scientific community, through peer reviewed research, has suggested a best practice (see here and here) that says Paris-aligned scenarios are scenarios that:

  1. limit global warming to 1.6°C above pre-industrial average throughout the 21st century (on an annual basis)
  2. limit global warming to 1.5°C above pre-industrial average in 2100, and
  3. reach net zero greenhouse gas emissions in the second half of the 21st century.
  • The reason for the first two requirements relates to the Paris goal of holding temperatures well below 2°C. Only scenarios that limit global warming to 1.5°C in 2100 and limit the peak temperature to 1.6°C have a very high chance - 90% - of staying below 2°C at all times. Scenarios that result in higher peak temperatures, say 1.8°C or 1.9°C,  have a much higher probability of breaching 2°C warming at some point - which would breach the Paris Agreement.
  • The third requirement means that greenhouse gas emissions (i.e. CO2, methane and all other greenhouse gases) need to reach net zero in the second half of the century. Many  scenarios that limit global warming to 1.5°C in 2100 do not reach this, often implying a slower fossil fuel use decline.

Question of the Quarter: Why should investors care about the social cost of carbon (SCC)?

The social cost of carbon (SCC) can often be seen by investors as an abstract concept, contained within the dark realms of academic institutions and having little practical application in the real world. However, it serves an important role in helping policymakers plan and legislate for the transition, and therefore has a significant effect on the way investors choose to allocate their money.

Put simply, the SCC is an estimate of the dollar cost of the damage done by each additional tonne of carbon emissions. The key problem for policymakers and investors alike, is that this cost has risen with each iteration of research into climate damages. As mentioned above, recent research places the figure at $1,056 per ton of CO2 equivalent, which is six times larger than the high end of existing estimates. Earlier this year, President Biden’s E.P.A revised its SCC, increasing it by a multiple of four since the Obama’s administration.

As policymakers around the world increasingly pay attention to the escalating costs of carbon, investors should be on the lookout for an acceleration in green policy implementation, which will have major impacts on heavy-emitting stocks that have failed to accelerate their transition.

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