Investor short-termism needs to be fixed to ‘keep 1.5°C alive’
Sustainable Investment Manager János Hidi argues that if the finance sector is to successfully respond to the needs of the climate transition and decarbonisation policies laid out by COP26, investors must start broadening their horizons and shift away from short-term views of the economy.
At COP26, finance was a major focus. To meet the commitments made in the Paris Agreement and keep 1.5°C alive, an enormous amount of capital will need to be mobilised in a relatively short period of time.
As re-emphasised at COP26 Finance Day, the focus to improve the involvement of financial institutions in the financing of the transition is on
- making available good quality, standardised, and verified climate data,
- the climate-related financial risk management,
- portfolio alignment to net zero,
- the roll-out of widespread mandatory sustainability disclosures and global reporting standards.
All these steps and efforts are needed and very welcome to help reallocate financial capital towards a net zero world. However, the finance sector faces a significant barrier to successfully responding to the needs of the climate transition: short-termism.
The tragedy of the horizon
Concerns around the lack of short-term actions during COP26 may be founded in what Mark Carney already observed in his speech in 2015 ‘Breaking the tragedy of the horizon – climate change and financial stability’.
A concept similar to the ‘Tragedy of the commons‘ Carney argued financial institutions were not showing a strong response to the transition challenge, because ‘the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors.’
There are two key aspects of short-termism which are barriers to successful climate action in the finance sector:
- The expected return of an asset is primarily driven by the near-term outlook on pay-outs, and much less by the returns expected over the longer term, which is when climate risks are expected to have material impacts.
- This short-termism is strongly driven by the discounting of future returns, so that they carry little weight in investment decisions. While this approach seems to make sense for any individual project, it holds back the flow of finance across projects collectively to build the assets needed for decarbonisation.
We need to start expanding the investment horizon now
Clearly in order to see the full potential of the finance sectors role in successful climate action, investors should adopt a longer-term view in their strategic asset allocation decisions. As my colleague Dóra Fazekas argues in her article on global warming and pension savings, if long-term investment policies do not factor in the impacts and risks posed by climate change, then we put for example our pension savings at a larger risk.
Here is an example to illustrate my point
If, as an investor, you were to choose between two expected cash flows, as in Chart 1, which one would you prefer?
The black bars in the charts below represent a lucrative asset with an end-of-life already within the horizon (e.g., a coal power plant in a country with announced coal phase-out date), whereas the green bars represent cash flows from a regulated product with a stable expected revenue stream (e.g., electricity generation from solar panels at a regulated price).
As a long-term investor who is more worried about the future of one’s own pension plan rather than shorter term financial returns, I would be inclined to choose the green option, especially if the future of the green asset can be extended beyond the 20 years shown in Chart 1.
However, if a 10% annual discount rate is applied to all future pay-outs, the picture will look radically different as seen in Chart 2.
In this case all cash flows occurring beyond a 10-year horizon contribute little to the present value of the asset. An asset manager in charge of my pension plan will invest to maximise his or her own near-term profit and may not consider my own requirement to ensure the long-term viability of my pension plan.
The net present value calculation also ignores the prospect of trade policies that could penalise carbon-intensive economies and an associated re-pricing of the fossil assets as sentiment shifts in favour of much stronger policies to mitigate emissions. The financial, economic, and environmental burden of investment now to build polluting assets may, however, only be realised for the next generation.
There is clearly a tension between the need to keep the fossil-based economy running whilst trying to transition to a decarbonised economy
60 of the largest banks provided $3.8 trillion of financing for fossil fuel investments during 2016-2020, the period after the Paris Agreement was signed. Banks probably see returns form these investments financially lucrative, despite physical and transition risks anticipated over the long-term.
However, the IEA analysis has found that starting in 2021 no new investments in oil, gas and coal are compatible with a net zero economy by 2050.
More will be needed to be done to solve the conflict between the need for some fossil investments to maintain a functioning economy and the goal to reach net zero before it is too late.
One way to keep 1.5°C alive is to break investor short-termism and put more emphasis on the long-term returns of financial investments.
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