The Paris Agreement, adopted at COP21, aims to limit the global average temperature increase to 1.5°C. To achieve the climate goal set out by the Paris Agreement, institutional investors need to embark on a long-term investment journey, which requires investment in low-carbon and energy-efficient solutions and aligning the financial sector with carbon reduction objectives.
The carbon reduction movement has mainly been notable in international policy and the corporate sector, with little movement in the financial sector. Although it is expected that the financial sector will follow the rest of the market, substantial participation by institutional investors in the decarbonisation of the economy is required to achieve global climate goals.
The Task Force on Climate-Related Financial Disclosure (TCFD) was created in 2017 by the Financial Stability Board as a response to a lack of transparency from institutions regarding climate-risk-related assets. The TCFD’s framework of recommendations focuses on improving and increasing the reporting of climate-related financial information and stresses the importance of climate-related financial disclosure. The Carbon Disclosure Project (CDP), created by prominent investors in 2002 as a global environmental impact disclosure system, is now the largest TCFD-aligned environmental database in the world.
Whilst transparency on climate-related financial information and risks is key for sound financial governance, it is not a sufficient market response to the challenges of financial climate change reform. Scaled investment is needed to achieve the Paris Agreement targets and broader Sustainable Development Goals (SDG).
Transformative actions and initiatives by the financial sector are called for to step-up sustainable carbon-efficient investment beyond clean energy into projects such as reforestation and responsible land use.
Climate Action 100+ is an investor-led initiative (with 700 investors on board in 2022 managing trillions of Euros in investments) established in 2017 following the Paris Agreement adoption. The initiative was launched to ensure that the most significant corporate carbon emitters take action on climate change.
The goal of these initiatives is that transparency and scrutiny on climate-related financial information and risks will drive investors to steer clear of carbon-intensive assets and move towards low-carbon opportunities.
While some investors are hesitant to enter the low-carbon market, citing the need for a clear and stable policy framework as a market entry barrier, most realize the critical role institutional investors play and could play in shaping and developing carbon markets into a fundamental climate-action driver.
The impact that institutional investors can effect on compliance carbon markets and voluntary carbon markets (VCM) is supported by the pure volume of capital under management by such investors.
How can investors benefit the carbon market:
- By trading in carbon allowances, investors can increase the market liquidity of carbon markets. Many investors believe that green bonds are the most promising liquid financial instrument to house low-carbon investments, thus posing an opportunity to be scaled.
- By investing in high-quality carbon-reduction and removal projects that generate carbon credits on VCMs, investors encourage and advance decarbonisation efforts and help expand the supply of such projects.
- Investors exercise a significant amount of influence over their portfolio companies and can steer such companies towards low-carbon solutions. In addition, institutional investors have the resources to guide portfolio companies in reaching net-zero targets. This can entail that companies either compensate for their carbon emissions by acquiring carbon credits or that they reduce their emissions by implementing carbon-avoidance or -removal programmes.
How can the carbon market benefit investors:
- Investing in carbon-reduction and removal projects not only fulfils environmental, social, and government objectives, but also investor mandates.
- Investors can hedge against possible climate transition risks affecting their other asset classes by including carbon allowances in their portfolios. Investors can further guard against possible climate transition risks by focusing on assets with climate-resilient business models, decreasing exposure in transition-exposed sectors and carbon-intensive companies, and increasing exposure in low-carbon or carbon-efficient sectors. Research shows that as little as approximately 1% of carbon-allowance allocation in a portfolio can be adequate to offset potential losses due to climate risks.
- As the demand for high-quality carbon credits is increasing, carbon prices could also potentially rise with the enactment of climate regulations by governments. The Taskforce on Scaling Voluntary Carbon Markets (TSVCM), sponsored by the Institute of International Finance, estimates that the demand for carbon credits could grow 15x or more by 2030 and up to 100x by 2050. Therefore, carbon products are becoming an increasingly attractive investment.
Investors committed to measuring, disclosing, and, most importantly, reducing their carbon portfolio could therefore mitigate their risk exposure whilst securing sustainable returns for their stakeholders.
Investors who move to decarbonise their portfolios thus sets a clear pathway to net-zero carbon emissions in line with the aim of the Paris Agreement, and they convey a prime message that carbon efficiency is now paramount.
In striving towards green finance, institutional investors should accordingly consider how they will incorporate carbon-efficient products and carbon markets into their portfolios and the benefits of such inclusion. Moreover, whether their targets are aligned with the inherent purpose of carbon markets: to reduce emissions.
Want to learn more about investing in DGB’s green bonds or purchasing carbon credits to diversify your portfolio?