The limits of fiduciary duty and corporate engagement could see institutional investors embrace systemic stewardship in 2024 to meet 1.5°C-aligned objectives.
COP28 reminded investors of the difficulties involved in reaching inter-governmental consensus on intensifying climate action. Now they must wait to see how signatories to the Paris Agreement act on the commitments outlined in the official response to the Global Stocktake, as well as multiple other pledges announced across the two weeks before that final text was signed, sealed and gavelled.
Opinions vary on whether Dubai delivered the urgent ‘course correction’ that climate action so evidently needs, not least among investors seeking the signals and certainty they have consistently called for. Most express cautious optimism.
“Governments’ commitment to transition away from fossil fuels is a positive signal,” says Eliette Riera, Head of UK Policy at the UN Principles for Responsible Investment (PRI). “However, we still need much more specificity in what this transition will entail and how sectoral decarbonisation can be put into practice.”
For now, investors are living in a world where politicians are not keeping their end of the collective bargain to limit warming to 1.5°C, and investee companies are not yet facing full scrutiny of their net zero transition strategies, posing challenges for institutional investors committed to decarbonising their portfolios in line with the Paris Agreement.
These were highlighted at last October’s PRI in Person event by Jan Rasmussen, Head of ESG and Sustainability at PensionDanmark. Rasmussen expects the scheme to meet its target – self-imposed, but in line with the protocol set by the Net Zero Asset Owner Alliance (NZAOA) – to reduce greenhouse gas (GHG) emissions from its listed equities and corporate bonds by 45% by the end of 2024, from a 2018 base.
But he was less clear on whether PensionDanmark, which has €40 billion AUM, could achieve its stated target of achieving a further 30% cut in portfolio emissions by 2030.
“If policy action has not improved, it’s very much in the balance if we can keep on working with that target,” he said, adding that the scheme’s ability to invest in climate solutions, including renewables, was being limited by economic and political factors, including permitting delays.
Against an uncertain policy backdrop, 2023 also witnessed growing tensions between asset owners and managers, notably in the UK, with the latter not seen as providing sufficient support for their clients’ net zero-aligned strategies, particularly during the proxy voting season.
All this suggests 2024 will prove a difficult and perhaps pivotal year for asset owners looking to make headway on their net zero commitments. It could also accelerate the nascent shift toward a broader definition of stewardship, as well as a possible rethink around the obligations of fiduciary duty.
Accepting the overshoot
When digging into different portfolio decarbonisation approaches within and between asset owners and managers, it’s worth considering net zero in the context of the goals of the Paris Agreement and the remaining carbon budget. In short, the best available science suggests halving of GHG emissions by 2030, on the path to net zero emissions by 2050, will give us a fighting chance of limiting warming to 1.5°C. Although this is widely understood, the wording of net zero targets varies considerably, says Will Martindale, Managing Director of specialist consultancy Canbury Insights.
“Some managers might not cover Scope 3 emissions,” he notes. “Others might set a target for some or all portfolio companies to be net zero aligned by 2030. This means the companies are on a pathway to net zero, according to a third-party assessment, but that’s not necessarily the same as targeting net zero by 2050 and may not be consistent with the remaining carbon budget. It may, for example, include predictions on new forms of technology or substantial use of carbon offsets.”
It’s not just the asset managers that are less than fully aligned with net zero, of course. While NZAOA members are seeking to decarbonise their portfolios at a rate consistent with 1.5°C of warming, the Inevitable Policy Response calculates that current government policies, ie those in place pre-COP28, will only limit climate change to 1.8°C at best.
Dr Tom Gosling, Executive Fellow at London Business School, has argued that some asset managers are effectively pulling their punches on net zero, holding off on implementing their collective and individual commitments, awaiting stronger policy direction from politicians. At least part of the rationale is the risk of breaching fiduciary duty by potentially landing clients with stranded assets and higher costs due to the persistence of policies that overshoot 1.5°C.
“If an investor clings onto the notion that the world is going to hit 1.5°C or that they’re going to try to drag the world on that trajectory, and if they invest in line with that, there’s a very high risk they end up not serving their clients’ interests in a scenario where the world hits 2°C,” said Gosling in a recent podcast interview, which explored ideas contained in a paper co-authored with Iain MacNeil, Professor of Law at Glasgow University.
Does the investor follow the science of what’s needed to limit warming to 1.5°C, or the less clear-cut calculations of what’s politically possible, effectively accepting the probability of the overshoot? Should they risk possible higher costs from leaning hard into the net zero transition, or the near certainty of much higher portfolio losses as higher temperatures wreak havoc across economies?
“Net zero targets are still valid because the effects of global warming are exponential,” argues Martindale. “The disruption that weather events will cause to economies and markets at 1.8-1.9°C are a degree of magnitude greater than at 1.5°C. It’s well within a fiduciary’s decision making to recognise that the resulting market dislocation is going to lead to a much more challenging long-term investment environment.”
The relationship between fiduciary duty and ESG risks has long been blurred by the perception of the latter as non-financial, at least in the short term. Paul Lee, Head of Stewardship and Sustainable Investment Strategy at investment consultancy Redington, says concerns that fiduciary duty may constrain investor action on climate change or indeed ESG risks more broadly are overstated.
“People should not feel that it is a barrier to them doing the right thing for the long-term interests of their beneficiaries or for the long-term value of their funds. These issues are material factors to long-term business performance, and therefore to long-term investment performance.”
While it remains complex to calculate exactly when and how climate issues will “land”, Lee suggests their consideration is integral to fiduciary duty because they will “go to value” over the time horizons that matter to pension schemes and beneficiaries.
Lee sits on the Financial Markets Law Committee (FMLC) working group which is due to release a paper on the relationship between fiduciary duty and “non-financial factors” imminently. The paper was effectively commissioned by the government in the Green Finance Strategy issued in March 2023, meaning its guidance is widely anticipated and expected to be highly influential.
But there are differences between the legal status and requirements of fiduciary duties across jurisdictions, as highlighted by the PRI which has examined the situation in 11 major markets, in conjunction with law firm Freshfields. In the UK and other common law jurisdictions, fiduciary – and indeed directors’ – duties are not prescriptive or fully defined, but tested in retrospect in the courts. Important differences can arise, notably between the US, where client interests are strictly viewed in financial terms, and the UK, where a broader interpretation is common.
“If we are talking about UK asset owners and their managers, which may be based in London but are US-owned firms, that language actually turns out to be a barrier and a gap in understanding rather than an aid,” says Lee.
This issue was among those flagged by Andreas Hoepner, Professor of Operational Risk, Banking and Finance at University College Dublin, in a report commissioned by a group of disenchanted UK asset owners, as one of the likely contributing causes of a growing disconnect between them and their asset managers over climate-related voting at the AGMs of oil and gas firms in 2023.
Differing national interpretations notwithstanding, how does fiduciary duty direct the investor to respond to climate risks when politicians are not yet doing so? This judgement is particularly tricky for asset owners with such diversified holdings to be universal owners, because they can’t avoid systemic risks. Looking at capital allocation through a net zero lens is challenging when investing across the entire economy, partly because of the need to take account of the impact of high-emitting assets, whether or not they’re in your portfolio.
“For assets that are not decarbonising and can’t attract the capital required to do so, the business could be unwound in the private sector and money returned to shareholders,” says Martindale. “But often governments are best placed to oversee that process in a just and fair way which supports the retraining of staff and the rebuilding of communities. That means the capital markets might decarbonise more quickly – because high-polluting companies come under state control – than the broader economy, arguably helping to justify net zero target-setting by investors.”
According to Martindale, these challenges on the path to whole-economy decarbonisation underline the value of 1.5°C-aligned target setting as a frame of reference for the investor, especially the universal owner, through which she can track and evaluate the climate ‘performance’ of her portfolio over time, potentially informing stewardship priorities or investment decisions, taking account of the prevailing direction of policy.
If 1.5°C targets are a legitimate frame of reference for asset owners, should they broaden and toughen their approach to achieving them via escalation of engagement activity? Taking a tough stance in the AGM season may not be effective without broad-based support or a deeper toolbox, as UK asset owners found out last year.
Academic evidence suggests there are limits to both the power of engagement and the threat of divestment, which is most effective when it serves to shift the perspective of directors to shared medium- and long-term interests. Beyond this, the portfolio-level fiduciary duties of the universal investor have the potential to clash with the director’s or owner’s duties to a particular company. But without regulatory support, the investor will struggle to force the company to take financially damaging actions, such as closing down profitable but polluting facilities, in order to benefit firms across her portfolio. But that’s far from the end of the story.
“Where a portfolio company has negative financial effects on other portfolio companies through its polluting activity, an investor might consider actions that are in the broader interests of the portfolio, but not of the company. In that instance, real economy policy intervention is necessary, because if it’s profitable in the long term for a company to act in a way that is disruptive to the value to other companies, that suggests a market failure,” says Martindale.
“This is why I don’t see a fiduciary conflict. The evidence is very clear that these (climate) issues are affecting financial value; leading the investment fiduciary to flag them to the company, enabling it to reconsider how it creates long-term value, leading also to a deeper consideration of sustainability issues. In cases of conflict, the investor can engage policymakers to correct the market failure.”
To help address market failures, a reappraisal of investors’ priorities may be in order. Stewardship is under-valued in asset manager fee structures compared to capital allocation, according to Martindale, with macro or systemic stewardship the least resourced.
“A recalibration is needed around the limitations of responsible investment. It has an extremely important role to play: the ultimate owners of companies ought to be providing clear direction on these topics. But it needs to be supported by real-economy policymaking, which we haven’t seen yet at scale,” he adds.
Redington’s Lee also sees a need for a shift toward systemic stewardship and policy-level engagement by investors. Simply decarbonising portfolios to meet climate targets has the potential to divorce a fund from the realities of the world in which it operates, he acknowledges, especially if that world is on track to use fossil fuels for several decades to come.
“As a universal owner, you can’t avoid being exposed to what the world Is doing. If you’ve got a problem with that, you need to try and change what the world is doing, rather than hide from it or pretend it’s not happening,” says Lee.
“You need to stay engaged in the policy discussion. Investors haven’t done a great job in that space historically, across the whole area of regulation. The intensity of the climate challenge means that’s an area where we particularly need to step up.”
While still relatively nascent, investors have been increasingly heading in this direction in recent years. They have increasingly launched engagement initiatives with policy-focused objectives, including the Investor Policy Dialogue on Deforestation, which engages with governments rather than corporates
Ahead of COP28, the PRI called for governments to pursue foundational financial policy reforms enabling financial flows to align with a pathway towards 1.5°C and to develop a “whole-of-government approach” to the transition of the real economy to net zero.
The practice of systemic stewardship by asset owners and managers may also receive a boost from regulators. In a discussion paper issued last February, the UK’s Financial Conduct Authority asked investors what additional measures would encourage firms to identify and respond to market‐wide and systemic risks, also seeking feedback on how to reduce barriers to system-focused stewardship.
Anticipate the transition
It’s possible that the combination of mounting evidence of destructive climate impacts, strengthening political will and intensifying stakeholder pressure, including from investors, will close the gap between prevailing policy trajectories and the objectives of the Paris Agreement.
Remco Fischer, Head of Climate Change at the UN Environment Programme Finance Initiative, sees less risk for investors taking bets on a 1.5°C outcome. “Looking at this COP from an asset owner’s perspective, the need to anticipate an economy in transition to aligning with 1.5°C has not lessened; if anything, it has increased,” he says.
While emphasising the limits of investor influence on investee firms to bend emissions toward a 1.5°C future, Gosling acknowledges there is scope for climate-positive action by asset owners and managers. As well as their own lobbying efforts to influence policymakers, this includes efforts to encourage lobbying alignment by investee firms, specifically asking firms to ensure consistency of advocacy positions with public commitments, whether relating to climate change or other issues. “That’s just a basic fair dealing and honesty requirement that could potentially have traction,” he says.
To pursue net zero goals more effectively, Lee also backs the ongoing shift toward investors focusing on forward-looking, transition-focused metrics that seek to assess alignment of firms’ known policies and planned investment strategies with a net zero future.
“It’s much more coherent to use these alignment-type metrics to frame your approach; we’re all investing into the future, so let’s use a metric that’s talking about the future, rather than thinking that we’re investing into the past, which is what using a hard emissions metric is doing,” he says.
But are investors really at risk of stranded assets by leaning too far into a net zero future? Lee suggests not.
“In practice, you would struggle to over-invest into the renewables space. We’re lacking opportunities, rather than a danger of over-investing,” he says, asserting that governments should work harder at establishing an enabling environment for transition.
“If not, it’s going to come at a clatter, because when the crisis really strikes and the politicians haven’t moved, they will have no option but to move quickly. And at that point, it will be very clear who’s invested in genuinely stranded assets and who’s invested in the future economy assets.”