The investment community may have limited control over net zero targets, but it can enable better outcomes, says London Business School Executive Fellow Tom Gosling.
Climate change is a critical issue that we, as a society, are underestimating and should be doing more on, according to Tom Gosling, an Executive Fellow at the London Business School and the European Corporate Governance Institute, who also advises the UK’s Financial Conduct Authority on ESG matters.
And in that, he includes asset owners.
Building on a long-held interest in the impact of climate change on the financial sector, Gosling has conducted much work in the area, including joint research with the UK Investment Forum.
“In 2021, we did a year-long project and developed a paper called ‘What does stakeholder capitalism mean for investors?’,” he said. “The paper addressed the question of how investors should think about the wider societal issues that surround them and align them with their primary obligations around value creation for clients.”
At the time, the Glasgow Agreement that ensued from COP26 had freshly been signed and the Glasgow Financial Alliance for Net Zero (GFANZ) had also been formed. Soon after, Gosling started to notice incoherences between the climate commitments that financial sector players were making, and the results that they were likely to be able to achieve in the prevailing policy setting.
“Asset managers and owners were, on the face of it, signing up to goals that the public policy direction on climate was very unlikely to support,” he said. “This triggered my curiosity as to what this dilemma meant for the investment industry. We are a long, long way off from being on that trajectory from a policy perspective, so how should investors think about that?”
A key issue, according to Gosling, is the lack of appropriate policy measures to encourage investors to make good on their pledges. He suggested that a good starting would be to recognise the relatively modest impact that they can have on climate outcomes in general.
“The finance industry will not make this happen without the appropriate economic incentives in place,” Gosling told ESG Investor. “The best that it can realistically do is lean into this to the greatest extent possible. But it can’t do stuff that’s going to be economically damaging to their clients’ interests.”
That’s not to say, however, that asset owners shouldn’t play their part, including in trying to influence the government’s position on climate policymaking.
“I reject this idea of ‘we can’t do anything until the government moves’, because governments don’t act in a vacuum,” Gosling added. “They find it much easier to act when citizens are banging on their door demanding change.”
In his view, the investment industry should be honing in on how it can create the circumstances that make it as easy as possible for governments to act. “This is actually where I think the investment industry has generally done too little,” he insisted.
As such, the industry’s chosen focus on portfolio decarbonisation methodologies has done little in the way of achieving climate change targets to date and may not be the best way forward. Asset owners have increased their lobbying activity in recent years, as well as their scrutiny of advocacy alignment of asset managers and investee companies, but these efforts remain in their early stages.
“When the finance industry is threatened with being included [in sustainability-related legislation], they pull all the stops out when it comes to lobbying,” said Gosling. “All of the dark arts of lobbying come into play there. But when it comes to the development of climate policy, there’s a much softer lobbying going on.”
Financial institutions were recently granted a temporary stay of execution on compliance with the EU Corporate Sustainability Due Diligence Directive. Under the exemption, they will initially only need to check for any human rights and environmental harms in their clients’ own operations, rather than across entire supply chains. As such, asset owners’ approach to lobbying in this domain needs a wholesale change in approach.
“They can provide a countervailing force to the momentum that is always slowing down political climate action,” he added. “Asset owners are really naive around policy lobbying and should get much smarter about how they support political change. This requires a different skill set.”
In Gosling’s view, asset owner groupings are not engaging enough in this. He suggested using the UN-Convened Net Zero Asset Owner Alliance (NZAOA) guidelines as guidance for the way they engage with asset managers as a good starting point.
“Everything that the industry does has to be viewed through the lens of: ‘Given that I can’t control of the climate outcome myself, is this action I’m taking making it more or less likely that good climate policy and outcomes will emerge?’,” he said. “And then – what are the costs and risks to my beneficiaries incurred through taking that action?”
Another significant element of Gosling’s work on climate change is his stand on universal ownership, on which he is due to publish a paper.
By his definition, the universal ownership theory proposes that widely diversified investors, who own a broad-based stake in the economy, can have a vested interest in reducing market-wide risks relating to environmental or social issues.
“There’s quite a serious dilemma for fiduciaries when it comes to climate targets, which the universal owner argument aims to resolve,” said Gosling. “It does so by saying that it is in their financial interest to sort these issues out, as their portfolios will go to hell in the long run if they don’t.”
However, a key impediment to this theory – which Gosling deems overly simplistic – is that financially optimising goals from a market perspective over beneficiaries’ time horizon does not align with socially optimised climate goals.
Many of the tools in the sustainable investing toolbox are not up to the job, he argued, which is why universal owners are bound to fail when they try to internalise climate targets within their portfolios.
“So-called universal owners are not actually in the position at all to control climate outcomes, but what they can do is influence the environment to enable better climate outcomes to occur,” he added. “What widely diversified investors need to therefore think about, is whether what they’re doing is going to be successful. And if it isn’t, how do they expose their clients to risks and costs in the process.”
Streamlining climate targets
Gosling’s overall message to asset owners is to focus their attention on actions that have the best chance of real-world impact on climate change. To this extent, he also expressed scepticism towards carbon offsets, arguing that their impact on emissions reduction is unclear, and that they may be enabling excuses for companies to embed them.
“The minute you say to somebody that buying this carbon offset is an exculpation for emitting this tonne of carbon, you create an incentive to deliver that product at the lowest possible price and we get this race to the bottom phenomenon,” he said. “Offsetting more generally just faces almost insurmountable problems in relation to whether it’s additional, permanent, or whether there’s leakage.”
Gosling deems global progress on climate targets to date too limited for carbon offsets to be part of the picture. If they do end up playing a role, it should be post-2050 – “when we’ve done everything else we possible can”.
“We keep banging our head against these totally unresolvable problems with offset markets,” he added. “We need to reframe the whole way that we think about these projects.”
With 2023 having just been confirmed as the hottest year on record and progress on capping global warming to 1.5C by 2050 still being too slow and limited, Gosling stressed the crucial need for future work on climate change to be more pragmatic.
“There’s a lot of people spending a lot of time on this, but unless you’re really clear on what works or not, you’re wasting that effort,” he said. “We are running out of time, so we can’t afford to be spending lots of time on distractions.”
The strong incentive to show action on climate in the investment industry in response to client demand has spurred momentum, but it has also resulted in creating products that look like they’re doing something but aren’t, Gosling explained.
“That’s quite a dangerous distraction, but it’s not to say that the industry can do nothing,” he added. “A more laser-like focus around a more modest ambition to achieve specific outcomes would actually lead to the industry to having much more impact.”