A framework for climate impact investing
Preliminary DRAFT version (CC BY)
Defining “climate impact“
Considering the magnitude and urgency of the climate crisis, it is apparent that humanity’s most important imperative for the 21st century is to stabilize the mean global temperature increase by 2100 at well below 2 degrees C relative to pre-industrial levels. To this end, the global annual volume of greenhouse (GHG) gas emissions will need to be reduced to net-zero well before 2050, followed by net-negative emissions thereafter. Therefore, at least for the next few decades, the term “climate impact” shall refer to the net volume by which annual global GHG emissions can be permanently reduced. In this context, climate impact can generally be characterized as systemic, collective, and social in nature.
· Climate impact is systemic because achieving sufficient GHG emission reductions at national, regional and global levels requires system-wide behavioral changes based on deep structural transformations of entire industries. The realization of such transformations, in turn, is based on interventions that successfully manage to address systemic leverage points at different levels:
1. policies, practices and resource flows (e.g. rules, regulations, standards, bans, taxes, subsidies, incentive structures, public spending, institutions, technology and entrepreneurship,…),
2. relationships/connections and power dynamics (e.g. new partnerships and alliances; relations between stakeholders and influencers, dynamics between forces promoting and resisting change,…)
3. mental models (i.e. mindsets, social norms, paradigms, fundamental assumptions, culture, values, …)
· The collective nature of climate impact can be described from two perspectives: First, while changes in the annual volume of greenhouse gas emissions are relatively easy to measure, it can be rather difficult to causally attribute them to specific individuals or organizations. Climate impact is often the result of a collective impact effort involving the combined activities of a multitude of different agents (influencers, decision makers, citizens, shareholders, consumers, policy makers, entrepreneurs, scientists, activists etc.), some of which can directly result in reduced GHG emissions while others can be more indirect, enabling or supporting in nature. Second, in order to achieve sufficient GHG emission reductions at a global level, it is necessary that a sufficient number (i.e. a “critical mass”) of relevant countries and companies contribute their “fair share” of GHG emission reductions, which collectively add up to climate impact at a global level, even though the individual contributions may appear to be relatively small.
· To the extent that we fail to sufficiently slow down anthropogenic global heating within this century, billions of human beings are at risk of being severely impacted by increasingly frequent and extreme weather events, humanitarian catastrophes, resource scarcities, economic crises, geopolitical conflicts and social instability. Given the current GHG emissions trajectory, 21st century born generations and their descendants must be considered a highly disadvantaged and vulnerable group that has basically been condemned to suffer in the future. Positive climate impact therefore not only represents an environmental outcome that is critical to our planet’s biodiversity and the continuity of modern civilization, but also implies a profoundly social outcome since the average future living conditions of today’s children could be drastically improved relative to the current projected baseline.
“Direct” vs. “Indirect” climate impact
Climate impact can be direct or indirect in nature. In contrast to direct contributions to climate impact, establishing the importance and magnitude of indirect contributions represents a considerable methodological challenge. Nevertheless, indirect contributions often play a critical role as enabling or supporting factors, which can either increase the speed, scale and probability of success of an intervention, or without which a given climate impact might not have been possible. Examples for direct contributions can be found in a framework provided by Project Drawdown, based on which net GHG emission reductions can primarily be achieved by reducing sources of greenhouse gas emissions, supporting carbon sinks, and fostering “equality for all” (especially for girls and women in developing and emerging economies in terms of health and education). The provision of financial capital provides perhaps the most salient example for an indirect contribution. In this context, the Impact Management Project distinguishes between the impact that the operation of an asset (e.g. a company or infrastructure project) achieves on the one hand, and “investor impact” — the indirect contribution that an investor makes to enable/support asset impact — on the other. Moreover, industries and solutions that indirectly contribute to climate impact include flexible power grids, energy storage, electric charging infrastructure, or GHG emissions tracking solutions, for example. These climate impact assets may not have an easily quantifiable impact on GHG emission reductions, but without them, the transition towards a low-carbon economy would be severely constrained. Finally, systems changing activities that deserve appreciation for their enabling or supporting role include climate awareness building, activism, advocacy, lobbying activities as well as systemic climate philanthropy. Collectively, they contribute to the realization of effective climate policies, practices and resource flows, with the game-changing potential to substantially shift the entire baseline of current “market rates” in terms of financial risk and return. The enforcement of an ambitious GHG emissions pricing policy, for example, would not only accelerate the long overdue depreciation of fossil energy-based assets but also dramatically expand the universe of investable assets by turning hitherto neglected climate impact companies or projects into highly attractive investment opportunities.
“Symbolic” vs. “Broad” vs. “Deep” climate impact
The contribution of a particular asset to a reduction of annual GHG emissions can be characterized by varying degrees of climate materiality and additionality. “Climate materiality” is defined as a measure for the level of positive real-world impact (i.e. net GHG emission reductions) that can be observed in connection with an activity or intervention, taking into account its relative size and relevance. “Additionality” provides a measure for the level of impact that would not have occurred in the absence of a specific activity or intervention. Assessing additionality can be challenging considering that the counterfactual or baseline often cannot be established empirically. Based on different specifications of climate materiality and additionality, we can differentiate between three types of climate impact: “symbolic”, “broad”, and “deep”[1].
· Symbolic climate impact (low climate materiality, low/high additionality). This type of climate impact characterizes most portfolio restructurings and financial market transactions involving the ownership transfer of already operating climate impact assets (e.g. re-financings, investments into ETFs or traded stocks and bonds without significant shareholder engagement, as well as divestments of GHG emissions intensive assets that don’t result in a negative impact on their operations). Due to their negligible impact on the actual volume of GHG emissions, these activities are more or less climate neutral. However, in contrast to a conventional financial market transaction, climate impact-oriented transactions and portfolio restructurings create at least an indirect, symbolic impact by publicly signaling that climate impact matters, by increasing the liquidity of climate impact assets, and by exposing the carbon (i.e. regulatory) and transition (i.e. market/technology) risks that GHG emissions intensive industries are subject to. The additionality can be low to high, depending on whether the transaction was made under concessionary terms (e.g. in order to amplify the symbolic impact or due to an underestimation of the climate materiality).
· Broad climate impact (high climate materiality, low additionality). A typical example for broad climate impact includes the provision of new financing under market terms for the realization or expansion of an economically attractive climate impact asset. Even though the additionality of such an investment is rather low, such activities deserve appreciation for making a material contribution to the transition towards a low carbon economy. Another example for broad climate impact includes pro-active shareholder engagement that succeeds in improving an investee’s behavior or carbon footprint in accordance with the current conception of fiduciary duty. Although fiduciary duty has traditionally focused on protecting shareholders’ interests, recent re-interpretations have been arguing for a better integration of ESG issues. But even with ESG factors taken into account, institutional investors, for example, are allowed to drive the transition of portfolio companies or projects towards becoming low carbon operations only for as long as there are no significant near-term economic (opportunity) costs or risks involved.
· Deep climate impact (high climate materiality, high additionality) refers to climate-material investment (and divestment) activities that are unlikely to happen, were it not for a determined and deliberate decision made by purpose-driven investors. The additionality of a particular investment’s impact is reversely correlated with the probability that the same investment would have taken place under “normal” market terms, at a given point in time: the less likely an investment from “mainstream” investors, the higher the degree of additionality. This includes, for example, the provision of new financing under sub-market terms for a climate impact asset with a relatively less attractive financial risk-return profile (e.g. because it is located in a developing/emerging economy or involves an unusual high level of technology or market risk in the absence of an effective GHG emissions pricing). The unusual high-risk-high-reward investment strategy applied by Chris Hohn’s Hedge Fund may represent another (rather exceptional) example for “deep” climate impact. Apart from such exceptions, due to the constraints imposed by the current conception of fiduciary duty, it is largely up to private wealth owners to deliberately allocate a share of their portfolio towards deep climate impact, thereby essentially trading off some financial return in exchange for additional emission reductions.
Climate impact asset allocation strategies
Based on a UN-report titled “Climate strategies and metrics — exploring options for institutional investors” and a UBS whitepaper titled “Becoming climate aware — Mobilizing capital to help meet climate change goals: an investor’s perspective” we can distinguish between three typical climate impact asset allocation strategies:
1) Climate Impact Divestment: This strategy refers to the mitigation of carbon and transition risk by reducing the exposure to potentially stranded assets and shareholdings in GHG emissions intensive companies and projects. Usually, the divestment signals to financial markets that climate impact matters. Ideally, it also results in a significant negative impact on the divested asset’s real-world operations, e.g. by driving up their cost of capital. Most importantly, the divestment frees up capital for increased allocations towards climate impact alignment and climate impact contribution. The DivestInvest initiative, which accounts for combined assets of 12.1 trn USD, and whose members have pledged to divest from fossil fuels and invest in climate solutions instead, provides an example for a combination of climate impact divestment and contribution strategies. Some impact investors might even decide to divest at a calculated risk-adjusted loss, in order to reallocate the proceeds towards climate impact, which can be interpreted as the equivalent to a deep climate impact investment.
2) Climate Impact Alignment: This asset allocation strategy refers to increasing exposure in companies and projects that are compatible with a stabilization of mean global warming at <2 degrees C by 2100. Such “<2 degrees C future compatibility” requires on the one hand a robust and believable public commitment to reduce current GHG emissions to net-zero in accordance with science-based targets as quickly as possible. On the other hand, of course, it requires adequate performance over time against the original commitment, which climate impact investors are keen to monitor and manage. In this context, the Net Zero Asset Owner Alliance represents a coalition of likeminded investors, which accounts for combined assets of 4.3 trn USD and whose members are committed to transitioning their investment portfolios towards net-zero GHG emissions by 2050. While most of the impact achieved through portfolio restructurings can be expected to be symbolic, successful shareholder activism driving the transition of assets towards “<2 degrees C future” compatibility can create broad and deep climate impact.
3) Climate Impact Contribution: This asset allocation strategy refers to increasing exposure in climate impact assets that are directly or indirectly driving, supporting and enabling net GHG emission reductions, resulting in broad as well as deep climate impact. A key objective is not only to reduce the asset’s “carbon footprint” but also to increase its climate-positive “carbon handprint”. A compelling economic rationale for this approach is the realization of “carbon opportunity” (as opposed to the mitigation of “carbon risk”), for climate impact assets are poised to disproportionately benefit from effective climate policies as well as new market opportunities that the transition into a low-carbon economy provides.
A framework for climate impact investing
Similar to general impact investing, the practice of climate impact measurement and management, in the spirit of continuous improvement and organizational learning, represents a defining characteristic of climate impact investing. This includes the measurement (or at least the approximation) of the investor’s as well as the asset’s (direct and/or indirect) climate impact. The climate impact investing framework shown in table 1 illustrates how different classes of investor impact can be defined by combining climate impact asset allocation strategies with different types of climate impact. The framework is intended to provide an increased level of clarity to practitioners in the impact investing field. For example, investment funds claiming “climate impact” as a benefit for investors can now more easily clarify which type of climate impact (and asset allocation strategy) they are referring to. The framework can also be used to analyze a given asset portfolio, define a desired target portfolio structure, and guide the portfolio restructuring process. In the end, each investor will need to find a balance between different asset allocation strategies and different types of climate impact in accordance with his or her preferences and/or the constraints imposed by current conceptualizations of fiduciary duty. From an impact performance perspective, more mature portfolios, which have been fully divested and tilted towards “Deep Contribution” rather than “Broad Alignment” can be considered most ambitious and impactful.
Table 1: Climate Impact Investing Framework based on Asset Allocation Strategies and Types of Climate Impact
[1] Similar distinctions between “broad impact” and “deep impact” have been provided in the general impact investing field by pioneers such as Jed Emerson, and Charly Kleissner, for example.
