Has the death of net zero been overstated?
Paul LeeHead of Stewardship& Sustainable Investment Strategy
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Sustainable investing, it’s the word on every investor’s lips. So, to ensure you’re well-versed with the latest happenings in this space, we’ll be speaking to a member of our Sustainable Investment team each quarter and sharing their responses via Investment Edge.
This quarter, we spoke to Paul Lee, our Head of Stewardship & Sustainable Investment Strategy, about whether index funds have a role to play in net zero following the news of several financial institutions abandoning their commitments.
I hear that financial institutions are abandoning net-zero commitments. What’s going on?
There were a series of financial industry initiatives announced around the time of the COP26 meeting about climate change in October 2021, which was hosted in Glasgow. These were collectively known as GFANZ – the Glasgow Financial Alliance for Net Zero – and there were net-zero groups formed for many of the different arms of the investment chain, including a Net Zero Asset Managers initiative, a Net Zero Asset Owner Alliance and even a Net Zero Investment Consultants Initiative (of which Redington is a member). The ‘net zero’ bit of the name means that the members of each group have committed to work towards helping to deliver on the Paris Agreement goal of net-zero CO2 emissions by 2050 – which the scientists tell us is necessary to avoid the worst effects of climate change.
Much of the positivity around addressing the climate change challenge seen in Glasgow had weakened by the time of this year’s COP27 in Egypt’s Sharm El Sheikh, which saw the world’s politicians make very little progress in negotiations. In a similar way, some of those institutions which signed up to the net-zero alliances have had second thoughts. Australia’s Cbus and Austria’s Bundespensionskasse left the asset owner group; Meketa and Wilshire of the US both left the investment consultants’ initiative; three of the largest US banks wobbled about their membership of the banking alliance, but after some toning down of the commitment have stayed in; and, most recently, index investing giant Vanguard has withdrawn from the group for investment managers.
Why the change of heart?
Vanguard, among others, cited ‘confusion’ about its position as the main reason for its departure: “we have decided to withdraw from NZAM so that we can provide the clarity our investors desire about the role of index funds and about how we think about material risks, including climate-related risks—and to make clear that Vanguard speaks independently on matters of importance to our investors.”
There’s more to it than that. Given the decisions by Cbus and Bundespensionskasse, it’s clearly not just a US issue, but it isn’t by chance that most of the organisations that have withdrawn from GFANZ, or are considering withdrawal, are from that country. Climate change, and particularly net-zero commitments, have become highly politicised in the US, particularly in states where fossil fuels have represented significant portions of the economy, including Texas and West Virginia. Some states have threatened to withdraw money from managers because of their net-zero commitments, arguing that these commitments are contrary to fiduciary duty – which is surprising given the financial risks inherent in climate change – and have generated significant political pressure.
So, can an index fund target net zero?
No investor will successfully achieve net zero without very significant shifts across the economy as a whole. Every company in our CO2-intensive world needs to decarbonise its business, and even active investors cannot avoid investing in carbon-polluting companies at the moment. The position for index investors isn’t very different, though if some businesses do change and others fail to, index investors may be left holding more of those remaining carbon-intensive businesses than others. All of us are dependent on each other to move, and we are also all dependent on policy-makers making the necessary steps to help ensure that the economic incentives encourage decarbonisation.
Index investors depend on that political will and on the wider shift of the economy, just as other investors do. But because they will be left holding every company, even the laggards in the climate transition, they are more dependent on the other lever that investors have: stewardship, meaning behaving as an active owner of companies, encouraging change where that is necessary. Index investors need to be active stewards, both in terms of actively engaging with companies and voting appropriately (and, indeed, using the other levers of power that investors have). Not all index managers achieve this – indeed, Redington’s work assessing the stewardship of investment managers generally shows weaknesses and a need for improvement across the market as a whole.
If we as a world are to deliver net zero, as the science tells us we must, we need investors to be good stewards. We need investment managers to follow companies closely, to understand their individual plans to deliver a decarbonised business and to consider on a regular basis whether they are delivering against those plans (recognising that decarbonisation will not be a straight-line affair). Stewardship is not just about understanding what companies are doing, it’s about encouraging change where necessary. It‘s about setting out a plan for change and working persistently and consistently to deliver it; in the context of climate change, it’s pressing companies to have aggressive plans and to deliver effectively against them.
Effective stewardship will often require collective action, or at least a collective message from the market. That was why the GFANZ groupings offered such a positive foundation. It’s a shame that some of their former participants no longer wish to be part of that collective voice.