Testing boundaries

August 9, 2021

12:30 am

Two highly important reports were released during the summer. The Intergovernmental Panel on Climate Change (IPCC)’s AR6 report highlighting that “Climate change is already affecting every inhabited region across the globe with human influence contributing to many observed changes in weather and climate extremes” got the enormous attention it deserved, against a background of deadly forest fires around the Mediterranean and American West, floods hitting China and central Europe, while Canada experienced its highest temperature on record, reaching 49.9 degrees Celsius On June 30th (link). AR6 says more of these kinds of extreme weather events are expected “Many changes in the climate system become larger in direct relation to increasing global warming. They include increases in the frequency and intensity of hot extremes, marine heatwaves, and heavy precipitation, agricultural and ecological droughts in some regions, and proportion of intense tropical cyclones, as well as reductions in Arctic sea ice, snow cover and permafrost.” It’s horrifying and hugely depressing reading.


The second report, with much less fanfare and attention, but very much worth reading was from Freshfields – ‘’A Legal Framework for Impact’’ (link). It was sponsored by the UNEP, PRI and Generation Foundation and is an attempt to move investing into an era of investor impact, much as the Freshfield’s report in 2005 did for ESG integration. It clearly links to the IPCC AR6 report as the foreword from the UNEP’s Inger Anderson says “The science cannot be disputed. Business-as-usual is having a devastating impact by propelling climate change, destroying nature, and raising pollution levels.”


What can portfolio managers take from the Freshfields report to help contribute to climate change mitigation and prevent some of the devastating scenarios offered by the IPCC? The report lays out a framework for how to think about investor impact, particularly how to consider limitations in pursuing impact given our fiduciary duty to our underlying clients. The report describes two types of investing for sustainable impact (IFSI):


Instrumental IFSI is where achieving the relevant sustainability impact goal is ‘instrumental’ in realising the investor’s financial return goals.


Ultimate ends IFSI is where achieving the relevant sustainability impact goal, and the associated overarching sustainability outcome, is a distinct goal, pursued alongside the investor’s financial return goals, but not wholly as a means to achieving them.


As with ESG, instrumental IFSI can be seen not only as an impact goal, but part of the fiduciary duty of a portfolio manager. It is focused on pushing a company to do better, with the objective that it will result in less risk or higher returns (or both) for the company and therefore the investment strategy. Instrument IFSI may overlap with ultimate ends IFSI, the latter where the positive sustainable impact is the goal. However, under current fiduciary rules ultimate ends cannot be pursued when it is at the cost of investment returns, for the typical market return strategy.


Nevertheless, I believe there is room to expand our understanding of instrumental IFSI and how it might align further with pursuing a positive climate impact. As an example, can investors demand an energy company to spend more capital on renewables, or low-carbon technologies (such as carbon capture and utilisation) or R&D developing these low-carbon technologies, even if a prudent CFO might want to see a clearer path through the transition before committing that capital, reflecting their own fiduciary duties to shareholders? Instead, paying out any excess cash to shareholders in the form of higher dividends and share buybacks, more visibly beneficial to those shareholders. The latter is welcome, but if it comes at the price of being locked into a depressed valuation multiple because the company is not perceived as committed to the transition, then from an investment perspective it may be counterproductive. Better less dividend and a little more speculative R&D, to raise the possibility of re-rating of the shares. This is what Ørsted achieved (link). This is not theoretical, the market is being fed the information to make comparisons on capex and R&D spend, the recent World Benchmarking Alliance oil and gas study being the latest report to do so (link)


The Freshfield’s report might seem a rather technical paper, but it gets to the root of the challenge we face as portfolio managers seeking a positive impact and to society as a result dealing with the “tragedy of the commons” and the “tragedy of the horizon”. We should test the boundaries.

Unless otherwise stated, all opinions within this document are those of the RWC UK Value & Income team, as at 9th September 2021. 

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