In amongst news of the latest twists and turns of the coronavirus pandemic, the final quarter of 2021 was punctuated by a depressingly familiar set of headlines on devastating weather events.
In December, tornadoes in the US flattened whole villages, killing over one hundred people. Unseasonal wild fires continued through late autumn and caused damage amounting to hundreds of millions of dollars. The Philippines was hit by one of its worst ever typhoons, leaving entire coastal communities destitute and killing hundreds.
Despite the undeniable evidence that the world is charting an increasingly dangerous climate course, world leaders once again missed a critical opportunity to act. The postponed COP26 summit held in Glasgow in November was widely billed as a moment of reckoning; the world’s last chance to set out serious plans to deliver the global commitment to keep temperature rises to 1.5°C. If we fail, scientists warn of potentially dire consequences for life on earth.
Yet COP26 came and went without the detailed action plans required. That’s not to say progress was not made. A new pact to reduce coal-fired power, a pledge to end deforestation by 2035, and a surprise net-zero commitment from India were all examples of meaningful break-throughs. The IEA estimated that, if they are all delivered, the promises amassed in Glasgow put us in reach of a 1.8°C temperature target, a big step up from the 2.8°C pathway we are currently on1.
The trouble is that these are just promises.
If we are to achieve the monumental 45% reduction in carbon emissions required in the next eight years to limit warming to 1.5°C, we need to redouble our efforts. Tweaks to business as usual won’t cut it. What is required is systemic change. Global warming is not someone else’s problem. Every organisation and every individual must embrace their own responsibility for climate change. This means 1.5°C-aligned behaviours need to be appropriately rewarded; and misaligned activities sanctioned.
Above all, the climate emergency needs to be made personal.
For investors, we see five immediate interventions to help re-calibrate incentives facing individual corporate decision-makers in line with a sustainable planet. These are not an alternative to governments setting hard caps on greenhouse gas emissions, with supportive policies prohibiting misaligned activities. What we propose are additive measures, which do not require new laws or regulations, and which we believe can have a meaningful impact.
1. Vote against climate inaction
Until now, there have been few sanctions for companies that fail to keep their promises on climate. The flurry of net-zero commitments announced in the run-up to COP26 made impressive headlines – an eye-watering $130 trillion of private sector assets have put their names to targets that would see dramatic decarbonisation – but it is hard to see how they will be realised. Concerns over corporate greenwash are widespread.
A key problem comes when directors do not see climate change as their responsibility. For most, the central and often singular objective is to maximise shareholder returns. While they might like to act to protect the planet, if this leads to lower profits, then their hands are tied.
This perception is not just wrong – in the UK and frequently elsewhere, director duties are far broader than maximising short-term shareholder returns – it is dangerous. The consequences of continued climate harm may be irreversible. We need a profound mindset change that explicitly links a director’s climate performance to their continued role on a board. In short, if directors fail to put a company on a 1.5°C pathway, then investors must vote against their reappointment. Only then will we make sure we have the right leadership delivering sustainable value to shareholders and society.
2. Appoint Audit Committee directors who ensure accounts are consistent with a 1.5°C pathway
Consistent with ensuring director responsibility for net-zero alignment, investors must demand that all companies’ financial statements are drawn up in alignment with a 1.5°C pathway. Such a policy has the potential to alter fundamentally the incentive framework driving capital allocation to support decarbonisation. It works as follows.
Companies’ financial statements act as the cockpit dashboard does for a pilot. They tell executives what is profitable and which way to channel fresh capital. They show what activities to avoid. Just as where the dashboard malfunctions and gives out incorrect readings, inaccurate accounts will result in poor and potentially dangerous decision-making.
Currently, financial statements are malfunctioning – they are generally ignoring the decarbonisation governments have committed to deliver, and thus presuming it won’t happen. A coal-fired power company, for instance, may ignore the requirement that its operations must be phased out by 2035. Similarly, an airline company may ignore the costs of switching to carbon-neutral propulsion systems necessary to secure its future business. A cement company may leave out the rising costs of carbon sequestration that would be needed to underpin future sales.
A recent of review of 107 carbon-intensive companies’ financial statements by Carbon Tracker made clear that the vast majority of financial statements omit the costs of climate change and the energy transition2. The result is that capital is being deployed as if it won’t happen, thereby helping to turn the assumption into a dangerous reality.
No new rules or regulations are needed to get companies to integrate the economic impacts of a 1.5°C pathway in their financial statements. Companies are already required to take account of anticipated events in forward-looking accounting assumptions that could have a bearing on their economic position. Financial statements should not omit the expected costs of carbon emissions; leave out climate-related liabilities; nor ignore impairments tied to anticipated decarbonisation.
Beyond the requirements above, companies must take care not to ignore the express demand from investors for visibility of the financial consequences of a 1.5°C pathway. Building on an initiative led by Sarasin & Partners, in 2020 investors representing over $100 trillion in assets have already made their expectations for 1.5°C-related disclosures clear, meaning that this information should be treated as material under the accounting rules and, thus, subject to appropriate disclosures3.
In 2022, investors must reinforce this message by only reappointing audit committee directors that have delivered on their expectations.
3. Appoint auditors that call out climate misrepresentation
Where accounts are not aligned with a 1.5°C pathway, auditors must sound the alarm – and be held to account if they do not. In 2021, Sarasin worked with a group of other investors representing over $4.5 trillion to write to the Big Four audit firms (PWC, KPMG, Deloitte and EY) to remind auditors of their responsibilities4. This was the second letter sent to the auditors and it stated that, from 2022, auditors that do not call out misrepresentation would face increasing votes against their reappointment at company AGMs.
4. Support Remuneration Committee directors who apply a net-zero underpin to executive pay
Until pay is aligned with a 1.5°C outcome, no amount of cajoling or grand ambitions will get us to net-zero. A fourth policy investors should, therefore, immediately adopt is to call for a net-zero underpin for all executive pay packages - a similar concept to capital adequacy underpins applied to UK bankers' bonuses following the financial crisis. An underpin requires that all executives’ bonuses and long-term incentive awards are conditional on the performance being consistent with achieving a 1.5°C pathway. Only once alignment is established would the routine performance metrics be assessed.
Pay is currently not aligned with taking robust action to combat climate change because it is normally paid out based on profitability, irrespective of whether the reported profits come at the planet’s expense (see point above on misleading accounts). While fixing the accounts offers the most enduring way to align pay with net-zero, instituting a net-zero underpin offers a valuable stop-gap.
Investors should make clear that the assessment for net-zero consistency would be the responsibility of Board Remuneration Committees, who would be expected to make a public affirmation of alignment with supporting evidence. Investors should then hold Remuneration Committee directors accountable where they fail to act.
5. Support moves to ensure climate misconduct faces court sanction
As measurement increases and accountability develops, the courts will have a growing role to play in attributing responsibility for climate change. This was made plain this summer in the landmark decision by a Dutch court that Royal Dutch Shell had failed to uphold international human rights law by knowingly pursuing a strategy that contributed to global warming. They have been ordered to revamp their strategy to address this shortfall.
As hard evidence of the direct causes of climate change accumulates, hundreds of other cases are now in the pipeline. So far, few are led by institutional investors. Yet, investors will increasingly need to consider whether there are instances where litigation is an appropriate course of action to protect long-term capital. Indeed, there are examples of large asset owners, like pension funds, facing calls to act on climate change as part of their fiduciary duty.
Treat the climate emergency like it is real
The world faces a climate emergency. We must all change to reflect this reality. Governments must go further than their pledges in Glasgow and introduce new laws and regulations that set hard limits on carbon emissions. But even in the face of political paralysis, investors can and should act. Critically, investors need to use their votes to ensure corporate directors are held to account for their impact on our climate - without individual accountability, climate action will prove elusive. Like many companies, the majority of investors have expressed deep concern about the climate and pledged to be agents of change. They must now show they mean it.