The Workings of GFANZ’ Net Zero Commitment Mechanism
The Workings of GFANZ’ Net Zero Commitment Mechanism
A Reply to Tom Gosling’s Trouble Ahead for GFANZ Blog Post
Jan 10, 2023
Peter Fox-Penner,
Senior fellow, Boston University IMAP and Institute for Global Sustainability,
Chief Impact Officer of Energy Impact Partners,
and advisor to the Brattle Group.
I especially thank Tom Gosling for his through and thoughtful comments. I also thank Dan Firger, Paul Bodnar, Patricia Hudson, Curtis Ravenel, Ken Pucker, Nalin Kulatilaka, Susan Murphy, Rebecca Francus, Albert Abaunza, Kevin Fitzgerald, Shayle Kann, Morgan Sheil, Gabriella Rocco, and Marianne Gray. All errors are my own.
Introduction
On 7 August, London Business School’s Tom Gosling wrote an extremely thought-provoking blog post about the Global Financial Alliance for Net Zero (GFANZ), a voluntary association of financial firms who make commitments to transition their investments to net zero by 2050 (“NZ50”). Summarized briefly, Dr. Gosling (who I will take the liberty of calling Tom) argued that the pace of climate action by the nations of the world means that adhering to the GFANZ pledge creates a significant conflict with the fiduciary duty to maximize profits for most managers of listed firms’ securities.
Tom has unquestionably raised important points that are real and deserve further discussion. However, his analysis is a bit one-dimensional or static, for lack of a better term. When the problems he points out are unpacked a little the actions of some asset managers and GFANZ can be reconciled with fiduciary duties. This limited reconciliation goes to the heart of GFANZ’ raison d’etre — to accelerate the natural cycle between governmental policy shifts and business’ response to them. Seen in this light, GFANZ has a specific, catalytic role to play in the ongoing interplay between business activity and government policy. It may not be a broad-based club that includes the vast majority of financial actors, but it can advance climate progress without jeopardizing a wide swath of fiduciaries along the way.
Response to Tom Gossling’s Post
In particular, Tom noted that current assessments such as the IPCC’s recent 1.5 degree report conclude that the world is not nearly on track to keep temperature rise to 1.5°C, meaning that high-carbon- emitting economic activity is continuing at a much higher pace than this target allows. (He followed up his first post with a second post suggesting changes to GFANZ, posted here.) Global investors, Tom noted, could not simultaneously be financing all of the economic activity associated with a much higher emissions path than 1.5°C– presumably most profitable under current policies — and be claiming that their investment actions were leading to net zero. Tom gives an especially compelling example of how actual economic activity could be inconsistent with projected activity in a 1.5°C scenario when he notes that the two-thirds of the oil and gas that could be burned in a 2° scenario could not be used without CCS in a 1.5°C future.
Tom is correct to note that the 1.5°C target, which is enshrined in the Paris agreement and UN Race-to-Zero guidance, is more stringent than 2° or (loosely) net-zero-by-2050. Nonetheless, while formally supporting the goals of the Paris agreement and requiring alignment to 1.5°C, GFANZ commitments are implemented via pledges to get to net zero emissions by 2050. Accordingly, in this post I will use net-zero-by-2050 as the key operational marker for GFANZ implementation
Tom also looked at several arguments asset managers might use to “reconcile the worsening climate outlook with their commitments under GFANZ.” For example, GFANZ’ guidance to financial institutions states, “Over 500 financial institutions have come together to form GFANZ, committing to achieving netzero greenhouse gas (GHG) emissions by 2050 in support of the global transition to a net-zero economy to limit global warming to 1.5 degrees C.” Governments could shift their policies to make 1.5°C most profitable, but this was “more an article of faith than a view consistent with the prudent person rule.”
The second rejected explanation is a redefinition of fiduciary duty. While the clients of fiduciaries are interested in “factors beyond financial returns,” the linkage between any one financial investor’s achievement of climate goals and global climate outcomes is so imprecise that one can neither guarantee nor measure any concrete climate benefits from a voluntary sacrifice of returns.
Finally, managers could assert that climate risks justified investing for net zero. However, Tom argues that climate risks for individual investments are not yet specific and large enough to warrant net zero shifts — and even if they were, the same inability to point to tangible payoffs would bedevil this strategy.
The GHG Investment Spectrum
Suppose we could assemble the set of every current investable GHG-emitting enterprise in the world along with its carbon emissions intensity (GHGs emitted per dollar invested). We then measure all investments that can be made into this universe that meet the risk/return threshold consistent with each investor’s fiduciary duties as they are now understood. If we ordered these investments, starting from the highest GHG-intensity emitters and progressing to ones that are successively lower, we would probably start with coal-fired power plants and factories, moving through oil refineries and other high-GHG emitters on to successively cleaner economic enterprises. This range is used as the horizontal access in Figure 1.
Some sources of carbon come from entities that can’t be invested in by third parties, which creates a source of leakage in the GFANZ mechanism but does not render it invalid. This includes state-owned enterprises, which Gosling has reminded me account for perhaps one quarter of all global GHGs based on a Columbia Center for Global Energy Policy report. However, the report notes that 69% of all SOE emissions come from China, which is a unique actor in climate diplomacy in any case, and 85% of all SOE emissions are from the power sector, which is influenced through many channels other than GFANZ. With respect to privately-held assets, there is not yet a GFANZ commitment mechanism but several are under development right now, including a Net Zero Venture Capital Alliance (NZVCA). Once these commitment mechanisms are in place the mechanism I discuss below will work just as it does for other assets already under GFANZ pledges.
Even though we can’t invest in everything that generates carbon, all investable entities exist somewhere along the spectrum in Figure 1. When an investor invests in one, they should be allocated their share of the emissions from the entity they are financing. The simplest assumption to make about these allocations is that the investor’s share of the emissions footprint of the entity they are investing in equals the current average emissions intensity times the amount invested. For example, if Acme manufacturing is now emitting 10 lbs of carbon equivalent emissions per dollar of capital, and I invest $5 new dollars in Acme, my Scope 3 financed emissions from this transaction is $5 x 10 lbs./$ or 50 lbs. of CO2e. If as an investment manager I’ve made a pledge to GFANZ, this 50 lbs. is now part of the footprint I need to transition to net zero by 2050.
This new investment may be used by the company to lower its current or future emissions, in which case it should not be viewed solely as having a footprint equal to the current average emissions intensity of the firm times the size of the investment. However, under current carbon accounting treatment and in the absence of a more sophisticated analysis, the effect of the investment would be to increase the financed emissions component of footprint at current intensity levels. One of the issues we are wrestling with in the formation of the NZVCA is the treatment of emissions impact – i.e., how our investment changes the footprint of our investee now or in the future, versus their current footprint.
As you proceed through the investments from left to right in Figure 1 you come to a key transition point where GHG intensity is at the current average level of about 283 mTCO2e/million dollars invested.
If you invest in entities to the left of this point you will be raising the average global carbon intensity and total carbon emissions, at least as measured by the increase in the emissions allocated to your footprint Conversely, all investments to the right of this point act to reduce total global average GHGs intensity per dollar invested (again gauged by footprint changes) — though not necessarily on course for NZ50.
As we continued rightward we’d come to a second point where investments reduced current emissions on a path that reaches NZ50. Beyond this point, all investments are already at a net-zero-consistent intensity. It is worth noting that this is a key point of disagreement between Tom and myself. Tom argues that portfolio manager who allocates investment to a firm whose intensity is on the right-hand side will have no effect on that firm’s actual emissions trajectory, “particularly with secondary markets activity.” In my view, greater market-rate capital available to low-carbon firms, even through secondary market trading, encourages them to grow faster, in turn signaling policymakers that policies promoting this type of investment are advantageous.
Incidentally, if the rules for creating this sample are relaxed to allow for nonprofit and government investment funds, concessionary returns, or multi-objective B-corp investors there is a larger pool of investments with lower-than-average GHG intensity that can now be accessed. This is because there are many low-GHG investments that are not yet profitable at going market rates, but do earn enough money to qualify for concessionary or public financing.
In this framework, one way to express Gosling’s point about the conflict between current investment opportunities and a net zero path is this: under current policies affecting investment profitability, the aggregate size of the investments to the left of the NZ50 point on this chart are demonstrably much larger than the investments to its right. Otherwise, GHG intensity would not be declining too slowly for the world to achieve net zero by 2050. In Gosling’s construct, governments have created an overall playing field where too much of the universe of now-profitable emits too much carbon and too little of the total aligns with net zero.
There is room for discussion around this point because we are assuming that each new investment into entities with a current carbon intensity of, say, 50 lbs. of CO2e per dollar causes 50 more pounds of CO2e per new dollar invested. Many companies on the left as well as the right side of Figure 1 have made commitments to cut emissions from current levels, and some of the financing going to these companies will be used for this purpose. A snapshot like Figure 1 could say that we are not on track for net-zero, but can’t factor in future, but real, decarbonization plans. This idea has been gaining traction lately in ESG investment circles by labelling some companies and their stocks “ESG improvers.”
Another wrinkle in Figure 1 is the ultra-important role of investment in new GHG-reducing innovations by governments, venture capitalists, and others. These investments are typically not yet producing marketed products, so the companies are causing emissions at some rate per dollar invested as they build and test prototypes and head towards product launch, but aren’t yet saving substantial amounts of carbon with their products . These companies’ emissions are adding to current global GHGs and quite possibly to Gosling’s key emissions observation. However, if these innovations yield improved ways to cut emissions not yet factored into the IPCC’s trajectory they will soon be in the rightmost block even if their present emissions profile puts them on the left. We see this phenomenon in my firm’s venture investments, and in addition to our own reporting the newly-forming Net Zero Venture Capital Alliance and Project Frame are trying to improve transparency on this mechanism as well.
These points notwithstanding, Gosling is correct that the sum total of investing activity in Figure 1 is not yet reducing global GHG emissions — after all, atmospheric carbon concentrations increased by 2.6 ppm in 2021. This must mean that more investment is going into the left block of the figure, increasing total global GHGs, than is going into decarbonizing investments across the entire spectrum.
While this may be so, there is most assuredly a portion of Figure 1 where NZ50-consistent investments reach market levels of return and where many investments are being made. Some investments fully compatible with NZ50 are profitable in many markets now, either in specific niches or even widespread use. PV solar, wind energy, storage, and many other parts of the clean energy system are clearly technologies that can be profitable investments today. Other NZ50 investments are not yet first-cost- cheapest, but in some cases consumers who value green products will pay more to create equal or better profitability for investors. In other cases, NZ50 products provide added services that allow market profitability even without green preferences. In still other cases, the likelihood of future government mandates, declining cost curves, and the time required to tool up to meet mandates indicates that investment oriented towards net zero is now prudent. This describes the electric vehicle market in much of the world today. All this is within the investable universe that my firm, Energy Impact Partners, primarily focuses on, as do many other climatech investors.
In sum, when Tom’s argument is unpacked it does not follow that there are few opportunities consistent with net zero and market returns. It may well be the case that, under current worldwide government policies, there aren’t enough of these opportunities to put the world on course to net zero by 2050, or more strongly 1.5°C, and still too many opportunities to invest in high-emissions enterprises. In my view, that’s right where GFANZ comes in.
GFANZ’ Role in the Government-Business Cycle
Obviously, the investment spectrum we’re discussing is anything but static. At every point in time, government policies play a pivotal role in determining how many investments reach market return thresholds within each of the three blocks in Figure 1. Policies that provide public subsidies for building coal-fired power in a country would expand the size of the left-hand, high-emissions investment opportunity block. Policies that tax carbon significantly in that same country would have the opposite effect. The aggregate size of each of these blocks is the result of thousands of government policies, regulations, court rulings, subsidies, taxes, and fees, all creating the complex playing field on which investors assess the expected return on of an investment. One way to describe the global climate policy framework is to say that the role of the Paris Accord and its surrounding commitment ecosystem is to steadily reduce profitable investments in the left-hand block and increase them on the right-hand side so as to shift the entire aggregate emissions profile down to NZ50.
We’re all familiar with the many constraints governments face in adopting emissions-reducing policies. Almost all climate policy shifts disadvantage some legacy businesses and their investors and often also create other just transition issues. Of course, each policy shift also creates more investment opportunities on the right side, along with more jobs and healthier and often more equitable economic development. For any government responsive to its citizens – including its businesspeople – its ability to shift policies towards decarbonization depends on its citizens’ and investors’ willingness to bear the transition costs. This is influenced enormously by the size and visibility of the businesses and investors who are in the part of the economy where they are making highly profitable investments and creating good jobs while substantially reducing GHGs.
I think this is the role of GFANZ and its alliance members. Through their commitments, members express confidence that they will find portfolio companies that reside primarily in the right-hand block of investments. They pledge to reduce their footprint of allocated financed emissions from its current level to steadily lower levels in the future, in effect notifying governments in advance that they accept this deal: if governments enable more low-GHG investments to be profitable they will invest it them. Some may already have investments with intensities consistent with NZ50 or they may be investing on track to hit the target even if current emissions put them on the left.
By expressing this willingness to invest via their pledge, policymakers are reassured that there is enough opportunity in decarbonization to ratchet policies further in this direction “It’s a lot easier to turn into law that which hundreds of your largest businesses are already doing,” Carbon Disclosure Project president Paul Dickinson recently remarked. For every policy ratchet they achieve, they open up a larger investable space for new and expanded GFANZ members who have pre-pledged to fill it. The Paris Accord envisions progressively higher ambition in each NDC; the cycle between GFANZ investors and policymakers should promote higher ambition through its complementary process.
The Implications for GFANZ
There are certainly challenges for GFANZ if this description of its overall role is correct. Most powerfully, Gosling’s critique reminds us that GFANZ membership likely cannot extend to all investments, only that fraction consistent with a net zero path. That includes many but not all companies in the right-hand block and the left-side investments that will take the investee’s operations to NZ50. To maintain its credibility, GFANZ commitments must ensure that the investments of those who commit meet these criteria. This assessment has to allow for rapidly-changing shifts in technologies, costs, energy prices, and other factors. In my role with Energy Impact Partners, we are constantly watching many climatech sectors where new innovations combine with the evolving policy landscape to make formerly-uninvestable opportunities now attractive.
Conclusion
Tom Gosling is right that there are substantial tensions between the fiduciary duty of some asset managers and the ability to commit an investment portfolio (or another similar financial activity) to a net zero path. These tensions suggest that the size of the GFANZ universe isn’t all financial investors, and that acknowledging these limits is part of the credibility establishment that pulls national ambition forward. While it is indeed tragic that all global economic activity is not yet on a 1.5°C path, this does not rule out significant investment that satisfies both fiduciary duty and a pathway to NZ50. GFANZ’ role is to demonstrate the economic opportunities arising from the clean energy transition and thereby contribute to virtuous cycle of improved policies and greater net-zero-aligned investment.