How financial markets can drive climate action

LONDON — Climate change is on the ballot in November’s US presidential election. A second Donald Trump presidency could lead to an additional four billion tons of carbon dioxide emissions by 2030, erasing the progress made under President Joe Biden. Conversely, Vice President Kamala Harris, the presumptive Democratic nominee, established a record of being tough on polluters during her tenure as California’s attorney general.

Meanwhile, Europe’s rightward shift and complicated coalition politics are slowing global climate action. As Western democracies grapple with rising political uncertainty, it may be up to capital markets to save the planet.

Alas, our financial system is caught in a classic prisoner’s dilemma: It is costly for any single institution to decarbonise on its own while others continue to profit from carbon-intensive portfolios. But if all asset owners and managers committed to reducing CO2 emissions and supporting a just climate transition that protects workers, communities, and consumers, they could create long-term value and deliver prosperity for all.

The inconvenient truth is that without robust climate policies, such as carbon pricing and elimination of fossil-fuel subsidies to reallocate capital toward clean energy, there is little incentive for collective action. In a world where it pays to pollute, investors will be tempted to support companies with unsustainable practices, shifting the burden of the energy transition to others and ultimately leaving everyone worse off.

Contrary to activists’ hopes, climate action is not necessarily a win for everyone. A once-in-a-generation transition carries financial and political risks, as well as opportunities, creating winners and losers throughout the investment value chain. The question, then, is whether major asset owners and managers can steer markets toward achieving climate goals and generate sufficient financial returns.

The answer is yes, but achieving this requires three major strategic shifts. First, investors must engage with high-emitting companies rather than simply divesting from them. Divestment campaigns often trigger partisan efforts to protect the fossil-fuel industry, whereas engaging with high-emitting companies and tracking their progress offers tangible climate benefits beyond portfolio decarbonisation.

In a 2023 study, for example, economists Kelly Shue and Samuel Hartzmark analysed nearly two decades of emissions data from more than 3,000 companies, finding that high-emitting “brown” companies produce, on average, 261 times the emissions of climate-friendly “green” firms. This suggests that a 1 per cent reduction in the emissions of an oil or gas company has a far greater environmental impact than a tech company or a bank achieving net-zero emissions. As geopolitical tensions rise and national fossil-fuel production becomes increasingly vital for energy security and affordability, policymakers should keep these findings in mind.

Second, investors must actively seek emissions reductions instead of passively investing in low-carbon industries. As recent years have shown, exchange-traded funds focused on environmental, social and governance investments not only underperform the market but also fail to accelerate climate action.

Moreover, it has become abundantly clear that Big Tech companies like Meta (Facebook), Apple, Amazon, Netflix and Alphabet (Google) tend to dominate sustainable equity funds. Although these funds may seem environmentally friendly at first glance, research shows that by directing capital away from high-emitting companies, they have inadvertently deprived critical sectors of the resources they need to invest in the clean-energy transition.

By contrast, active funds that focus on encouraging carbon-intensive companies to decarbonise can drive climate action by channeling investments into sectors like renewable energy and waste management. A prime example of this approach is the $100 Billion Climate Action Plan launched by the California Public Employees’ Retirement System, which aims to improve cement production and retrofit fossil-fuel facilities.

Importantly, there is little evidence that merely decarbonising a portfolio translates into reduced greenhouse-gas emissions. To support the clean-energy transition, institutional investors must engage with both high- and low-emitting industries, incentivising carbon-intensive companies to provide emissions disclosures to mitigate the negative impact of high emissions on their stock-market valuations. Given that the shift to a low-carbon economy requires significant long-term investment, institutional investors could also direct capital toward emerging technologies such as sustainable aviation and safe nuclear energy.

Lastly, investors must seize the unique market opportunities created by weak national climate policies. According to the International Energy Agency, clean-energy investments will exceed $2 trillion in 2024, roughly twice the amount invested in fossil fuels.

To be sure, a second Trump administration could jeopardise the Biden administration’s landmark Inflation Reduction Act. But a slowdown in green investment is not inevitable, given that the IRA’s incentives, including $369 billion in tax breaks and subsidies for clean energy, have won support from voters, investors, companies, state and local officials, and even some Republican lawmakers. The IRA’s impact, catalysing $240 billion in clean-energy investments in its first year, cannot be ignored.

While green investments enable institutional investors to navigate domestic volatility, contribute to the fight against climate change and generate returns, today’s unregulated carbon markets might give the impression that companies are prioritising carbon offsets over meaningful de-carbonisation that benefits local communities. Initiatives led by climate and finance experts, such as the Integrity Council for the Voluntary Carbon Market, could thus play a pivotal role in setting standards for carbon credits and maintaining market integrity, helping to scale this essential climate-financing tool.

Regardless of the political climate, 2024 is set to surpass 2023 as the hottest year on record. In an economy that values financial returns above all else, it is natural for individual companies to focus on profits. But focusing exclusively on generating returns overlooks the catastrophic impact of increasingly frequent extreme weather events like hurricanes, floods and wildfires.

As climate-related disruptions intensify, large institutional investors are uniquely positioned to lead the green transition while still delivering financial returns, thus bringing us closer to meeting the emissions targets set by the 2015 Paris climate agreement. Now is the time for markets to rise to the occasion and help us win the defining fight of our time.

Lynn Forester de Rothschild, CEO of E.L. Rothschild, is founder and CEO of the Council for Inclusive Capitalism. Copyright: Project Syndicate, 2024. 

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