California Climate Rules, Inflation Reduction Act Were Milestones for Investors. Here’s What’s Next.

Discussions about scope 1, 2, and 3 greenhouse gas emissions are deadly at cocktail parties, but they’re critical to the fight against climate change (you can read why and what they are here). Those discussions grew louder this month, as the California assembly passed two sweeping climate disclosure bills.

With Climate Week poised to begin and the U.N. summit on climate change looming in November, we checked in with Wendy Cromwell, head of sustainable investing at Wellington Management and a 25-year veteran of the firm. Wellington has an ESG Commitment Level rating of Advanced from Morningstar; the rating helps investors identify asset managers dedicated to delivering sustainability outcomes. One reason for the Advanced rating is Cromwell, under whom Wellington has bolstered its emphasis on climate, grown its central sustainable-investment team, and exceeded industry standards on disclosure, says Morningstar analyst Mahi Roy. Here’s what Cromwell said during our conversation.

Norton: The California Assembly just passed two major climate disclosure bills. How useful are they?

Cromwell: Both are very positive. They mimic the proposed mandatory climate disclosure regulation from the Securities and Exchange Commission that has not been finalized. One bill requires disclosures of scope 1, scope 2, and scope 3 emissions with safe harbors [protections for a company disclosing in good faith]. The other basically mandates [disclosures according to guidelines of the Task Force on Climate-Related Financial Disclosures, or TCFD]. More information is better. It helps us make better investment decisions. This data allows us to have a richer dialogue and understand who is planning for this major macroeconomic theme and what their capex [capital expenditure] is going to be and how they’re going to address it.

Norton: In what ways, specifically?

Cromwell: Right now, the data is from a third-party source. In many cases, the scope 3 data is estimated. Having it come straight from the companies, even if not perfect, is a step in the right direction. Them reporting this data is an indication that they recognize that climate and the transition is a major economic transformation and potentially an opportunity. Supply chains are risky because of geopolitical risks or pandemics or physical climate risks or carbon pricing schemes. If they’re looking at upstream scope 3 emissions, that means they’re really thinking about their supply chain, they understand it, they want to mitigate risks in it. That’s just good risk management from the operational standpoint. [Ed. Downstream emissions are related to customers.] We’ve also seen companies come up with interesting ideas for new innovation because they think about appealing to consumers. Individual investors will hopefully get better returns, because they’re investing in companies that have a plan, a recognition of risk mitigation for this major economic transformation.

Norton: Will California become the standard for companies even if they’re not doing business in California?

Cromwell: This is to be determined. There are other disclosure initiatives. A lot of companies are voluntarily creating TCFD reports. That’s all raising the level of information on climate that’s being provided to the market. We had proposed to the SEC, and I imagine this will stay in their proposal, that companies disclose the physical location of their material operation sites. Right now, that’s not mandatory. And then the market can sort through whether those sites are in a flood plain.

Norton: Climate Week is this week, and COP28, the annual United Nations climate change conference, is in November. What are the rising priorities for investors?

Cromwell: You’ll see more and more discussion of adaptation plans alongside transition plans. People are more and more focused on adaptation. There’s greater recognition that the climate is changing no matter what we do to mitigate emissions in the short term. Climate scientists have all these scenarios. The trajectory of emissions over the next 20 years looks the same. It’s very hard to change the climate outcomes over the medium term no matter what you do in terms of mitigation. That doesn’t mean we shouldn’t try. But until we figure out a way to suck emissions out of the atmosphere, it’s hard to reverse what’s already there because of this long half-life of greenhouse gas emissions.

We’re going to deal with increased frequency and intensity of physical climate events, and we need to prepare society to think more about adaptation.

Also, you’re starting to hear the community talk about overshoot [where global temperatures temporarily exceed specific targets]. There’s a line drawn in the sand of 1.5 degrees Celsius [the goal of the Paris Agreement to limit global warming]. It’s an acknowledgment that we’re marching closer to this line in the sand, and we need to think about the ramifications.

Norton: What are those ramifications for individual investors?

Cromwell: As human beings, they’ll recognize the need to adapt to a changing climate. As a beneficiary or an investor in a mutual fund, they could benefit from portfolio managers and strategies that are investing in companies that provide adaptation solutions. Might we need more generators, air conditioning, engineering firms, hurricane-proof glass, earthquake-proof building materials? Human ingenuity is amazing. Lots of solutions currently exist to help us live in a changed climate, and more will be created. Those can be very exciting investment opportunities—say, things that allow us to become more energy efficient or to lower methane emissions.

Norton: In the U.S., sustainable investing and environmental, social, and governance approaches, many of which are already embedded in U.S. finance, are under scrutiny. Is this scrutiny helpful?

Cromwell: The scrutiny is helpful because in an immature industry, sometimes people rush to capture the opportunity, with less rigor, with less of a rule implementation. The scrutiny encourages a research-led approach that appreciates nuance and digs into evolution. It’s really healthy. It’s a maturation of sustainable investment generally to say, move away from something that says I’m going to take a rating and put it on my investment process and not own companies below a certain rating. That’s not a research-led approach and in my view unlikely to create a lot of value for clients. The scrutiny says, Why are you taking a rating from over here, and putting it in the process, and what’s your end outcome? It makes portfolio managers really articulate the research they did to conclude why a company will benefit or not and what information is useful to enhance returns. That makes it a more robust approach generally.

Norton: How has climate investing changed with the new European regulations and last year’s passage of the Inflation Reduction Act?

Cromwell: The IRA continues to be a very big deal. Wellington sponsored a sustainability conference last year in London, where we met with 18 CEOs a month after IRA was introduced. They all had a plan for how to take advantage of the IRA. This was even before the Treasury tax guidance was written out. The big delta is that the IRA gives you a 10-year look, versus previous incentive programs that lasted two to three years. That aligns more with strategic planning and capex cycles. As you get more guidance, you’ll see more companies taking advantage of it. Since the IRA was announced, over 100 new clean energy manufacturing plants have been announced in the U.S. They’re often in states with traditional energy communities. Right now, we’re in the middle of a backlash, and during the whole debt-ceiling renegotiation this past summer, there were threats to the IRA. But the IRA remained because it provides real economic benefit to those states that need it during the transition. So, it’s pretty powerful. Wellington comanages Hartford Climate Opportunities fund HEOIX, which has a major focus on investing in transition names and adaptation names, many of which could be the beneficiaries of IRA incentives.