How to Achieve Net Zero? Match Action to Ambition

Earth Day has come and gone, yet it’s natural to think about the state of the world’s commitments to forestall the worst effects of climate change.

Major strides have been made for sure: The U.S. Inflation Reduction Act of 2022, said to be the largest investment the U.S. government has made to combat climate change, was a powerful policy response to shift capital flows to make a difference in the transition to a clean energy economy. Europe’s Green Deal Plan does the same for clean energy investments, bolstered by Europe’s comprehensive regulatory approach. Both are important to achieve net zero, in which global warming needs to be limited to 1.5 degrees by 2050 to curb the worst impacts of climate change. We shouldn’t underplay how hard it will be to achieve that target. But without this global milestone, the consequences of climate change could make planning for the future very messy.

For investors, and for Morningstar Sustainalytics, tracking the progress of companies toward that future is critical because of the coming transition. Investors will need to pay attention to 1) physical climate risks, including damage to and loss of property for companies, due to floods, heat, drought, storms, and other manifestations of global warming and 2) transition risks and opportunities, as the companies face the costs of decarbonizing the global economy, including changes in consumer behavior and new policy responses such as carbon taxes. These considerations are complex and will require strong leadership and accountability. That is why Sustainalytics has created a suite of tools to measure them, including our Physical Climate Risk Metrics and Low Carbon Transition Ratings.

Our time to do something significant to address the changing climate is contracting. The world is paying more attention every year to the ravages of global warming, but there is much more to be done. Even if we move 80 centimeters, we need to move a meter. The gap between climate ambition and action accumulates over time, and it’s important to narrow it.

Europe Inspires Global Progress on Climate

Hats off to Europe and its impressive diligence in creating a regulatory framework around the low carbon transition that automatically embeds an approach to climate change. What’s even more impressive is that Europe hasn’t backed off, even if the effort is challenging and it is feeling the pain of ongoing market critiques. The legally binding European climate law says EU countries must cut greenhouse gas emissions by at least 55% by 2030, with a goal of making the EU climate neutral by 2050.

Among other things, the Sustainable Finance Disclosure Regulation imposes mandatory environmental, social, and governance disclosure obligations for asset managers and other financial markets participants. From the outset, European regulators knew the transition to a low carbon economy would be challenging. They asked institutions and investors to begin reporting, even before the portfolio companies were doing so, rather than sequentially. They didn’t say, “OK, we’ll spend two years making companies report and two years to get investors to comply.” Instead, they made everyone do it simultaneously.

And today, the U.S. Securities and Exchange Commission is willing to engage on the topic, proposing rule changes that will require registrants to include certain climate-related disclosures in their statements, including information about material climate-related risks.

Why Individual Investors Must Focus on Climate Transition Risks

In the coming years, individual investors must also pay attention to the risks of the carbon transition. Investments face risks because of the effects of climate change. Your preferences are a good starting point. 1) Do you want your investment decisions to contribute to a transition to a sustainable future? Or 2) are you concerned about returns? You may prefer an impact-focused investment approach that considers both positive and negative impacts in combination with financial materiality.

Consider Apple AAPL. Apple represents a robust example of a value chain that is very exposed to the policy and pricing risks associated with the transition. It’s important for investors to understand that it isn’t just utilities or oil companies that face these risks. Apple has been publicly advocating carbon neutrality across its global supply chain and the lifecycle of every product. Last year, the use of renewable electricity by its manufacturing partners increased by nearly 30%. Investors focused on meaningful transition should be mindful of risks within all tiers of a company’s supply chain. Morningstar Sustainalytics’ Low Carbon Transition Ratings allow you to look at a company’s direct and indirect operations, products, and supply chain and with a 1.5-degree future.

If you want to align your investments with your net-zero vision and use your investment dollars to help solve climate change, then you may want to look at companies that are well-positioned to manage their transition risks.

I can see a future where reporting on the path to a net-zero pathway, either by companies or investors, becomes mandatory. One day, a bond investor will ask, “Do I want to buy this company’s bonds?” She will ask if the company is on this trajectory and remind herself that she is making a bet on the trajectory of the company and on management. The commitment of companies will change over time. They will increasingly focus on and build momentum over the transition. It will become a real, foundational way to think about investments.

For the Rest of 2023, Continued Focus on Climate

As we navigate market volatility, which could roil the carbon transition, most companies still aren’t aligned with getting to a 1.5-degree future. They will probably maintain their climate investment trajectory, positive or negative, if meaningful corporate action isn’t taken.

While our industry grapples with navigating ESG discourse in the United States, climate change still presents risks for investments, no matter where you live or what your political views are. This is why understanding how issuers and companies will address those risks is of paramount importance to all investors.

This is one of a series of quarterly letters from Bob Mann, president of Morningstar Sustainalytics.