Long term investors must focus on transition not divestment at COP28

Investors and corporations will arrive in Dubai for COP28 later this month, and the world is depending on them to recognize and address a paradox: ordinary net zero 2050 commitments are one of the biggest threats to achieving net zero carbon emissions in 2050.

While paradoxical, this is quite simple to understand. On their own, net-zero commitments reward divestment, and that merely changes the ownership of dirty assets, not emissions into the atmosphere. We will only lessen emissions in the atmosphere by long-term investors and companies owning and cleaning dirty assets.

We have to clean up our mess, not hide it.

Take it from Ontario Teachers’ Pension Plan. Jonathan Hausman, executive managing director of global investment strategy, recently remarked, “We need to use the levers of investment that we have to make an impact well beyond the portfolio footprint of Ontario Teachers, and that is something that we call ‘high carbon intensity transition assets’.”

Ontario Teachers’ intends to allocate around C$5 billion to such assets – high-emitting companies with credible decarbonisation plans that can be accelerated via capital and expertise. OTPP is doing this in the context of its net zero 2050 commitment and interim targets, and this effort to decarbonise, rather than divest, is what makes their commitment practical and meaningful.

The hard part is actually cleaning up dirty assets.

Long-term investors and companies see private markets as offering a special pathway to success. Private ownership is more concentrated, long duration, and prepared for this type of risk compared to the diffuse, high-turnover, and volatility-sensitive shareholders in public markets. All of these are advantages when the investment strategy depends on a big transition like decarbonisation.

Still, the work is hard, in part because limited partners (LPs) have deep concerns about allocating to general partners’ (GPs) transition strategies. LP concerns can range from greenwashing on the impact portion of the strategy to concessionary performance on the financial portion of the strategy.

We know this because long-term investors brought these realities to us in the larger context of FCLTGlobal’s effort to develop tools that allow LPs and GPs commit together to grey-to-green strategies.

Fee provisions are an example of these tools. In the course of this effort, LPs and GPs together identified sample fee and expense terms, such as including an emission-reduction target in the hurdle rate, putting carbon performance targets into the carry, and expensing offsets out of the management fee for any carbon underperformance.

And fees are just one example. Mandate terms are the centerpiece of any relationship between clients and managers and, in a deeper toolkit for top-down portfolio decarbonization, a similar group of owners and managers offer carbon-related mandate provisions for benchmarking, contract term, redemptions, projections, and reporting.

Long-term investors can come to COP28 ready to talk about how they are putting tools like these to work. Hausman continued, “We have one [high carbon transition asset] that we’ve worked on already, but we want to do more at a bigger scale.”

OTPP is in good company with this approach to decarbonisation. CDPQ has allocated C$10 billion to decarbonisation investments, and AIMCo is doing similarly, as chief executive Evan Siddall has stated explicitly: “We’re a long-term investor, so unlike public markets that tend to operate quarter to quarter with much shorter-term horizons, we can look to a transition into 2030 and see the path to earning a return on decarbonisation.”

There are limits to this sort of strategy, of course, just as there are for any investment. Two are particularly relevant to climate.

Transition strategies require trust. For asset owners, the sponsor has to trust that the fund can handle the usual financial aspects of an investment while simultaneously pulling off a highly-technical, scientific transition. For asset managers, the same trust is required from their clients. Trust is earned before it is applied, so the only agents in a position to accept this opportunity cost are those that have prepared their principals for it well in advance.

Relatedly, transition strategies test investors’ willingness to tolerate a bumpy ride. Ordinary net zero 2050 commitments with interim targets are appealing in part because they promise a smooth and foreseeable path to a clear destination. Transition strategies promise that the investor’s carbon footprint will get worse before it gets better. Emissions will go up every time the investor brings a dirty asset onto the books, it will take years for each to decarbonise, and the exact moment when those results begin to appear is very uncertain.

OTPP, CDPQ, AIMCo, and other long-term investors are committing to transition strategies nonetheless because they have the tools, they understand the long-term financial appeal, and that this is what it will take to get to planetary net zero 2050. That is what COP is about, and all of us are depending on this approach scaling at COP28.

Matthew Leatherman is managing director, research strategist at FCLTGlobal.