Financing the transi-on to a low carbon economy Bridging the long-term financing gap Controlling speculaon Preven-ng systemic risks Op-mising tax schemes CONNECTING THE DOTS BETWEEN CLIMATE GOALS, PORTFOLIO ALLOCATION AND FINANCIAL REGULATION ABOUT THE EXECUTIVE SUMMARY 2° INVESTING INITIATIVE The 2° Inves-ng Ini-ave [2°ii] is In this report, the 2° Invesng Iniave proposes to create a a mul--stakeholder think framework that connects the dots between climate Goals, porQolio tank that brings together allocaon and financial regulaon. financial ins-tu-ons, policy • The main objec-ve of the 2° Inves-ng Ini-ave is to build a set of makers, research ins-tutes, new approaches that integrate climate change issues into experts, and environmental mainstream finance. In this context, climate change issues can be NGOs. Our work is dedicated to seen as the -p of a larger iceberg: the need to finance the real research, awareness raising, and economy and the long term. advocacy to promote the integraon of climate constraints • While the goal to limit climate change to +2°C has been officially in financial ins-tu-ons’ established by world governments, the “price signal” approach investment strategies and promoted in the last 20 years has yielded limited results. Meanwhile, financial regulaon. The 2°ii we are geng closer to a carbon-intensive future every day. It now organizes sharing and diffusion appears necessary to use other tools that will ‘push’ available capital of knowledge, and coordinates into financing the energy transi-on. research projects. • The cornerstone of our ini-ave is the concept of “2° inves-ng”: a 2°ii was created in Paris in 2012 financial environment that promotes financing and investment in by French and internaonal accordance with +2°C climate pathways. For this to become possible, partners. Other branches will new tools and new rules are needed to connect exis-ng regulatory follow in Europe and throughout frameworks with emerging performance and risk assessment the world star-ng in 2013. prac-ces. 2°ii aims to be an open plaorm where experts and The name of the ini-ave relates stakeholders who share these objec-ves can meet and share their to the objec-ve of connec-ng ideas. the dots between the +2°C climate goal, risk and • The present report raises two ques-ons: performance assessment of - How can an investment porTolio’s contribu-on to financing the investment porTolios, and energy transi-on and the long term be measured? financial regulatory frameworks. - What should methodologies and rules that place these indicators and environmental constraints at the heart of daily investment ACKNOWLEDGEMENTS prac-ces and decision-making processes look like? The authors would like to thank CDC Climat and the Department • The conceptual framework developed by 2°ii follows three pillars: of the Commissioner-General for 1. Assessment: The contribu-on of financial products and Sustainability of the French ins-tu-ons to financing the energy transi-on and the long term; Ministry of Ecology, Sustainable overall evaluaon of climate risk exposure. Development and Energy (CGDD/ MEDDE) for their support. We 2. Disclosure: Transparency in the risk and impact assessment would also like to thank Jean- conducted by companies, asset managers, and financial ins-tu-ons. Pierre Sicard, Ulf Clerwall, James 3. Incenves: Greening of exis-ng schemes, such as incen-ves, taxes Leaton, Robin Edme, Ben Collins, on savings, and capital requirements in order to push asset Yann Louvel, Jean-Paul Nicolaï, allocaon onto a +2°C trajectory. Stéphane Voisin, Dominique Blanc and Benoît Lallemand for AUTHORS: their help in pung together this Stanislas Dupré (2°ii) & Hugues Chenet (2°ii) report. The views expressed in this report are the sole responsibility of the authors and do not necessarily reflect those of 2°ii members. The authors are solely responsible for any errors. 1 CONTENTS A. WHY DO WE NEED TO DRIVE ASSET ALLOCATION? 1. The long-term financing gap 3 2. The energy transi-on: The capital reallocaon challenge 4 3. The inadequacy of current price signals 5 4. A window of opportunity for policy makers 6 B. THE BARRIERS TO LONG-TERM INVESTING 1. Desynchronised -me horizons 7 2. Asset allocaon: driving through the rear-view mirror 8 • Household savings • Strategic asset allocaon • Asset allocaon by sector 3. The case for an economic/climate performance indicator 10 • A new paradigm • The case for a cross-assets performance indicator 4. ESG rangs and beyond 11 • ESG rangs • Towards impact assessment • Integrang ESG rangs in financial analysis C. WHAT WOULD A 2° REGULATORY FRAMEWORK LOOK LIKE? 1. Pillar 1: Assessment 14 • Financial porTolios’ contribu-on to financing the energy transi-on • Exposure to long-term and climate risks 2. Pillar 2: Disclosure 16 • Repor-ng requirements for companies • Repor-ng requirements for financial ins-tu-ons • Key informaon documents for financial products 3. Pillar 3: Incen-ves 18 • Investor remuneraon schemes • Taxaon on savings • Calculaon of capital requirements 4. The 2° inves-ng roadmap 20 • Legend • The roadmap • Is it a Utopia? D. BIBLIOGRAPHY 23 E. EXPERTS’ VIEWS ON 2° INVESTING 25 Hervé Guez (Mirova-Naxis AM) • Stéphane Voisin (CA Cheuvreux) • James Leaton (Carbon Tracker) • Nick Robins (HSBC) • Didier Janci (CDC) • Thierry Philipponnat (Finance Watch) • Yann Louvel (BankTrack) • Ben Collins (Rainforest Ac-on Network) • Jean-Paul Nicolaï (Centre d’Analyse Stratégique) • Romain Morel, Ian Cochran and Benoit Leguet (CDC Climat) • Gertjan Storm (University of Maastricht) • Jan Willem van Gelder (Profundo) • Sirpa Pie-käinen (Member of the European Parliament) 2 A. WHY DO WE NEED TO DRIVE ASSET ALLOCATION? DESIRED GLOBAL INVESTMENT 1. THE LONG-TERM FINANCING GAP Source: MGI 2011 1 24$ According to the McKinsey Global Ins-tute (MGI), the world is at trillion the beginning of an enormous wave of capital demand, driven by emerging markets and the energy transi-on. The global demand for capital is expected to rise from ~$11 trillion today to $24 trillion in 2030.1 In par-cular, demand for infrastructure investments will boom due to a lack of maintenance in developed countries over the 11$ trillion past few decades and the expansion of ci-es in the developing Others world. At the same -me, the global savings rate will likely not follow this trend, due to a change in demographics and lower expected Health & edu. savings by Chinese households. New capital requirement rules Services (Basel III for banks and Solvency II for insurers) will lead banks to Agri. & mining reduce their lending to the real economy and insurers to reduce the Manufacturing weight of long-term assets in their porTolios.2 Residen-al real estate This new regulatory wave, combined with the exis-ng bias for Infrastructure1 short-term assets, will create a financing gap for long-term and risky 2008 2030 assets, such as infrastructure and company equity, and non-listed SMEs. For instance, McKinsey es-mates that the annual equity gap INVESTMENT HORIZONS OF (between offer and demand) over the next ten years will reach $3.1 3 LONG-ONLY EQUITY trillion at the European level and $12.3 trillion at the global level. MANAGERS (2006-09) At the same -me, speculave ac-vi-es siphon assets away from Source: Mercer/IRRC 20106 investment ac-vi-es and cons-tute a permanent threat to the price formaon func-on of financial markets. High frequency trading (3 milliseconds) now represents 40% (Europe) to 60% (US) of equity 6 months 5 years trading. In commodity trading, speculators represent a 70% market 8 months 3 years share.4 The most troubling news however is that a majority of long- term asset managers currently adopt short investment horizons. This disconnects their strategy from the long-term objec-ves of their clients. It reduces the supply of capital for long-term 1 year investments and forces investees to focus their strategies on 5 2 years quarterly results. These issues will play an increasingly important role in determining the compe--veness of both countries and companies. They will 1,5 year require policy makers to create new regulaon that enables investors with long-term liabili-es – insurers, pension funds, mutual “Short-horizon investors can funds, etc. – to focus on long-term value creaon and drive help to improve the efficiency of the market, both from an household savings towards ‘investment’ rather than ‘trading’ arbitrage perspecve and also porTolios. A}er remaining under the radar for many years, this in terms of market liquidity (…). subject has recently been introduced onto the agenda: the The poten@al problems start European Commission is currently preparing a Green Paper on long- when long-only investors term financing. In France, a parliamentary commi~ee will be set up behave as short-horizon in 2013. In the UK, the Kay Review has recently called for a investors” Mercer/IRRC reshaping of equity market incen-ves in order to lengthen investment horizons.6 1. Eleccity, gas, water, transporta@on and 3 communica@on. 2. THE ENERGY TRANSITION: THE CAPITAL REALLOCATION CHALLENGE The transi-on to sustainable energy sources will be the key challenge of long-term financing. World governments are commi~ed to limi-ng global warming to +2°C over pre-industrial levels, the threshold the scien-fic community iden-fied in order to avoid large-scale climate change, and a -3% to -20% impact on global GDP. If this target is missed, the financing challenge related to adaptaon will be even greater. According to the Internaonal Energy Agency, the energy transi-on requires a massive shi} in investments, from fossil-fuel based sectors to clean technologies.7 For financial markets, this does not only mean financing addi-onal investment in transport infrastructure, low-carbon real estate, and clean technologies.