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Climate solutions: working back from 2050’s low-carbon economy.

Helen Xiong, Investment Manager Caroline Cook, Head of Climate Change

Key points

  • It’s useful to imagine a net zero world and ask what made it possible
  • This technique can help investors identify long-term opportunities
  • We need companies to create game-changing solutions to global warming, and risk-based metrics can be a distraction

Edinburgh’s Newhaven district is a fitting place to discuss climate change. Historically it was famous as a landing point for oysters, which grew in abundance in the Firth of Forth.

Their shells absorbed and permanently locked away carbon from the water and atmosphere before industrial developments and overfishing wiped them out.

These days the harbour is home to only a few dozen fishing boats moored close to an upmarket restaurant. But the estuary may deliver another blow to the area.

Two members of a US think tank recently published a study in Nature predicting that rising sea levels caused by global warming could threaten 150 million people’s homes globally by 2050. They accompanied it with an interactive map that forecasts Newhaven’s shoreline will be among locations below annual flood levels by that date.

Whether or not human interventions keep the area safe, it helped focus minds when Baillie Gifford’s Head of Climate Change, Caroline Cook met investment manager Helen Xiong by the water in February.

Helen:

Caroline, you used to be an oil and gas analyst. How did you make the journey from that to Head of Climate?

Caroline:

I suppose I do come to it with a bit of the convert’s zeal – I believe we can solve this.

My pivotal moment happened during the beginning of the oil sands boom in the early 2000s when I went to see a project in Canada. It was the first time it hit home that the sector I’d covered since 1990, had studied as a historian for longer, and which had underpinned so much economic progress, was unsustainable.

We flew in over forests to what was effectively an open-cast oil mine. These things are vast – 40 to 60km across in the middle of the wilderness. I challenge you to use Google Earth to spot another man-made mine from space.

A lot of the analyst chat was about the mega-trucks, but all I could think was that this wasn’t going to be acceptable or scalable. If this was what it took to feed the world’s oil demand, we’d find another path.

I came away thinking two things would follow: first energy prices would rise, and then we would innovate.

We’re still in that cycle. Society’s rejection of Russian supply has caused the latest spike in fossil prices. But it also reinforces the preferential direction – to cheaper, more reliable, low-carbon alternatives.

My background isn’t in geophysics or engineering. As I said, I’m a historian. I also grew up in oil-boom Shetland in the 1970s. These experiences gave me a strong sense of transition and an appreciation that it’s better to be on the leading edge than to wait for the cliff edge.

And I can still see that in Shetland today. Just as it took a chance with oil, now it’s looking to offshore wind and hydrogen and using its farms as carbon sinks. I think the biggest threat to a ‘just transition’ is the delay tactics of incumbents, not the new ideas.

Helen:

For those of us who are earlier on our climate journeys, this feels like being a very dynamic, difficult and overwhelming area to get to grips with. How do we begin to understand how the future might unfold?

Caroline:

The key is to avoid thinking about small incremental steps but instead to think about replacing the energy system’s entire underlying base.

There’s a parallel with the Industrial Revolution in the late 18th century. Fossil-fuel steam power triggered all sorts of surrounding advances in engineering and transport, and it affected how we live and behave.

Now there’s another industrial revolution: we’re going from 80 per cent fossil fuel use to hopefully 100 per cent renewables. This time the extras are computing, digital and artificial intelligence [AI].

The resulting deep transformation could take us from a centralised to decentralised economy, and from extractive to circular industries. Perhaps it will also provide greater resilience.

The key is to imagine yourself in the year 2050 asking: What does a low-carbon economy look like? What is successful within it? What made it happen?

When you look at it that way, you see it’s not just about technologies. It’s also about behaviours. It’s about the way we do things. It’s about our values.

From an investment perspective, that opens your eyes to a huge range of opportunities.

It’s not just about batteries and wind turbines, it’s also about new ways of living and the new things we might be able to do with our time. As investors, that means the theme of climate becomes important to all companies – not just the big emitters.

Helen:

I like the idea of going to the end state and working backwards to see what needs to be done. When you do that, are we as a society and an industry doing enough?

Caroline:

No. Patently we’re not.

There is some good news: governments of countries responsible for about 90 per cent of global GDP are committed to limiting global warming to 1.5C above pre-industrial levels.

And at the COP26 UN Climate Change Conference, diplomats referred to a ‘climate crisis’, rather than more cuddly phrases like ‘global warming’. Language is how we share values. So that change represents a fundamental shift.

That’s the good part. But there’s a huge gap between aspiring to reach net zero greenhouse gas emissions by 2050 and taking the hard steps necessary to halve emissions over the next decade.

The critical thing is to avoid jumping from climate change denial to despair. Neither response is helpful. If we deny it, we don’t need to take responsibility because it’s not happening. If we despair, it’s too big, and we can’t solve it.

We can take some responsibility here as individuals in terms of what we buy, our behaviours, what we learn and how we share thoughts with others.

It’s also important not to get side-tracked. Coming from the fossil fuel sector, I know a whole industry is trying to distract us.

The sector loves it when we feel bad about taking cheap flights because focusing on that stops us from demanding policy changes and the tilts to the playing field that would remove their privileges and make innovations possible. So, as individuals, we can do more by learning and staying on track.

Regarding those of us in the finance sector, there’s still too much inconsistency in approach. We’ve got to move away from box-ticking and risk-based disclosures to think about system-wide changes.

As an industry, we need to do more to embed climate-related analysis in our investment work. We need to ask: how do we allocate capital to release the innovation that’s going to give us the solutions to all of this?

Helen:

You say, and I agree, that the financial industry’s response has not been fit for purpose. On the positive side, there has been an increased focus on disclosure and reporting, which brings climate to the top of the agenda for many companies.

But the response is still too centred on risk rather than opportunity and quantitative rather than qualitative analysis. Can you point to specific examples?

Caroline:

There are lots – one is so-called implied temperature scores. These are supposed to be indicators of the future temperature rise that any company’s particular activities might generate if the whole world was on the same path. The answers have an alluring simplicity, which makes them popular shorthand.

The major rating agency we use has great people working on deeply complex models. But they’re still not complex enough and are built on a layer of estimation.

Beyond Meat, whose very core is about accelerating the energy transition by replacing high-emission beef, is apparently a greater-than-3-degrees-company. Shell, which continues to invest in growing fossil fuel production, apparently ranks at less-than-3-degrees.

If they can’t even get these tall poppies right, they’re not going to get more complex examples right. That matters because we can’t waste time on bad capital allocation. And this kind of risk focus is a major distraction for the actual companies. 

Helen:

What do you think the mainstream fails to understand about how things are changing?

Caroline:

We’ve not fully taken on board the favourable characteristics of some of the new stuff relative to the old.

For example, the other day I watched a video of somebody driving a Land Rover Defender retrofitted with a Tesla Model S battery. The guy was laughing. The acceleration was fantastic, it did everything you need to do at low torque, and it wasn’t noisy. That’s a low-carbon superpower.

NIBE’s home heat pumps, which take energy from the environment, are another example. Using the same amount of electricity, they can produce four times the heat output you would get from an electric heater. Build those on top of local renewables, and you’ve got energy efficiency and energy security in one package. These are new technologies that can be lower cost and offer a better service.

The other thing the mainstream misses is that consumers are interested in this. The pace of adoption could be a lot quicker than we anticipate.

And this is dangerous to say, but perhaps the market overstates the risk of stranded asset value loss.

Stranded assets are things that have no value because we don’t need them anymore. The fossil fuel economy is built on oil wells, refineries and coal-fired power stations. Analysts ask: “What if we suddenly lose all this value? Is it going to cause a catastrophic meltdown in the financial system?”

But a lot of that’s already happened. When I started covering the oil and gas sector in the early 90s, it accounted for perhaps 10 per cent of the market. More recently, absent the geopolitical spike delivered by Russia, it’s settled back to 2 to 3 per cent.

Consultants at McKinsey have just attempted another quantification of this. They calculated the amount of capital invested in fossil fuel power stations globally is $2tn.

That’s a lot of money, but it’s less than Apple’s worth. Would we be massively upset if Apple disappeared tomorrow? Probably not.

Helen:

I might be a bit upset if Apple disappeared tomorrow…

Caroline:

So would I, but I think we could more than cope.

The critical thing is to move from a risk-frame perspective to an opportunity one. To think less about how a company is going to be affected by climate change and more about how this company can affect the climate.

Similarly, you can shift from seeing this as everybody’s problem to it being everybody’s opportunity to find climate solutions.

Helen:

You mention climate solutions. It’s a term that a lot of people throw around, but it’s not very well-defined. What do you think about climate solutions?

Caroline:

The key is to keep your idea of a climate solution broad. If you define it too narrowly you risk imposing artificial constraints on where capital should flow to.

We’ve started to think in terms of two buckets:

You have clear solutions providers – they are often quite narrow, purpose-driven companies. Innovators. Electric vehicle [EV] and battery makers. A firm revolutionising what we eat. A wind farm builder. So Tesla, Beyond Meat, Ørsted. Another we’re talking to is trying to strip back energy-hungry redundant web traffic.

The other group of companies can be called solutions accelerators. They enable change by supporting and buying new low-carbon alternatives – and they encourage us to buy them as well. They show real climate leadership. Any company from cement to food to Netflix could be in this bucket.

This is important, because, directly applied, those corporate and consumer budgets massively outweigh the capital brought by the finance sector itself.

Helen:

I guess there is a mismatch between the current sources of emissions and the potential sources of mitigation.

In some ways that reflects the difference between a risk-based approach, where you think about how to reduce the emissions of a certain company, and an opportunities-based approach, where everyone is thinking about how this company can help reduce or mitigate the wider economy’s emissions.

Can you talk about the concept of avoided emissions and whether they are a good way to quantify impact?

Caroline:

This is about how we move from thinking about linear emissions reduction to exponential low-carbon growth. It’s not just about how I chip away at coal-fired power with solar panels, but how I imagine the potentially explosive growth of entirely new low-carbon solutions.

If we’re capital constrained, we need to allocate to the biggest impacts. Some of these will be tangible – like those solar panels. Some will be intangible, like cost-free changes to our behaviours and values, and others completely new – like carbon removal.

So this problem is about how we capture the potential for impact when current data – which is all emissions-based, static and current – doesn’t capture how things could change.

Avoided emissions help address this. For example, by driving an EV you are not emitting from a combustion engine.

If you go for a vegan diet that results in a more regenerative use of land, then you avoid all the gases that would have come from the beef and dairy industries. If people have better access to education, they make more informed, longer-term choices. That is a ‘climate solution’.

Some of these activities are likely to be much more outlier and significant in their impact than others. This is very close to the way that we often think about investments.

If you think about a new company coming to market, you ask: “What’s the total addressable market in 10 or 20 years? What’s the opportunity that this company is addressing?” We estimate that in monetary terms. Well, we should be just as imaginative when we think about the impact from an emissions perspective.

Helen:

Especially for markets that don’t yet exist.

Caroline:

Exactly. It’s not something that you can pin down and express precisely on a spreadsheet. It’s much more qualitative. It’s a judgement.

To give you an everyday example, Ocado is, in part, a supermarket home-delivery company. There are various mechanisms for it to avoid emissions. It can buy electric vehicles and have renewably powered warehouses, which are also much more efficient than supermarkets where customers open and close all the freezer doors.

Those are quantifiable improvements. But they’re small compared to the system-wide impact Ocado could have by encouraging us to eat a lower-carbon diet. That’s harder for me to put into a spreadsheet. But it might be much more impactful and ultimately more important for Ocado itself if it becomes the market leader in encouraging consumers to take up that alternative diet.

Helen:

I think the point about not all emissions being equal is important. If we believe the Earth can only handle a certain amount more warming before the consequences become devastating, then we’re all under a carbon budget, so to speak.

We need to discuss which sources of emissions are important and unavoidable and which we need to be much more aggressive in cutting back on. I feel like, as a society, we haven’t had those types of conversations yet.

To wrap up, what’s Baillie Gifford doing to address this crisis? What can we all do to help with the energy transition?

Caroline:

Exactly: what can we all do. It’s like when we look at companies, each can do something, but the ‘what’ and ‘how’ might be different. We all have different levers we can pull.

This might not be popular in all quarters, but we must support governments to make policy. As investors, as companies and as individuals with votes. After 200 years, the regulatory playing field is tilted towards a disposable fossil economy. We need it to support the characteristics of a renewable system.

To give one example, a lot of good renewable technologies have relatively high upfront costs and then deliver their benefits over their lifetime, whereas the fossil fuel system is characterised by being relatively cheap to begin with, but we pay for it dearly every day. So that’s a very different shape of financial return.

Many natural world resources which we have used for free – from freshwater to bees – are becoming scarce. Maybe they need to be brought inside our economic system. This isn’t about the government trying to pick winners, it’s about setting an overall direction.

In my day job, we’re actively doing some things to address this, but there’s more I’d like to encourage. Companies need to make long-term investments in game-changing solutions. We need to be supportive shareholders, engaging with their managers to encourage them to provide the capital and research required.

We also need to speak up to policymakers and our own sector. I hope Ballie Gifford’s membership of the Net Zero Asset Managers initiative serves as one way to hold us to account to be ambitious and to share that ambition more widely.

We need to think about how to route capital beyond our traditional remit, where its impact could be most significant. We’ve built a Private Companies Team to invest primary capital. Could we do more in the developing world?

The land system is a huge part of the net zero solution, but it’s quite absent from conventional financial markets. Can we be part of that change?

No one has all the answers. But Baillie Gifford can come up with new ideas. So in addition to targets for our own emissions reduction, we need to make sure we’ve got educated and aware colleagues who feel empowered to speak up and act.

Tackling climate change will involve us all.

 

Thanks to the Loch Fyne Restaurant and Bar, Newhaven Harbour, Edinburgh for allowing us to use their premises.

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Authors

Helen Xiong

Investment Manager

Helen joined Baillie Gifford in 2008, is a member of the Global Alpha Team and will become a decision maker on the 1st May 2021. Helen became a Partner in 2020 and has also spent time working on our Developed Asia, UK, North America, Emerging Markets and Global Equity Teams. Before coming to live and work in the UK, Helen lived in China, South Africa and Norway. She graduated BSc (Hons) in Economics from the University of Warwick in 2007 and MPhil in Economics from the University of Cambridge the following year.

Caroline Cook

Head of Climate Change

Caroline joined Baillie Gifford in January 2020 and became a member of the Global Stewardship Portfolio Construction Group in June. An experienced investment analyst, she is now one of the Strategy’s governance and sustainability specialists. Her background is in energy, both as co-head of Deutsche Bank’s number one rated global and European oils equity research team and as an independent consultant. Immersed in a variety of G&S issues across her career, the formal switch began in 2016, when she initiated and led Deutsche Bank’s integrated, cross-sector coverage of the accelerating energy transition. Caroline graduated from Cambridge with an MA in Modern History in 1989.

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