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VIEW FROM THE STREET

VIEW FROM THE STREET

Reallocating capital for the age of sustainability

Written by Andrew Cave, head of governance and sustainability at Baillie Gifford
13 October 2020

Normally at this time of year, governments are preparing to come together for the annual United Nations Climate Change Conference (or ‘COP’), now in its 26th year. This year’s event, which was to be held in Glasgow, should have been a pivotal moment in terms of galvanising action to address the looming climate catastrophe. However, with the world preoccupied by Covid-19 and escalating regional tensions, COP26 probably wouldn’t have been the breakthrough summit that many climate scientists now believe is urgently required.
 
With so much jargon to contend with, it can be hard to see the wood for the biomass in this area. In short, the 2015 ‘Paris Agreement’ hammered out at COP21 determined the collective goals that signatory nations are now focussing on: keeping global temperature rises this century to well below two degrees Celsius above pre-industrial levels. Subsequent COPs were meant to fill in the details on how this will be achieved in practice, by agreeing stretching national targets. This second stage hasn’t really happened to date, so the postponement of COP26 is highly regrettable although entirely understandable in the current circumstances.
 
However, there is consolation to be found outside the COP process, where much is now happening. Alarmed by the increasing incidence of extreme weather events, Europe is pushing ahead with an ambitious green deal. There is a new-found resolution among many national regulators to increase the requirements for companies, asset owners and asset managers alike to understand and report on climate transition risks to their business, through initiatives such as the internationally backed Task Force on Climate-related Financial Disclosures (TCFD). Forward looking corporations are setting ever more stretching targets to reduce or even negate the carbon intensity of their businesses. Most significantly of all, President Xi Jinping has recently set the goal for China (currently contributing 28% of global emissions) to become carbon neutral by 2060, with emissions to peak no later than 2030.
 
It is difficult to appreciate the scale of change required to present day economic activity for the world to be ‘Paris-aligned’ in the decades ahead. Early estimates suggest that Covid-19 lockdowns have led to an approximate seven per cent reduction in global carbon emissions. The International Panel on Climate Change (IPCC) believes we would need to achieve this same level of net carbon cuts every year for the next decade to have a chance of limiting warming to two degrees. China’s pledge to go carbon neutral by 2060 goes even further, as this can only be achieved by both a massive reduction in emissions and a programme of measures such as reforestation to remove (or, to use the jargon, sequester) an equivalent amount of atmospheric carbon emissions as the remaining footprint. Global carbon emissions have increased more than tenfold since 1900, and we now need to return to something like the order of Victorian-era emissions – preferably without undermining economic growth or living standards – if the metamorphism is to be politically feasible. This level of change is daunting, not least because it simply can’t come from incremental changes to our current business models and consumption patterns.
 
We have however been given something of a psychological and literal head start by Covid-19. This has highlighted the fragility of globalised capitalism: few could have predicted that large swathes of the economy would be on state life-support within months of the first cases of a new virus being detected in many high-income countries. Collective interest in addressing the systemic risks of climate change and ecological degradation has increased accordingly. The lockdowns have also accelerated a number of pre-existing structural trends, such as the shift to online retail and the growth of flexible and remote working and education, all of which has a potentially much lower carbon footprint than the alternatives. Importantly, 2020 has helped us to imagine some very different ways of living and working, with surveys showing a widely held determination to make more enduring changes to working patterns and lifestyles after Covid. Only the most dedicated collectors of airmiles could prefer routine business travel to video-conferencing, and the dramatic improvement in localised air quality during the lockdown has given many cities an enticing glimpse of what a future of tailpipe-emissions-free motoring might look like.
 
With the emerging political consensus on the appropriate transition goals, the good news is that there is an enormous opportunity in the years ahead for innovative and entrepreneurial businesses (and investors alike) to profit from decarbonising the economy and improving lives at the same time. When fuel was cheap and emissions untaxed, distance and ecological footprint became somewhat irrelevant. In many sectors, products are assembled from materials and parts that come from all over the world, driven only by pricing and logistical considerations. Shipping currently accounts for around three per cent (and growing) of global carbon emissions as well as significant localised pollution and other detrimental impacts on eco-systems, so figuring out how to ensure that growth doesn’t equate to ever increasing volumes of international freight is a big priority. Optimising supply chains for footprint as well as price will have a profound effect on current global trade flows.
 
An intriguing glimpse into the future of global design but regionalised manufacturing comes from Tesla. It is in the process of building out a regional manufacturing model, with a Shanghai factory already operational and a Berlin facility due to open soon. Unlike its competitors, these factories won’t make different products for regional markets, or cars for global export, but the very same models as their US factories. This is regionalised production in action and 3D printing and other manufacturing innovations will, in time, make it viable to produce many more products locally to a global design standard. Vertical farming under LED lighting will eventually reduce the need to fly and ship many agricultural products across the world, with all of the associated waste from perishability. When combined with renewable energy, rainwater harvesting and re-localised production could potentially offer the choice of fresh, high-quality fruits and vegetables for a fraction of the ecological footprint.
 
In other ways too, entire industries are ripe for disruption: fashion garments, for example, are produced on a speculative basis. Consumers then travel to brightly lit, temperature-controlled stores in the hope that they will find something appealing that will also fit. Much of the unsold inventory eventually goes on to landfill or is even burnt. An alternative reality where the latest fashions can be browsed from home and then manufactured on demand by a regional production facility in bespoke sizing for customers is not only appealing to many, but has the potential to enable a quantum leap in resource efficiency. The list of areas where we could make massive improvements in resource efficiency while actually improving human utility is almost endless. We currently heat or cool whole buildings to heat or cool people; ‘smart’ LED lighting has the potential to reduce energy bills by 90% for cities and householders alike; and virtual reality is set to transform the quality of long-distance communications and remote learning beyond recognition. The scope for artificial intelligence and sensor technology to improve resource efficiency in a vast range of applications is similarly vast. In the healthcare sector too, the combination of genetic sequencing, real-time patient data, and preventative medicine is also set to significantly improve health and wellbeing while simultaneously contributing to greater resource efficiency.

To supply the manufacturers of key transition technologies such as computing power, solar panels and batteries, we will very much need mining companies and we will actually need the scale and resources of international corporations more than ever, to focus on ecologically sensitive extraction and improved health and safety for workers. We will also need industrial hydrocarbons (and therefore the most responsibly run and efficient oil and gas companies) to manufacture a range of essential products for many decades to come. However, over time, we will no longer require most fossil fuels for transport or for heating or cooling.

Many younger consumers already prefer the convenience of the ‘shared economy’ to the cost and hassle of ownership. For this reason, transport-as-a-service will grow apace in the years ahead, from electric bikes through to autonomous taxi fleets. Innovative firms such as Michelin and Interface now lease, rather than sell, everything from tyres to carpet tiles, ensuring that firms are fully incentivised to focus on the circular economy themes of durability, reusability and recyclability, rather than just sales. What is not to like? There is no escaping the fact that there will be significant transition costs and turbulence. The risk is that this impact is most keenly felt by those who can least afford it, with an estimated 10% of UK households already living in fuel poverty. For many, it will also be hard to reconcile ourselves with the need to reduce absolute emissions from flying, although there will still be a role for the most carbon efficient conventional airlines in the near term. But even this will not be forever: electric aviation is rapidly becoming more viable for small passenger numbers over short distances, and in time this will also become the case for long-haul journeys.

Another area of predicted change that may not be universally welcomed is food production and consumption. At roughly 25% of global emissions, agriculture and forestry is the single largest contributor to global warming.  The rapid growth of interest in veganism is in part driven by spiralling interest in lower impact nutrition, and the market for meat free alternatives is booming. Beef and the soya that goes into livestock feeds together account for a large percentage of global deforestation. But even meat eating can become much more resource efficient with changes to production techniques. While 100% grass-fed burgers from low methane cattle breeds will not be an everyday purchase in the future, they will arrive on plates with a significantly reduced carbon footprint.  

With the long-term trajectory increasingly clear, Baillie Gifford’s portfolios are already well aligned with the opportunities arising from the low carbon transition, with themes such as battery storage, electrification, personalised healthcare, and products-as-a-service well represented in our holdings. We are also engaging with management teams to understand how they are addressing both the risks and opportunities arising from climate change. With almost all major economies now committed to radical decarbonisation, it is time to reallocate capital accordingly for the age of sustainability.  

Andrew Cave is the head of governance and sustainability at Baillie Gifford. 

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