7 August 2022

Asset managers need to figure out how to align membership of GFANZ with their fiduciary duty to clients

A short pre-amble

I believe that climate change exists, that it’s caused by humans, and that the Paris goal of limiting global warming as close as possible to 1.5°C strikes the right overall trade-off between risks and benefits for humanity. As I’ve written elsewhere, I’ve demonstrated my personal commitment to this goal by attempting to shift my own family’s carbon footprint a little bit left within the right tail of the global distribution of carbon footprints.

However, I’ve become increasingly convinced that voluntary attempts by the corporate sector to reduce emissions, while well-meaning, will largely be ineffective given the scale of challenge we face. Robust government action will be needed if we are to have any hope of containing global warming to acceptable levels. So far, so uncontroversial. But, worse than this, I’ve also become convinced that asset managers making claims that they are investing in line with GFANZ (Glasgow Financial Alliance for Net Zero) commitments are increasingly on a collision-course with their fiduciary duty to clients, which will be deeply problematic unless addressed in a timely way.

I’ve sat on this blog for a while, as the conclusions are uncomfortable for someone who wants to see more action on climate change not less. If I’ve missed something that undermines my arguments, please do point it out.

Summary

Governments, particularly in the rich world, show little appetite to do what is required to limit global warming to 1.5°C with no or limited overshoot. Yet this is the scenario to which GFANZ signatories are committed to aligning their investment and lending goals. Investing based on what is an increasingly unlikely scenario creates significant problems of fiduciary duty for asset managers, as it likely results in misallocation of their clients’ capital, with overinvestment in assets benefiting from a quicker transition and underinvestment in assets benefiting from a slower transition. This could have economically significant impacts for their clients.

In this article I look at a number of arguments asset managers could rely on in order to reconcile the worsening climate outlook with their commitments under GFANZ.

• Governments could accelerate action to hit 1.5°C with no or limited overshoot. But based on evidence to date, this seems more an article of faith than a view that is consistent with the prudent person rule.

• Climate is a systemic risk and mitigating it improves risk adjusted returns at the portfolio level. True, but the optimal trade-off for financial risk-adjusted returns is likely to be considerably higher warming than 1.5°C, as this target incorporated many factors that are inevitably ignored by financial markets, including just transition and non-financial aspects of our environment and lifestyle.

• Clients are interested in factors beyond financial returns, including the liveability of the planet. True, but collective action problems mean that clients don’t get to choose a clear trade-off between financial returns and climate outcomes. Moreover, the interests of rich world clients and beneficiaries are not necessarily aligned with the global interests taken into account in setting the 1.5°C goal.

• Governments around the world have signed up to the Paris agreement, which creates a democratic mandate for action. True, but governments are interpreting Paris in different ways and generally not as 1.5°C with no or limited overshoot. Moreover, fiduciary duty is owed to specific clients and beneficiaries not the electorate in general (unless the law is changed).

In summary, none of these arguments seems to resolve signatories’ emerging problems with fiduciary duty. The only fiduciary duty cover seems to be extremely clear and informed client mandates that support investment aligned with a 1.5°C scenario, regardless of the likely trajectory towards 2°C, and regardless of the costs of this approach for clients. It seems implausible that asset managers will be able to get this clarity for anything other than a minority of the assets they manage.

It should be said that GFANZ signatories have been clear that their commitments are contingent on government action to introduce policies consistent with the 1.5°C goal. These have not been forthcoming so arguably signatories are off the hook. This may be the reality, but creates a perception problem for the industry, as it suggests that the commitment wasn’t quite as radical as it was made out to be. It also leaves open the question of the status of the GFANZ commitments in these circumstances. Clients deserve clarity on these issues, whatever their views on the appropriate response to climate change.

GFANZ is a worthy initiative that has produced good work. But less than a year in, some of the difficulties for signatories are becoming clear. Given the looming, and apparently unavoidable, conflict with fiduciary duty, work needs to be done now to reframe GFANZ in a way that allows investors to support politically determined goals on climate while also authentically meeting the expectations of clients.  

I expand on these arguments in the remainder of this article.

The GFANZ commitments

GFANZ was announced with great fanfare at COP26 in Glasgow, and now boasts 450 members with $130 Trillion in assets under management.

The focus of this article is asset management, although the issues likely translate to other subsectors of the finance industry. Asset managers or owners who sign up to GFANZ join the NZAM (Net Zero Asset Managers initiative) subgroup, which, like GFANZ, is a formal partner of the UN’s Race to Zero campaign. I will refer to NZAM rather than GFANZ for the remainder of this article.

NZAM signatories need to agree to a number of commitments, the headline being:

“…my organisation commits to support the goal of net zero greenhouse gas (‘GHG’) emissions by 2050, in line with global efforts to limit warming to 1.5°C (‘net zero emissions by 2050 or sooner’). It also commits to support investing aligned with net zero emissions by 2050 or sooner.”

The asset manager then needs to agree to set a target for the portion of assets managed in line with net-zero goals, reviewed every five years and ratcheted up to 100% over time, including a target for 50% reduction in emissions by 2030 on the committed part of the portfolio. They need to ensure that products, engagement with clients and other players in the investment ecosystem, stewardship, and advocacy are aligned with the net zero goal.

Alignment with the UN’s Race to Zero adds further constraints. In a recent update, Race to Zero toughened requirements for accredited organisations. These now require members to produce a net zero plan within a year of joining, set clearer expectations on phase out of unabated fossil fuels, and require a positive advocacy stance on climate policy. In a final, but important detail, the pathway should be consistent with warming of at most 1.5-degrees with no or limited overshoot. According to the AR6 report of the International Panel on Climate Change (IPCC), this requires approximately a halving of global emissions by 2030. 

The fiduciary duty problem

The problem faced by NZAM signatories is that it is no longer likely that society globally will do what is required to limit global warming to 1.5-degrees with no or limited overshoot. The IPPC’s AR6 report lays out the maths quite clearly (my rounding for simplicity):

The IPPC report puts it starkly:

“Global GHG emissions in 2030 associated with the implementation of Nationally Determined Contributions (NDCs) announced prior to COP26 would make it likely that warming will exceed 1.5°C during the 21st century.”

We can hope for some strengthening of NDCs, but to limit warming to 1.5°C requires a dramatic change in policy, with 3x the emissions reduction by 2030 that is currently envisaged under existing NDCs. This equates to an annual reduction in global carbon emissions of 8.3% pa every year for the next eight years, starting now. By way of context, during the COVID-19 pandemic in 2020, emissions fell by just 6.4%.

You don’t need to be a climate scientist to recognise that limiting warming to 1.5°C with no or limited overshoot is no longer the most likely future scenario. The world seems more on track towards something around 2°C of warming or even a bit more. The difference in emissions implied over the next few decades is stark. In a 2°C scenario emissions are one-third higher in 2030 and twice as high in 2050 as compared with a 1.5°C scenario.

To highlight one specific consequence, the quantity of oil reserves that can be used by 2050 is around two-thirds higher in a 2°C than 1.5°C scenario. This is a big difference, so the assumed scenario will have a substantial impact on valuations of firms benefiting from continued use of fossil fuels and those benefiting from their replacement.

Therefore, investors who are allocating clients’ and beneficiaries’ money on the basis of a 1.5°C scenario with no or limited overshoot are investing on the basis of a scenario that is now both unlikely and economically significantly different from the most likely scenario. This will inevitably result in significant capital misallocation, overinvesting in companies that will benefit from a rapid transition, and underinvesting in companies that will benefit from a slower transition.

This seems to me to be a very significant problem for NZAM signatories. What are the potential solutions for asset managers facing the increasing inconsistency between their commitments and reality?

Rely on governments accelerating action

One possibility is for investors to take a bet that governments will accelerate action to limit warming to 1.5°C with no or limited overshoot. But while the 1.5°C aspiration has been part of the conversation since the Paris accord, it has been observed largely in the breech. The extra commitments required to keep “1.5 alive” were noticeably lacking even at COP26 and there is little sign of them emerging since.

For what it’s worth, my view is that the rich world governments have decided they can afford to adapt to 2°C warming, even as scientists warn of the resulting risk and unpredictability associated with every additional 0.1°C temperature rise. Politicians are not prepared to impose on their electorates the additional costs, or perhaps more importantly the short-term economic and lifestyle change and disruption, required to limit warming to 1.5°C. Rich world governments will have noticed that most economic models show the costs of allowing global warming to reach 2°C rather than 1.5°C predominantly fall on the poor nations of the world.

To those of us concerned about the social justice of climate change, this seems a moral travesty, particularly given the rich world’s culpability for the problem. But to those that doubt the rich world’s willingness to impose large economic and social costs elsewhere to avoid small costs to its own citizens I present a perfect recent case study: the woeful underfunding of COVAX during the COVID-19 pandemic.

So while it is possible to have an investment belief that governments will introduce policies to limit warming to 1.5°C, it seems clear that this would not meet the prudent person rule.

Rely on the systemic risk argument

A common argument in favour of investor action on climate change is that it is a systemic risk that affects the whole market. Runaway global warming will be damaging to the economy and to companies, leading to widespread stranded assets. Acting to limit this risk, even if it harms the prospects of individual heavy emitting companies, improves risk-adjusted returns at the portfolio level and therefore is in clients’ interests. This is the core argument of Jon Lukomnik and James P. Hawley’s book “Moving beyond modern portfolio theory”.  Note that this reconciles climate action and fiduciary duty at the portfolio level through an argument based on long-term financial self-interest. 

However, this argument falls down in two respects.

First is the collective action problem. I may act and invest to limit warming to 1.5°C, but other investors may not. We may all be worse off as warming increases to 2°C, but, because I have misallocated capital in the hope of a 1.5°C world, my clients are even worse off than others’. Even if all investors in publicly investible assets could be persuaded to act in concert, this still leaves state owned actors able to act rogue and undermine the overall goal. Without clear government regulation, unity of action even among non-state actors seems implausible. Fiduciary duty must surely take some view on the likelihood of a particular scenario coming about.

Second is the difference between global welfare maximisation and financial value maximisation. The target of limiting warming to 1.5°C quite rightly takes into account four important dimensions that are entirely ignored by financial markets. 

• All citizens of the world should be viewed as of equal value, and in particular action on global warming should reflect a just outcome across the geographies and regions of the world.

• Future generations should be given due consideration as compared with current generations, leading to low discount rates (higher current values) applied to future economic costs of climate change.

• Diminishing marginal utility of wealth means that the welfare impacts of climate change on poorer citizens, largely in the developing world, will be much greater than on citizens in the rich world, who are much more able to adapt.

• We care about quality of life beyond purely financial factors, and so have an interest in avoiding increased geriatric mortality from heatwaves, increased storm prevalence, need for mass migration and so on.

Financial markets are not designed to manage these moral and non-financial trade-offs. They intermediate between current and future consumption for existing investors and take account only of discounted cashflow implications of climate change. As a result they “care” much more about the rich world then poor countries, about current than future generations, are indifferent to the impacts on rich versus poor, and take no account of non-financial factors relating to our quality of life.

This is not a criticism of financial markets; it is what they have been set up to do, and very useful it is too. We shouldn’t expect a cat to behave like a dog. But an important result of this is that the value-maximising level of global warming for financial markets, dominated as they are by the rich world, is very unlikely to be as low as 1.5°C. So while it is certainly true that at some point it is in the self-interest of a purely financial investor to act to limit global warming, there is no reason to think that this will align with 1.5°C with no or limited overshoot, and indeed every reason to think that it would result in a much higher equilibrium level of warming.

So the systemic risk argument does not come to the rescue of NZAM signatories.

Rely on a broader view of fiduciary duty

A common response to the type of view I’ve espoused here, especially in Europe, is that I’ve got it all wrong and, on the contrary, it is absolutely an investor’s fiduciary duty to do all they can to pursue a 1.5°C scenario, because their clients care about the state of the world they and their children will live in, not just money.

This is almost certainly true. Financial market valuations miss all sorts of factors that are important to us as humans. My portfolio value in July 2020 was identical to a year earlier, but life was much less pleasant due to the emergence of COVID-19 and all that meant. But financial markets didn’t care so much as at the time it appeared that the economy and performance of many firms was remarkably resilient to the major (and largely negative) changes to our lives brought about by the pandemic.

But even here we come up against two problems we found with the systemic risk argument.

First is the collective action problem. I might trade off money for a more liveable world, if that were an option. But this isn’t the choice available. The chance of my investment choices affecting the real-world outcome is limited. And if the world does warm to 2°C rather than 1.5°C, while I might not be happy about that, I would still, all else equal, like to have more rather than less money in that scenario. It might help me adapt better to a less pleasant world. Given the low probability of collective action without regulation, investors investing towards limiting global warming to 1.5°C will only achieve a fraction of that goal, but will incur the full costs in terms of lower returns. This does not meet the investor’s fiduciary duty to their clients.

Second is the regional problem. Most investors, and certainly on a $-weighted basis, live in the rich world. The trade-off between lifestyle and global warming for them, with their inherent geographical advantages and greater adaptation ability, is very different from the global trade-off implied in the Paris accord. Even if liveability is taken into account as a factor, notwithstanding the difficulties highlighted just now, it is far from clear that the optimum point for a self-interested rich country investor is to invest towards 1.5°C. This is reflected in the difficulty of getting political support in rich countries for the level of action really required to meet this goal.

Rely on the democratic mandate

Governments around the world have signed up to the Paris accord and some, including in the UK, have implemented regulation to implement it. Could an investor therefore rely on this general democratic mandate to invest in line with 1.5°C with no or limited overshoot?

This seems difficult to sustain for three reasons.

• First, the Paris agreement itself does not explicitly commit governments to the Race to Zero goal of 1.5°C with no or limited overshoot. It is unfortunately much vaguer than that.

• Second, the vigour with which national governments are implementing the agreement suggests a varied level of political support for it around the world.

• Third, majority acceptance for the agreement does not imply support for it amongst any given group of an asset manager’s clients or asset owner’s beneficiaries.

Therefore, while the democratic context of net zero commitments is relevant, it is not sufficient to justify an investment approach that may be to clients’ financial disadvantage.

Rely on the client mandate

It is quite possible that some investors would like to invest towards 1.5°C even if it is highly likely that warming will be closer to 2°C and even if, as a result, their risk-adjusted returns are lower than if they had taken a more realistic view of the future scenario. They may wish to know that “they did all they could”.

This is a perfectly legitimate position, but requires a very clear mandate, including recognition of the possible costs. It would be dangerous to assume that this is a common position. For example, there is evidence to suggest that while changes in Morningstar sustainability “Globe” ratings do drive fund flows, they do so less than changes in performance “Star” ratings, suggesting that for the market as a whole performance trumps sustainability. 

I would also argue that if an investor relies on such a clear client “climate” mandate to ensure they are meeting their fiduciary duty, then they would be well-advised to highlight the potential costs to the client. It is commonly said that clients are prepared to pay for more sustainable investment outcomes. But the extent to which this is true is mixed:

• There is some evidence that investors in impact venture capital funds are willing to accept returns around 3% pa lower than on conventional funds.

• Experiments on experienced investors in more conventional investments suggest that they may be prepared to sacrifice a little over 1% pa of return for a more sustainable fund.

This mixed evidence suggests that asset managers need clear articulation of the investment proposition to ensure that any consent is informed. Most client mandates or fund documentation do not currently achieve this.

Clear mandates are clearly one route through the fiduciary duty problem for investors. However, the NZAM commitments require the proportion of assets covered by the commitment to be ratcheted up until it reaches 100% of assets under management. It seems unlikely that asset managers will succeed in convincing all of their clients of the need to invest towards 1.5°C, if this looks an unlikely scenario.

Rely on the small print

The NZAM commitment contains some important qualifiers at the end, which were doubtless necessary to get the commitments through firms’ compliance departments (my emphasis):

“We also acknowledge that the scope for asset managers to invest for net zero and to meet the commitments set forth above depends on the mandates agreed with clients and clients’ and managers’ regulatory environments. These commitments are made in the expectation that governments will follow through on their own commitments to ensure the objectives of the Paris Agreement are met, including increasing the ambition of their Nationally Determined Contributions, and in the context of our legal duties to clients and unless otherwise prohibited by applicable law.” 

Perhaps anticipating the looming fiduciary duty problem, the latest GFANZ documentation seems to be making the print a bit a bit bigger. The latest suite of publications makes multiple reference to the need for “clear policy signals from governments”.

NZAM members could legitimately say that, even since COP26, there has been backsliding, in response to priorities of COVID-19 recovery and Russia’s invasion of Ukraine. Governments around the world are clearly not sending clear signals to align with a scenario of 1.5°C with no or limited overshoot. Even where action and regulation is relatively advanced, such as in the EU and the UK, the pace of change and extent of implementation falls far short of what would be required for this scenario to be achieved.

This will prove politically difficult for NZAM members less than a year after the fanfare of COP26. It would also call into question the value of the commitment. If all that NZAM members were committing to was to invest in line with economic incentives on climate set by government, then this is rather weaker than how it was presented to the world at the time.

Moreover, if NZAM members want to exercise this opt-out, it needs to be done transparently. As well as having regard to investors who may be concerned about the impact on their returns of investing towards a scenario that is now looking unlikely, they also need to have regard to investors who are taking at face value the commitments made as part of their asset manager selection process.

Transparency in the way forward is key, as the industry cannot afford to be accused of not really meaning what it says.

Where next for NZAM?

I cannot avoid the conclusion that NZAM signatories are facing a looming conflict between the commitments they have made and their fiduciary duty to clients. Given the short window over which the 1.5°C Paris aspiration may become unachievable, this conflict is becoming very real very fast.

To date, NZAM has been protected by the lack of specificity about what the NZAM commitments really mean: the timing; the definition of a net-zero plan; how to define portfolio decarbonisation. To date, members have been able to make general exhortations on climate change, demand better disclosure, engage with heavy emitters on their net zero plans, and make some relatively uncontentious calls at the margin on coal financing.

But this ambiguity cannot last. Race to Zero is ratcheting up the pressure. GFANZ’s own workstreams are filling out the detail. The problematic conflict between NZAM commitments and fiduciary duty will become all too real in investment choices before too long.

Mandates are a way through, if they are clear about the potential trade-off between investing towards 1.5°C and risk-adjusted returns. But they will never be the entire solution, as not all clients will agree to these terms.  

Some will argue that this doesn’t matter. That we face a crisis and that asset managers must “do all they can” in the fight against climate change. To admit that 1.5°C is no longer likely is defeatist and will become a self-fulfilling prophesy.

Emotionally I agree with that. But then my head reminds me that asset managers are using other people’s money to take that action. Is it right to that without consent? Concepts of fiduciary duty are an important underpinning of property rights in our democracy and trust in our financial system. If we play fast and loose with them, we open the door to an inevitable reaction. But more than that, it is unrealistic to think that investors will ultimately contravene their legal obligations in the push for net zero. So the initiative will yield less than is expected of it. This should inform the resources and attention we devote to the NZAM initiative and also inform where we ask it to focus .

Is NZAM dead? No, but it’s seriously wounded, even if this is not yet widely recognised. Let’s do the work now to reframe its objectives to align with what can realistically be expected of the investment industry given its role in the economy. And let’s press governments to do their job properly, rather than seeking to pass the buck to others. Then the investment industry can support politically determined goals on climate while also authentically meeting the expectations of clients.

What that reframing might look like will be the subject of a further article.