Climate change is the major environmental challenge facing nations today, and it is increasingly viewed as one of the central issues in international relations. Yet governments have used a flawed architecture in their attempts to forge treaties to counter it. The key agreements, the 1997 Kyoto Protocol and the 2015 Paris climate accord, have relied on voluntary arrangements, which induce free-riding that undermines any agreement.
States need to reconceptualize climate agreements and replace the current flawed model with an alternative that has a different incentive structure—what I would call the “Climate Club.” Nations can overcome the syndrome of free-riding in international climate agreements if they adopt the club model and include penalties for nations that do not participate. Otherwise, the global effort to curb climate change is sure to fail.
In December 2019, the 25th Conference of the Parties (COP25) of the UN Framework Convention on Climate Change (UNFCCC) met in Madrid, Spain. As most independent observers concluded, there was a total disconnect between the need for sharp emission reductions and the outcomes of the deliberations. COP25 followed COP24, which followed COP23, which followed COP22, all the way back to COP1—a series of multilateral negotiations that produced the failed Kyoto Protocol and the wobbly Paris accord. At the end of this long string of conferences, the world in 2020 is no further along than it was after COP1, in 1995: there is no binding international agreement on climate change.
When an athletic team loses 25 games in a row, it is time for a new coach. After a long string of failed climate meetings, similarly, the old design for climate agreements should be scrapped in favor of a new one that can fix its mistakes.
THE PRISONER’S DILEMMA OF CLIMATE CHANGE
Concepts from game theory elucidate different kinds of international conflicts and the potential for international agreements. A first and easy class of agreements are those that are universally beneficial and have strong incentives for parties to participate. Examples include coordination agreements, such as the 1912 accord to coordinate the world measurements of time and, more recently, the agreement to use “aviation English” for civil aviation, which coordinates communications to prevent collisions during air travel. A second class of agreements, of medium difficulty, rely on reciprocity, a central example being treaties on international trade.
A third class of international agreements confront hard problems—those involving global public goods. These are goods whose impacts are indivisibly spread around the entire globe. Public goods do not represent a new phenomenon. But they are becoming more critical in today’s world because of rapid technological change and the astounding decline in transportation and communication costs. The quick spread of COVID-19 is a grim reminder of how global forces respect no boundaries and of the perils of ignoring global problems until they threaten to overwhelm countries that refuse to prepare and cooperate.
Agreements on global public goods are hard because individual countries have an incentive to defect, producing noncooperative, beggar-thy-neighbor outcomes. In doing so, they are pursuing their national interests rather than cooperating on plans that are globally beneficial—and beneficial to the individual countries that participate. Many of the thorniest global issues—interstate armed conflict, nuclear proliferation, the law of the sea, and, increasingly, cyberwarfare—have the structure of a prisoner’s dilemma. The prisoner’s dilemma occurs in a strategic situation in which the actors have incentives to make themselves better off at the expense of other parties. The result is that all parties are worse off. (The studies of Columbia’s Scott Barrett on international environmental agreements lay out the theory and history in an exemplary way.)
International climate treaties, which attempt to address hard problems, fall into the third class, and they have largely failed to meet their objectives. There are many reasons for this failure. Since they are directed at a hard problem, international climate agreements start with an incentive structure that has proved intrinsically difficult to make work. They have also been undermined by myopic or venal leaders who have no interest in long-term global issues and refuse to take the problem seriously. Further obstacles are the scale, difficulty, and cost of slowing climate change.
But in addition to facing the intrinsic difficulty of solving the hard problem of climate change, international climate agreements have been based on a flawed model of how they should be structured. The central flaw has been to overlook the incentive structure. Because countries do not realistically appreciate that the challenge of global warming presents a prisoner’s dilemma, they have negotiated agreements that are voluntary and promote free-riding—and are thus sure to fail.
MORE KNOWLEDGE, NO PROGRESS
The risks of climate change were recognized in the UNFCCC, which was ratified in 1994. The UNFCCC declared that the “ultimate objective” of climate policy is “to achieve . . . stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system.”
The first step in implementing the UNFCCC was taken in the Kyoto Protocol in 1997. Kyoto’s most important innovation was an international cap-and-trade system for emissions. Each country’s greenhouse gas emissions were limited under the protocol (the cap). But countries could buy or sell their emission rights to other countries depending on their circumstances (the trade). The idea was that the system would create a market in emissions, which would give countries, companies, and governments strong incentives to reduce their emissions at the lowest possible cost.
The Kyoto Protocol died a quiet death, mourned by few.
The Kyoto Protocol was an ambitious attempt to construct an international architecture to harmonize the policies of different countries. Because it was voluntary, however, the United States and Canada withdrew without consequences, and no new countries signed on. As a result, there was a sharp reduction in its coverage of emissions. It died a quiet death, mourned by few, on December 31, 2012—a club that no country cared to join.
The Kyoto Protocol was followed by the Paris accord of 2015. This agreement was aimed at “holding the increase in the global average temperature to well below 2°C above pre-industrial levels.” The Paris agreement requires all countries to make their best efforts through “nationally determined contributions.” For example, China announced that it would reduce its carbon intensity (that is, its carbon dioxide emissions per unit of GDP), and other countries announced absolute reductions in emissions. The United States, under the Trump administration, declared that it would withdraw from the agreement.
Even before the United States withdrew, it was clear that the national targets in the Paris accord were inconsistent with the two-degree temperature target. The accord has two major structural defects:
it is uncoordinated, and
it is voluntary.
It is uncoordinated in the sense that its policies, if undertaken, would not limit climate change to the target of two degrees. And it is voluntary because there are no penalties if countries withdraw or fail to meet their commitments.
Studies of past trends, as well as the likely ineffectiveness of the commitments in the Paris accord, point to a grim reality. Global emissions would need to decline by about three percent annually in the coming years for the world to limit warming to the two-degree target. Actual emissions have grown by about two percent annually over the last two decades. Modeling studies indicate that even if the Paris commitments are met, the global temperature will almost certainly exceed the two-degree target later in the twenty-first century.
The bottom line is that climate policy has not progressed over the last three decades. The dangers of global warming are much better understood, but nations have not adopted effective policies to slow the coming peril.
FREE RIDERS
Why are agreements on global public goods so elusive? After all, nations have succeeded in forging effective policies for national public goods, such as clean air, public health, and water quality. Why have landmark agreements such as the Kyoto Protocol and the Paris accord failed to make a dent in emission trends?
The reason is free-riding, spurred by the tendency for countries to pursue their national interests. Free-riding occurs when a party receives the benefits of a public good without contributing to the costs. In the case of international climate change policy, countries have an incentive to rely on the emission reductions of others without making costly domestic reductions themselves.
Focusing on national welfare is appropriate when impacts do not spill over national borders. In such cases, countries are well governed if they put their citizens’ well-being first rather than promoting narrow interests such as through protectionist tariffs or lax environmental regulations. However, when tackling global problems, nationalist or noncooperative policies that focus solely on the home country at the expense of other countries—beggar-thy-neighbor policies—are counterproductive.
Free-riding lies at the heart of the failure to deal with climate change.
Many global issues induce cooperation by their very nature. Like players on athletic teams, countries can accomplish more when acting together than when going their separate ways. The most prominent examples of positive-sum cooperation are the treaties and alliances that have led to a sharp decline in battle deaths in recent years. Another important case is the emergence of low-tariff regimes in most countries. By reducing barriers to trade, all nations have seen an improvement in their living standards.
However, alongside the successes lie a string of failures on the global stage. Nations have failed to stop nuclear proliferation,overfishing in the oceans, littering in space, and transnational cybercrime. Many of these failures reflect the syndrome of free-riding. When there are international efforts to resolve a global problem, some nations inevitably contribute very little. For example, NATO is committed to defending its members against attacks. The parties to the alliance agreed to share the costs. In practice, however, the burden sharing is not equal: the United States accounted for 70 percent of the total defense spending by NATO members in 2018. Many other NATO members spend only a tiny fraction of their GDPs on defense, Luxembourg being the extreme case, at just 0.5 percent. Countries that do not fully participate in a multiparty agreement on public goods get a free ride on the costly investments of other countries.
Free-riding is a major hurdle to addressing global externalities, and it lies at the heart of the failure to deal with climate change. Consider a voluntary agreement, such as the Kyoto Protocol or the Paris accord. No single country has an incentive to cut its emissions sharply. Suppose that when Country A spends $100 on abatement, global damages decline by $200 but Country A might get only $20 worth of the benefits: its national cost-benefit analysis would lead it not to undertake the abatement. Hence, nations have a strong incentive not to participate in such agreements. If they do participate, there is a further incentive to understate their emissions or to miss ambitious objectives. The outcome is a noncooperative free-riding equilibrium, in which few countries undertake strong climate change policies—a situation that closely resembles the current international policy environment.
When it comes to climate change policies today, nations speak loudly but carry no stick at all.
MEMBERSHIP BENEFITS
In light of the failure of past agreements, it is easy to conclude that international cooperation on climate change is doomed to fail. This is the wrong conclusion. Past climate treaties have failed because of poor architecture. The key to an effective climate treaty is to change the architecture, from a voluntary agreement to one with strong incentives to participate.
Successful international agreements function as a kind of club of nations. Although most people belong to clubs, they seldom consider their structure. A club is a voluntary group deriving mutual benefits from sharing the costs of producing a shared good or service. The gains from a successful club are sufficiently large that members will pay dues and adhere to club rules to get the benefits of membership.
The principal conditions for a successful club include that there is a public-good-type resource that can be shared (whether the benefits from a military alliance or the enjoyment of low-cost goods from around the world); that the cooperative arrangement, including the costs or dues, is beneficial for each of the members; that nonmembers can be excluded or penalized at relatively low cost to members; and that the membership is stable in the sense that no one wants to leave.
Successful international agreements function as a kind of club of nations.
Nations can overcome the syndrome of free-riding in international climate agreements if they adopt the club model rather than the Kyoto-Paris model. How could the Climate Club work? There are two key features of the Climate Club that would distinguish it from previous efforts. The first is that participating countries would agree to undertake harmonized emission reductions designed to meet a climate objective (such as a two-degree temperature limit). The second and critical difference is that nations that do not participate or do not meet their obligations would incur penalties.
Start with the rules for membership. Early climate treaties involved quantitative restrictions, such as emission limits. A more fruitful rule, in line with modern environmental thinking, would focus on a carbon price, a price attached to emissions of carbon dioxide and other greenhouse gases. More precisely, countries would agree on an international target carbon price, which would be the focal provision of the agreement. For example, countries might agree that each will implement policies that produce a minimum domestic carbon price of $50 per metric ton of carbon dioxide. That target price might apply to 2020 and rise over time at, say, three percent per year in real terms. (The World Bank estimates that the global average carbon price today is about $2 per ton of carbon dioxide.)
Why would carbon prices be a better coordinating device than the quantity of emissions? One important reason is that an efficient path for limiting warming would involve equating the incremental (marginal) costs of reductions in all countries and all sectors. This would be accomplished by having equal carbon prices everywhere. A second and equally powerful reason involves bargaining strategy, a point emphasized in the writings of the economist Martin Weitzman. When countries bargain about the target price, this simplifies the negotiations, making them about a single number: dollars per ton. When the bargaining is about each country’s emission limit, this is a hopeless matter, because countries want low limits for others and high limits for themselves. A bargain about emission limits is likely to end up with no limits at all.
A treaty focusing on an international target carbon price would not mandate a particular national policy. Countries could use carbon taxes (which would easily solve the problem of setting the price) or a cap-and-trade mechanism (such as is used by the European Union). Either can achieve the minimum price, but different countries might find one or the other approach more suited to its institutions.
The second and critical feature of the Climate Club would be a penalty for nonparticipants. This is what gives the club mechanism its structure of incentives and what distinguishes it from all current approaches to countering climate change: nonparticipants are penalized. Some form of sanction on nonparticipants is required to induce countries to participate in and abide by agreements with local costs but diffuse benefits. Without penalties, the agreement will dissolve into ineffectiveness, as have the Kyoto and Paris schemes.
Although many different penalties might be considered, the simplest and most effective would be tariffs on imports from nonparticipants into club member states. With penalty tariffs on nonparticipants, the Climate Club would create a situation in which countries acting in their self-interest would choose to enter the club and undertake ambitious emission reductions because of the structure of the payoffs.
One brand of penalty could be a countervailing duty on the carbon content of imports. However, this approach would be both complicated and ineffective as an incentive to join a club. The main problem is that much carbon dioxide is emitted in the production of nontraded goods, such as electricity. Additionally, calculating accurately the indirect carbon content of imports is exceedingly complicated.
A second and more promising approach would be a uniform tariff on all imports from nonclub countries into the club. Take as an example a penalty tariff of five percent. If nonparticipant Country A exported $100 billion worth of goods into the club countries, it would be penalized with $5 billion of tariffs. The advantage of uniform tariffs over countervailing duties is simply simplicity. The point is not to fine-tune the tariffs to a nonparticipant country’s production structure but to provide powerful incentives for countries to be part of the Climate Club.
SANCTIONING THE NONPARTICIPANTS
There is a small academic literature analyzing the effectiveness of clubs and comparing them to agreements without sanctions. The results suggest that a well-designed climate club requiring strong carbon abatement and imposing trade sanctions on nonparticipants would provide well-aligned incentives for countries to join.
I will illustrate the point using the results of a study I presented in my 2015 Presidential Address to the American Economic Association and summarized in my Nobel Prize lecture. (The former provided a full explanation of the model, the results, the qualifications, and the sensitivity analyses; the latter was a nontechnical discussion of just the key results.) The study divided the world into 15 major regions. Each region has its own abatement costs and damages from climate change. Because of the global nature of climate change, however, the abatement costs are local, whereas virtually all the benefits of a region’s emission reductions spill over to other regions. Even for the largest players (the United States and China), at least 85 percent of the benefits of their emission reductions accrue abroad.
Voluntary international climate agreements will accomplish little.
The modeling of the study tested alternative uniform tariff rates, from zero to ten percent, and different international target carbon prices, from $12.50 per ton to $100 per ton. It then asked if there were stable coalitions of countries that wanted to join and remain in the club. One case is a regime with a carbon price of $25 per ton and a penalty tariff of three percent. With this regime, it is in the national interest of every region to participate, and it is in the interest of no region to defect and free-ride. The coalition of all regions is stable because the losses from the tariff (for nonparticipants) are larger than the costs of abatement (for participants).
The Kyoto Protocol and the Paris accord can be thought of as regimes with zero penalty tariffs. Both history and modeling have shown that these induce minimal abatement. Put differently, the analysis predicts—alas, in a way that history has confirmed—that voluntary international climate agreements will accomplish little; they will definitely not meet the ambitious objectives of the Paris accord.
Such detailed modeling results should not be taken literally. Modeling offers insights rather than single-digit accuracy. The basic lesson is that current approaches are based on a flawed concept of how to manage the global commons. The voluntary approach needs to be replaced by a club structure in which there are penalties for nonparticipation—in effect, environmental taxes on those who are violating the global commons.
TOWARD EFFECTIVE POLICIES
The international community is a long way from adopting a Climate Club or a similar arrangement to slow the ominous march of climate change. The obstacles include ignorance, the distortions of democracy by anti-environmental interests, free-riding among those looking to the interests of their country, and shortsightedness among those who discount the interests of the future. Additionally, nations have continued with the losing strategy (zero wins, 25 losses) pursued by the UNFCCC’s Conference of the Parties structure. Global warming is a trillion-dollar problem requiring a trillion-dollar solution, and that demands a far more robust incentive structure.
There are many steps necessary to slow global warming effectively. One central part of a productive strategy is to ensure that actions are global and not just national or local. The best hope for effective coordination is a Climate Club—a coalition of nations that commit to strong steps to reduce emissions and mechanisms to penalize countries that do not participate. Although this is a radical proposal that breaks with the approach of past climate negotiations, no other blueprint on the public agenda holds the promise of strong and coordinated international action.
Whether you agree with it or not, the sentiment around ESG has dramatically shifted and talk of an impending ‘Carbon Correction’ is going to create havoc in the markets. Company valuations are about to be judged by different metrics which will create huge opportunities for investors. With insights from politicians, financiers,0 environmental consultants and tech experts, this investigative documentary will get you ahead of the curve so you can understand what’s coming.
Transcript
00:02
right morning everyone morning oh yeah
00:07
that’s what keys look it’s great
00:20
[Music]
00:29
I’m Jamie McDonald and I was a fund
00:32
manager in London in New York for 10
00:34
years in that time
00:36
ESG investing was certainly something we
00:37
talked about but it wasn’t something
00:39
that really mattered and it didn’t
00:41
matter because it couldn’t be valued and
00:43
therefore it didn’t really affect Morken
00:45
sentiment but now now I’ve got a feeling
00:49
that’s gonna change wore off to Davos
00:55
the World Economic Forum melting pot of
00:58
business politics and finance and we’re
01:00
going to get underneath the skin of the
01:02
key question this year which is what is
01:04
the future of capitalism and how can we
01:07
sustain our economic system for future
01:09
generations
01:17
so I’m here I’ve made it to Davos and
01:19
through the tunnels on through the
01:20
numerous security checks and I’ve got
01:22
one to hear on to the high street now
01:24
I’m really getting a sense of the kind
01:26
of chaotic atmosphere that’s going on
01:28
there’s people in ski suits and business
01:29
suits there’s expensive cars as cable
01:31
cars it’s sort of mayhem really I know
01:34
already I’m gonna have to grab people in
01:35
between their meetings as they come out
01:37
of interviews very much on the fly
01:39
[Music]
01:47
Marcus hey how are you I’m really good
01:49
thank you so much for taking our with
01:51
pleasure
01:51
I’m going around Davos and I’m speaking
01:53
to people about this shift that’s
01:54
happening in terms of environment and
01:56
investing yes and it’s taught that 2020
01:58
might be a tipping point now I really do
02:00
value your opinion on this is that
02:02
something you agree with you know I
02:04
started to feel this was happening in
02:06
couple of years ago I think 2019 was the
02:08
transition here millions of people start
02:10
to understand that the environment was
02:12
much more than something given to us you
02:14
we have to actually have a return on
02:15
this and I think business understanding
02:17
this if you’re invest in sustainability
02:19
you’re improving the quality of business
02:21
sophistication of consumer more more
02:23
consumer they want to know where the
02:24
things are coming from
02:25
I think 2020 is really at the beginning
02:27
of maybe the 21st century finally this
02:30
is the echo chamber that will push it
02:32
and propel us to the future
02:33
[Music]
02:43
I’m now heading across town for meeting
02:45
with David Craig he’s the CEO of
02:47
affinity they are a data company right
02:51
at the heart of this issue on ESG
02:52
because they’re at the forefront of
02:53
helping companies and governments both
02:56
monitor the issue and measure it so
02:58
really interesting it feels like 2020 is
03:02
going to be the year for green investing
03:06
but why now why 2020 the reason that
03:08
it’s cool is that people are realizing
03:11
the price of the harm that we’re doing
03:14
to the environment be it carbon
03:16
emissions or carbon equivalents or
03:18
illegal logging that price isn’t
03:20
factored in it’s gonna mean a reprice of
03:23
many assets and funds and debt and
03:26
liabilities and when you talk in those
03:27
terms when central bank’s say they’re
03:29
going to ask companies to look at this
03:31
you know that actually a substantial
03:33
shift is coming so this shift is going
03:36
to lead to a reshaping of the world of
03:38
finance
03:39
yes finance is going to be reshaped I
03:42
think there’s no doubt in our mind that
03:43
this is going to happen and people have
03:45
talked about this for many years but now
03:48
I think everything’s coming together to
03:50
say the shift is coming the question
03:52
people are asking is not if it’s coming
03:53
it’s how quickly is this a cliff event
03:55
or is a a gradual shift over several
03:58
years David what is going to be the role
04:00
of data within all of this and how can
04:02
we use that data well the data is
04:04
incredibly important because if you want
04:06
to understand the the environmental
04:08
footprint the emissions for example or
04:10
the water usage of the investments in
04:12
making you need data you need to
04:13
understand and what those are and you
04:16
need to compare between companies to
04:18
make those investment decisions even
04:19
quoted as saying that financial markets
04:21
need to prepare themselves for this
04:23
impending carbon correction what do you
04:25
mean by the companies and funds and
04:29
banks are going to revalue instruments
04:32
based on the true forward-looking likely
04:35
price of carbon and that they would move
04:37
that estimate so that they had
04:39
incorporate an overall revaluation of
04:41
those assets and the overall impact
04:45
could be significant a but of course it
04:46
won’t be uniform it would be different
04:48
from high carbon intense
04:50
and carbon equivalent emissions
04:51
industries too low so that was daily
04:55
prayed from repetitive and what I took
04:57
away from that was the debate previously
05:00
may have been is climate change
05:02
happening or not but that’s not the
05:04
debate anymore because companies and
05:06
governments are making that shift debate
05:08
now from vestiges this shift is
05:10
happening how am I going to be able to
05:12
profit from that and clearly at the
05:14
center of this is data because it’s data
05:17
that makes people accountable and I
05:19
think it’s data that’s gonna be the
05:20
catalyst for the shift
05:22
[Music]
05:27
one thing I’ve noticed is that the shops
05:30
and stores are then if you can see
05:31
they’ve been taken over by some of the
05:33
larger corporates around the world and
05:35
they’ve turned them into their
05:36
headquarters for the next few days why
05:38
it presumably they talk about their
05:40
agenda for the next twelve months now
05:42
Shannon I know you’ve just come out of a
05:44
private web session here at Davos as
05:46
much as you can can you tell us who is
05:49
there
05:49
what you talked about and what your
05:51
conclusions were this session which was
05:53
banking on sustainability so it’s the
05:55
financial services industry banks
05:58
there were CEOs of some pretty important
06:00
banks in the room nope I cannot but
06:04
we’re all passionate about the subject
06:06
of obviously the topic which is the
06:08
climate crisis and the financial
06:09
services role in the climate crisis and
06:12
it was fascinating because I think that
06:13
there were two really key threads or or
06:17
themes of this which was to
06:19
differentiate between climate risk and
06:21
climate transition climate risk is
06:24
evaluating how much risk you are exposed
06:26
to with the carbon that you have in your
06:28
portfolios and are you financing the
06:29
climate risk and what was interesting is
06:31
the voices around this for and we’re all
06:33
in favor of a carbon tax and really
06:35
really you know to the point of we’re
06:38
ready for it and we would like this tax
06:39
to be proportional to the damage it’s
06:41
doing to the climate now what about
06:42
those companies that are using carbon
06:44
now I mean they can’t just switch
06:45
overnight there’s got to be some sort of
06:47
transition phase did they talk about
06:48
that yeah absolutely so that was the
06:50
second part of the topic which was the
06:51
climate transition and there was this
06:53
notion of it’s not a binary thing
06:55
between what they started calling green
06:57
assets and brown assets right so green
06:59
obviously being carbon you know limited
07:02
or neutral and brown assets being those
07:03
dirty ones that are quite carbon heavy
07:05
so we can’t just divest from the brown
07:08
ones is the the notion but that the
07:11
financial services industry and banks in
07:12
general really need to invest and
07:14
finance the transition so keep investing
07:17
in let’s call the brown assets but do so
07:20
with conditions in place that makes it
07:22
apparent that the funding is going
07:24
towards the transition to renewable
07:26
energy sources well Shannon thank you so
07:28
much you’ve literally give us insight
07:30
into what’s going on behind closed doors
07:31
so thank you for your time absolutely no
07:33
problem
07:38
exactly my sink another slap you only
07:42
like the name planet’ the name is my
07:44
living together on the bow and at the
07:47
company so when we arrived this morning
07:50
it was certainly a few protesters around
07:52
I’m talking like tens of protesters why
07:54
are we marching up and down the street
07:56
you can tell there’s a sense of protest
07:58
but here we are you know six or seven
08:00
hours into the day and now we’re talking
08:01
hundreds of protesters all singing
08:03
chanting behind me
08:12
[Music]
08:23
we’re very lucky indeed to have grabbed
08:26
here former Prime Minister Helen Clark
08:27
who’s literally dashing in between
08:29
meetings in interviews so we’ve got this
08:32
opportunity to ask her a few questions
08:33
which if you don’t mind I’m just going
08:34
to dive straight into so when it seems
08:37
like this financial shift is happening
08:39
in markets and more credit being given
08:42
to those companies who are behaving
08:43
should we say more responsibly do you
08:45
think that’s going to come from
08:46
shareholders or do you think it’s going
08:47
to come from governments and policy
08:49
makers no I think it’s going to come
08:51
from the public I think it’s going to
08:52
come from the consumer if you’re a
08:54
company who’s not taking ESG and the
08:56
data around ESG seriously are those
08:59
going to be companies who fall behind
09:00
I think they’ll suffer financially as
09:03
consumers increasingly make their
09:04
choices wanting to know what the whole
09:06
value chain was how was this made what
09:09
were the ethics behind it was that
09:10
sustainably produced was the labor
09:12
exploited people asking these questions
09:14
and they’re asking these questions more
09:16
and more as we go to more and more and
09:17
the companies that don’t measure up are
09:20
going to suffer financially in my
09:21
opinion
09:24
good
09:27
[Music]
09:31
so it’s very clear that this shift in
09:34
financial markets is happening and
09:36
that’s going to produce winners and
09:37
losers so we want to know is who are
09:40
going to be the winners and losers and
09:42
when are we going to see that divergence
09:44
starting to happen at Davos for many
09:47
years the whole conversation about ESG
09:49
has been sort of present but this year
09:53
there’s a real palpable shift from a
09:55
rhetoric to an urgent call for action
09:59
there is a real top-down push from
10:02
responsible governments and then there
10:05
is a huge groundswell and a surge of
10:09
emphasis particularly from the
10:11
Millennials and I think the companies
10:14
that win are going to be the companies
10:16
that have real strong proof points that
10:18
they’re not just focused on a financial
10:20
bottom line they’re actually focused on
10:23
sustainable performance that is good for
10:26
shareholders but it’s good for employees
10:28
it’s good for customers and it’s good
10:30
for the planet I think the the
10:32
corporations that do that convincingly
10:36
and with integrity they will attract
10:39
more customers they’ll attract a
stronger talent base because Millennials
all want to work for companies that have
a real commitment to sustainability and
those companies through changes that are
taking place sweeping changes that are
taking place in financial services are
going to have much greater access to
capital and much greater access to
financial services they’ll be the
winners and conversely the companies
that fail to make that leap you know
they’ll lose on every one of those
dimensions do you think investors going
11:12
forward are going to get much more
11:14
they’re going to require a lot more
11:16
transparency into the ESG comply ability
11:21
of the companies they invested in the
11:22
funds that they invest in and will there
11:23
be a shift of money away from general
11:26
funds more towards these greener funds
11:28
yeah absolutely financial services firms
11:30
are really looking for the data proof
11:33
points of companies and the data proof
11:36
points of their funds investors are
11:39
seeking them out most corporations today
11:42
that
11:43
going on let’s say a roadshow listing to
11:47
go public the number one question that
11:49
they are asked is what is the ESG score
11:53
investors are going to be putting
11:54
pressure on corporations to make sure
11:56
that they understand the ESG scores of
11:59
the companies that are in their supply
12:01
chain as well so the knock-on effect of
12:03
this is going to be extremely pervasive
12:06 companies that have very very very
advanced and proactive practices around
diversity and inclusion are actually the
highest performing financial companies
out of the 7,000 companies in our
database that was really interesting as
12:24
there was alluding to its those
12:25
companies that are paying attention to
12:27
issues around ESG that are outperforming
12:29
so ESG is now at the forefront of
12:32
investors decisions because it’s
12:33
becoming a deciding factor
12:35
who knows that win and those that lose
12:37
there are some people out there some
12:39
cynical people who don’t believe in
12:41
climate change what would you say to
12:42
those kind of investors we don’t even
12:43
necessarily have to have the
12:45
conversation about whether you believe
12:47
in climate change or not let’s have the
12:49
conversation about what are you
12:51
concerned about in terms of risks and
12:52
opportunities for your portfolio we’re
12:54
seeing increasing evidence that weather
12:56
patterns waters or h3 Georgia’s energy
12:58
shortages material shortages that all
13:01
these things are increasingly realities
13:03
when you have a consuming growing
13:05
population and a finite planet so if you
13:07
isn’t a business person or investor care
13:09
at all about any of those inputs of
13:11
costs or risks to your business then you
13:14
need to care about this whole other
13:15
suite this whole suite of issues many of
13:18
those things happen to be involved in or
13:21
affected by sort of the mega issue of
13:23
climate change I mean think about it
13:25
another way if I said to you would you
13:27
like me to invest your money in a way
13:29
that ignores a number of factors that
13:31
could affect your business whether
13:33
that’s weather or water or pollution or
13:36
do you want me to take into account
13:37
those things that could be risks
13:38
opportunity to your business I don’t
13:39
know many investors who say please
13:40
ignore all those macro megatrend effects
13:43
now you’re talking about the change
13:44
happening and I want to talk about the
13:46
pace of that chat because in 2020
13:48
I’m walking around Davos and I feel like
13:50
a lot of people are talking more about
13:52
this topic do you feel that 2020 is a
13:54
real tipping point for the
13:55
I think now that it sort of bubbled up
13:57
to the level where you’re hearing pretty
13:58
much every CEO here at Davao is talking
14:01
about how do we do this how do we
14:02
integrate this into our sustainability
14:03
strategy that it’s really we’re at this
14:06
tipping point well I think there’s been
14:07
a psychological and sociological shift
14:09
to understanding that there’s been more
14:11
and more data supporting that you can
14:13
actually do both and in fact good
14:15
business good asset management run you
14:18
know running a company well all involves
14:20
thinking about the environment and how
14:22
your business affects that when all
14:23
these things come together I think we’re
14:25
really just gonna see you know a real
14:27
sea change so the shifter seems to be
14:28
coming from so many different angles
14:30
it’s coming and all the stars are
14:31
aligning so investors stop thinking
14:33
whether climate change is real or not
14:34
right a fact is the future for those
14:36
companies who are not being here XI
14:38
compliant it’s going to be more
14:39
difficult exactly I mean look look at
14:40
the reality of all these factors that
14:41
are coming together and again I don’t
14:43
know any investor who will ignore
14:44
regulatory issues you know ignore
14:47
governmental changes ignore commodities
14:49
prices you know ignore new markets that
14:52
are emerging and you know other works
14:54
that are becoming more risky
14:56
[Music]
15:02
this has got a message saying that from
15:04
quick about two minutes with Jimmy Wales
15:07
so I’m off to try and grab him Jimmy
15:10
thank you so much for taking the time so
15:12
we’ve got really one fundamental
15:14
question want to ask which is is 2020 a
15:17
tipping point for the world of ESG I do
15:21
think so I think there been a lot of
15:23
important developments I think the sense
15:26
of urgency around climate change is
15:28
stronger than ever I think companies are
15:29
now beginning to realize that their
15:31
customers are demanding it their
15:33
employees are demanding it and that
15:35
there’s actually opportunities in it I
15:36
think there is a moment here where
15:38
caring about some of these issues is no
15:41
longer just like a do-gooder thing but
15:43
it’s actually profitable and if that’s
15:44
true then we’re gonna make some progress
15:47
and how do you think this area is going
15:49
to affect the valuation of companies
15:50
well you know obviously consumers care
15:52
about these issues more than ever before
15:54
governments care about these issues when
15:55
they’re before this means there’s
15:56
pressure on companies ultimately I think
15:58
companies need to answer to their
16:00
shareholders but I think shareholders
16:02
are beginning to realize that these
16:03
things actually do have an positive
16:05
impact on the bottom line doing the
16:06
right things consumers as their tastes
16:08
change then it’s gonna have a negative
16:11
impact on companies that don’t wake up
16:13
and actually get ahead of the trend and
16:14
have an image with consumers like yeah
16:16
you actually care now follow up
16:19
questions that is investors have
16:20
previously to some extent ignored ESG as
16:23
a topic because it hasn’t typically made
16:25
you money to be a green investor should
16:27
we say but now would you say that
16:29
investors have to wake up and pay
16:30
attention to ESG because those are the
16:32
companies that are going to basically
16:33
outshine I mean yeah if you’re an
16:36
investor is it’s just like every single
16:38
sort of fundamental shift in society if
16:41
you’re ahead of that trend and you
16:43
recognize that trend there are
16:45
opportunities to make money and so being
16:47
a green investor that’s simply trying to
16:49
sort of do good might not have had
16:53
superior returns but if you’re entering
16:55
into an era where we’re fundamentally
16:56
transforming the infrastructure society
16:58
hey you better be ahead of that and
17:00
there’s going to be returns to be
17:03
[Music]
17:08
I’m getting towards the end of the day
17:10
here in Davos and of course been quite a
17:12
long day
17:12
to be honest I’ve met with politicians
17:14
finance ears tech experts data experts
17:17
ESG experts obviously and I’ve had so
17:20
many conversations that what I want to
17:22
do now is just go away and have a real
17:23
think about everything I’ve talked about
17:26
today and then in the car come up with
17:28
some conclusions and finally work out is
17:32
2020 the year when we see this real
17:35
shift and ESG is at the forefront of
17:37
investors Minds
17:41
[Music]
17:45
as I look back on my time at Davos
17:48
it’s clear to me that whatever your
17:50
views on ESG investing and I was
17:53
definitely a cynic we’re now at a
17:55
tipping point seismic changes are coming
17:58
and that’s going to create massive
18:00
opportunities for investors the huge
18:03
increase in ESG data led by companies
18:06
like ref init ‘iv is the catalyst
18:07
because it means that after years of
18:10
false promises in greenwash companies
18:12
are suddenly going to be accountable and
18:14
this will surely be reflected in their
18:17
valuations David Craig called this the
18:20
carbon correction and he says the
18:22
adjustments could reach trillions of
18:25
dollars this will trigger extraordinary
18:27
shifts in prices the trick for investors
18:30
is to get on the front foot in terms of
18:33
risk management while taking advantage
18:35
of the new profit opportunities that
18:37
will be created by this shaker
18:40
hold onto your hats
18:45
[Music]
18:53
[Music]
18:59
you
The BlackRock CEO auditions to be the next Treasury Secretary.
BlackRock CEO Larry Fink is among the world’s most powerful investment managers, but it seems he longs for more influence. To wit, he has assumed a role as self-styled conscience of the business world in telling CEOs how to run their companies.
“We believe that sustainability should be our new standard for investing,” he wrote to clients in his annual letter this week. He added that “all investors—and particularly the millions of our clients who are saving for long-term goals like retirement—must seriously consider sustainability in their investments.”
Mr. Fink gets attention because BlackRock is the world’s largest asset manager, with some $7.43 trillion in client assets. He is now threatening to vote against corporate directors and management if they don’t do what he says, and he is especially exercised about climate change. He is demanding that companies disclose climate risks, and wants to see their plans to operate under scenarios in which warming is limited to fewer than two degrees Celsius this century.
Corporations in which BlackRock invests will also have to comply with the rules from a “Sustainability Accounting Standards Board” on issues such as labor practices and workforce diversity. “Disclosure should be a means to achieving a more sustainable and inclusive capitalism,” Mr. Fink writes.
Like his friends at the Business Roundtable, Mr. Fink is big on “stakeholder” capitalism. “Each company’s prospects for growth are inextricable from its ability to operate sustainably and serve its full set of stakeholders,” he says. If he means serving employees, customers, suppliers and communities, he is merely saying what any successful company already does. But our guess is that by stakeholders Mr. Fink really means regulators and politicians.
The giveaway is that Mr. Fink says BlackRock will divest its actively managed funds from corporations that generate 25% or more of their revenues from coal production. “We don’t yet know which predictions about the climate will be most accurate,” Mr. Fink acknowledges, but “even if only a fraction of the projected impacts is realized, this is a much more structural, long-term crisis.”
He might be right, but then estimates of future temperature increases are based on climate models that have overstated warming to date. Mr. Fink wants to make corporations plan for unknown temperature increases as well as climate regulations that are even less certain.
Coal is an easy target since its share of American power is declining. But the International Energy Agency projects that oil and coal demand will stay flat through 2040 and natural gas consumption will increase 40% even if all countries keep the promises they made in the 2015 nonbinding Paris climate accord. The U.S. is predicted to account for 85% of the increase in global oil production over the next decade thanks to shale drilling.
All of which means that fossil fuels still have a long shelf life, especially in developing countries. There are 170 gigawatts of coal-plant capacity under construction across the world, which is more than what currently exists in Europe. So what happens if Mr. Fink’s political and climate predictions prove wrong? His clients will pay the price.
BlackRock is a fiduciary and as such is legally obligated to act in its clients’ best interest. This is ostensibly why BlackRock has voted against more than 80% of the climate resolutions on proxy ballots by activist shareholders. But suddenly Mr. Fink is prioritizing the interests of liberal politicians and pressure groups.
We can’t help but wonder if Mr. Fink, after a profitable life in business, is auditioning to be Treasury Secretary in, say, the Warren Presidency. His “stakeholder” notions sound similar to her plans to put American corporations further under the government’s thumb.
CEOs who take Mr. Fink seriously might note that his political and moral importuning isn’t satisfying progressives. “BlackRock will continue to be the world’s largest investor in coal, oil and gas,” the Sierra Club said in response to Mr. Fink’s letter.
Businesses will never be able to appease the climate absolutists. The best way they can prepare for climate risks and serve their stakeholders is to succeed as a business and create the wealth and broad prosperity that will make the world better able to adapt to whatever happens. That’s real “sustainablility.”
Climate crises, like financial crises, will be damaging, unpredictable and almost impossible to avoid
Last year Australia’s central bank hoped that several interest-rate cuts would mark a turning point for its slowing economy. That was before the worst bushfires in Australia’s history hit tourism, consumer confidence and growth forecasts for this year. There is now a good chance the bank will cut interest rates again soon.
Welcome to a world in which climate change’s economic impact is no longer distant and imperceptible.
Extreme drought in California and poorly maintained utility power lines led to severe wildfires in 2018, the utility’s bankruptcy and blackouts last year.
Climate change can’t be directly blamed for any single extreme weather event, including Hurricane Maria, California’s wildfires or Australia’s bushfires. But it makes such events more likely. “They are starting to be more than tail events, they’re starting to affect economic outcomes,” Robert Kaplan, president of the Federal Reserve Bank of Dallas, told an economic conference earlier this month.
Climate crises in the next 30 years may resemble financial crises in recent decades:
potentially quite destructive,
largely unpredictable and, given the powerful underlying causes,
inevitable.
Climate has muscled to the top of business worries.
Every year, the World Economic Forum asks business, political, academic and nongovernmental leaders to rank the most probable and consequential risks, from cyberattacks to fiscal crises. This year, ahead of its annual meeting next week in Davos, Switzerland, climate-related risks took the five top spots in terms of probability, the first time a single issue had done so in the survey’s 14-year history.
The New NormalAs global temperatures rise, extreme temperatures and environmental disasters become more common.Summer temperatures for local regions in the northern hemisphere
STANDARD DEVIATION FROM 115-YEAR AVERAGETHOUSANDS OF OCCURRENCES1961-19802011-2015-4-3-2-10123450102030405060
World-wide extreme weather eventsSources: McKinsey Global Institute (temperature distribution), JPMorgan (extreme weather events)
Of course, economies have always been vulnerable to natural disasters. Before the modern industrial era, crop failures were a leading cause of recession. The monsoon season remains a key economic variable in India, and the Tohoku earthquake and tsunami in 2011 tipped Japan into recession.
And while estimates of climate’s economic impact are suffused with uncertainty, they don’t suggest any major economy will be pushed into recession, much less depression.
Studies reviewed by David Mackie of JPMorgan Chase suggest climate change could reduce global gross domestic product by 1% to 7% by 2100, assuming “business as usual” (i.e., absent policies to mitigate emissions of carbon dioxide). Given that the impact is spread out over 80 years, in which per capita incomes probably rise 300% to 400%, even larger climate change impacts would appear small, he said.
Aggregate changes in GDP, though, can be misleading. As global temperatures climb, the probability of extreme temperatures and events and the associated economic consequences should rise more.
This relationship is driven home in a study released Thursday by the McKinsey Global Institute. It estimated that “unusually hot summers” affected 15% of the Northern Hemisphere’s land surface in 2015, up from 0.2% before 1980.
McKinsey estimated that climate change made the European heat wave that in 2019 killed 1,500 in France 10 times more likely and the forest fires that devastated northern Alberta in 2016 up to six times more likely.
Satellite Images Show Smoke From Australian Fires Circling the World
NASA says smoke from Australian fires has made a full circuit of Earth. It has affected New Zealand’s air quality and turned skies in South America hazy. Photo: NASA Earth Observatory handout/Shutterstock
Looking ahead, assuming business as usual, McKinsey projected the probability of a 10% drop in wheat, corn, soybean and rice yields in any given year will rise from 6% now to 18% in 2050. Such a change wouldn’t cause food shortages but could cause prices to spike. The probability that a catastrophic cyclone disrupts semiconductor manufacturing in the western Pacific will double or quadruple by 2040. Such an event “could potentially lead to months of lost production for the directly affected companies,” McKinsey said. The probability of rain heavy enough to halt the mining in southeastern China of rare-earth elements, vital to many electronic devices, will rise from 2.5% now to 6% by 2050.
Such an exercise comes with plenty of caveats. The projections make no allowance for adaptation, though no doubt some outdoor activity will move indoors, some businesses will relocate from flood plains, and insurance will cushion the cost for many.
But adaptation goes only so far. Humans can’t survive prolonged high heat and humidity beyond certain thresholds. Those thresholds are rarely met now, but will be reached regularly in some regions by 2050.
Adaptation and insurance may be deemed too costly. “Underinsurance may grow worse as more extreme events unfold, because fewer people carry insurance for them,” McKinsey predicted.
Some on Wall Street are starting to treat climate change the way they regard financial crises. “Climate change is almost invariably the top issue that clients around the world raise with BlackRock,” Chairman and CEO Laurence Fink told chief executives this week in explaining why climate would be a key criterion in how BlackRock Inc. invests its $7 trillion of client money. For businesses, mandates—private or government-driven—pose a risk distinct from climate change itself. Car companies are now spending heavily to market electric vehicles with no assurance they will be profitable.
Some central bankers are also talking about climate risk the way they talk about financial crises. Christine Lagarde, the newly installed European Central Bank president, told European parliamentarians last fall, “At a minimum…[the ECB’s] macroeconomic models must incorporate the risk of climate change.”
SHARE YOUR THOUGHTS
How do you adjust an economy for climate change? Join the conversation below.
Yet worrying about it isn’t the same as doing something about it. Unlike financial crises, neither Wall Street nor central bankers have the tools to alter the forces making climate crises more likely: rising carbon dioxide emissions and economic development in vulnerable regions. Only political leaders can—and it isn’t clear they will.
The Madrid climate summit in December “is the most recent example of countries failing to cooperate to create a global emissions trading regime,” Mr. Mackie said. “Most likely, business as usual will be the path that policy makers follow in the years ahead…[which] increases the likelihood that the costs of dealing with climate change will go up as action is delayed.”
