A Sustainable Future: Dr. Tom Gosling, London Business School, on Whether Investors Can Save the Planet

Listen to Jason Mitchell discuss with Dr. Tom Gosling, London Business School, about investors’ ability to control climate outcomes and if it’s time they rethink their net zero commitments.

 

To what degree can investors control climate outcomes? Listen to Jason Mitchell discuss with Dr. Tom Gosling, London Business School, why investors may need to rethink their net zero commitments; what universal ownership theory represents in the context of climate change; and how engagement at different levels plays a fundamental role in terms of investor influence.

Recording date: 20 November 2023

Dr. Tom Gosling

Dr. Tom Gosling is an Executive Fellow in the Department of Finance at the London Business School and an Executive Fellow at the European Corporate Governance Institute where he contributes to the evidence-based practice of responsible business by connecting academic research, public policy, and corporate action. His projects at LBS have included a collaboration with PwC on whether and how executive pay should be linked to ESG targets and a collaboration with The Investor Forum on What does stakeholder capitalism mean for investors? Tom is also on the ESG Advisory Committee at the Financial Conduct Authority and on the Advisory Panel of the Financial Reporting Council.

 

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

 

Jason Mitchell

Welcome to the podcast, Dr. Tom Gosling. It's great to have you here and thank you for taking the time.

Dr. Tom Gosling

Jason, I love this podcast. It's a real privilege to be a guest on it. I'm looking forward to the conversation.

Jason Mitchell

Kind words from a fellow podcaster. Thank you so much. So, Tom, I'd like to first set up our discussion with why you're here. You recently coauthored a paper titled Can Investors Save the World, which sort of examines the tension between the Net Zero Asset Managers initiative and the notion of fiduciary duty. So to start off, can you lift the text off the paper to briefly summarize its thesis? Essentially, what's the problem in sustainable investing that you're describing?

Dr. Tom Gosling

Yeah, so this is a paper that I coauthored with Ian McNeil. He's a professor of law at Glasgow University. And what we do in the paper is look at how investors have signed up to net zero commitments actually go about implementing that through their investment strategy. And generally there are three main strategies that are adopted. One is a variant on portfolio decarbonization, where you tilt portfolios away from carbon intensive assets and towards companies that are net zero aligned. The second is an engagement strategy which may be predicated, for example, on the number of companies that you persuade to adopt science based targets. And the third one is impact investing.

And what we do is we look at the implications of these strategies in a world that actually isn't heading towards 1.5 degrees. And, you know, we ask the question, how are these strategies kind of likely to perform and how does that balance with the impact that creating? And what we find overall is that the more likely a strategy is to create impact, to kind of push the world more towards 1.5 C, the more likely that strategy is to expose clients and beneficiaries to costs and risks in the scenario where the world does not head towards 1.5 degrees but actually heads towards something more like two.

In a very simple example of that is that if you are investing in a way that assumes 1.5 C with limited or no overshoot, you might invest in the electrification of everything right here, right now in the next kind of 5 to 10 years, whereas actually a lot of those investments may not be so profitable if fossil fuels remain a bigger part of the mix for several decades to come. You know, there is an implication of this, which is, of course, asset managers and investors are very concerned about their fiduciary duties and they tend not to do things that they think will harm financial returns to clients. And so what really happens is that these strategies are generally implemented in a way that doesn't actually have a lot of impact on the climate outcome. And it's this tension that we seek to explore in the paper.

Jason Mitchell

Thanks, Tom, for that overview. I want to dig into this a little bit more. I want to frame it a bit so the defense net zero commitment limits global warming to 1.5 degrees with little to no overshoot. You've said that. I think it's also worth adding that that is very different from the Paris Accord, which limited warming to two degrees. Right. So there's certainly a half a degree difference there. Also, the United Nations Environment Program states that there's no credible pathway to 1.5 degrees. Indeed, the IPCC six Synthesis Report, which was released earlier this year, projects that the implemented policy pathway currently sits at 3.2 degrees in a range of 2.2 to 3.5 degrees. So you probably see what I'm trying to set up. What given these data points, are the implications for net zero signatory investors.

Dr. Tom Gosling

Yeah, I think there are a couple of implications of this. The first one is what does it actually mean to invest in line with 1.5 C with limited or no overshoot in a world is heading towards two. So does it mean that you can just pretend that we're still headed towards 1.5 and invest as if that's going to be the climate outcome? Or does it mean that you invest in a way that tries to drag the world back on track towards that 1.5 C trajectory? And then once you've decided what it actually means to invest in 1.5 C with limited or no overshoot and invest, it needs to decide whether that's actually in the interests of their clients to invest in that way. Because the reality is that it it may not be. I mentioned before the fact that if you believe in 1.5 C willing to until now overshoot, you'd be investing in immediate electrification of everything. But if the world actually ends up heading towards two, it sees electrification assets, it might end up being stranded rather than the fossil fuel assets that we're continuing to be told by sustainable investors are the ones that are going to be stranded. So I think that this is something that investors really need to treat quite seriously.

Jason Mitchell

Tom, I've got to say, your response seems overly polite in the context of what you've said sort of rhetorically in the past. So I do want to push you on this. I mean, you've talked about how investors are your words caught between a rock and a hard place in respect to net zero. But you've also said that investors are on a collision course between their net zero commitment and fulfilling their fiduciary duty. So I kind of pull apart what you meant by that.

Dr. Tom Gosling

Okay. Let me try to be a bit more direct. I mean, I think that if an investor kind of clings onto the notion that the world is going to hit 1.5 C or that they're going to try to drag the world on that trajectory, and if they invest in line with that, then there's a very high risk that they end up not serving their clients interests in a scenario where the world hits too, you could end up with a very misaligned investment strategy.

And that's a really big problem for fiduciary duty, because I think that, you know, one of the kind of clearest underpinnings of fiduciary duty is to look after your clients kind of long term financial interests. And, you know, if I think about my own position, I mean, I would love the world to be on more of a 1.5 C trajectory than it is. But if it ends up not being so, I'm still kind of pretty interested in what my portfolio is doing in that kind of less favorable scenario. In fact, some might even be more concerned about what my portfolio is doing because of what's going to be necessary to cope with living in that world. So the problem with this is that we've now created this scenario where investors who have made these commitments to invest in that way, if they follow through on that, a real risk of harming their clients interests. But if they don't invest in that way, then they're in danger of being accused of greenwashing.

So I that's what I mean by a rock and a hard place. And I think we've almost ended up in the worst of all worlds where investors are saying they're investing in line with 1.5 C with limited or no overshoot, but they're not really because they're pretty concerned about these fiduciary implications. And so that's opening them up to accusations of greenwashing on the one side and on the other side, accusations of political overreach, because they're saying they're going to let go even though they're not ready. And you pointed out the fact that the 1.5 C with limited or no overshoot is a goal that sort of reinterprets the Paris Agreement and for very valid reasons, because I think understanding of the science has developed since Paris, and I think we understand better the risks of exceeding 1.5 C But the reality is that that target of 1.5 C with this little no overshoot has much less political support and political backing than did the initial Paris goal of two C.

Jason Mitchell

I definitely want to come back to the greenwashing point, but you've made the point that investors can't control climate outcomes. But one of the premises of universal ownership theory is that investors who own the market, who have broad exposure to the wider economy, actually can drive change. Indeed. I mean, some would say that they're obliged to drive change towards a net zero outcome through how they direct capital or through engagement. Why do you think differently? Why do you say they can't?

Dr. Tom Gosling

Yes, I mean, you know, the idea behind universal ownership is that if you've got companies in your portfolio that are causing externalities, that damage other companies in your portfolio, then you can solve that problem yourself without government regulation by getting those kind of polluting companies to clean up their act. You take the hit on that part of your portfolio that you get a corresponding financial benefit elsewhere. So why doesn't this work in practice? There are a couple of reasons for that. One is that the tools that investors have to direct change in their portfolio companies are actually somewhat limited and maybe will kind of come back to talk about all of those.

But, you know, investors, particularly institutional investors, are not generally like controlling family owners. You can just get their companies to do whatever they want them to do. In fact, we find that the tools and the potential influence are quite weak. Secondly, in the situation of universal ownership, those tools have to in fact be really, really strong because they've got to be used to get these polluting companies to act in ways that are against their long term economic interests for the benefit of the investors portfolio.

Now, that's a pretty tough ask, and it immediately comes up against the kind of single firm focus that we have in corporate governance, where directors have fiduciary responsibility towards the companies they oversee, and there's nowhere in their fiduciary duties that suggests that they can subordinate the interests of that company to the interests of other companies in their investors portfolio. So, you know, this is something that has been, you know, laid out pretty clearly, I think, by Muscle Kane and Ed Rock in a paper. They've been called systematic stewardship with tradeoffs, which means that there are really big practical constraints about the extent to which this universal ownership idea can get traction.

Jason Mitchell

Yeah, I feel like it opens up Pandora's Box with universal ownership, so I'm going to save it towards the end of this conversation.

Dr. Tom Gosling

Maybe we'll come back to it.

Jason Mitchell

It's a big one. You know, investors often talk about the channels of influence engagement, as well as impacting the cost of capital. I'm going back to a recent podcast I did with Kelly Shu. It's at Yale University, where she really passes the kind of the impact to the cost of capital between brown and green firms. At the same time, promoting the benefits of engagement. But how do you weigh into this? What do you see as the limitations, especially in the context of net zero of these two?

Dr. Tom Gosling

Yes. So it said there are lots of papers, studies on the impact of different channels of investor influence. And, you know, quite a lot of these papers do find some kind of impact. But the problem is that this then gets translated into kind of universal truths, like engagement works, for example. But when you really look through the evidence, it's probably more accurately summarized as engagement works a little bit some of the time rather than just engagement works. And I think it's worth just giving some kind of tangible examples of this. Say it's a pretty famous paper that Johnson wrote with Caracas and Lee on on active ownership, where they look at engagements, pre triggered engagements on environmental and social themes. And that's quite often used as evidence for the fact that engagement works. But in fact, they only find that engagement succeed on about 10% of occasions for climate change related engagements.

And the objectives aren't kind of fully specified within that study, but they quite plausibly just related to things like getting companies to disclose more or, you know, things that don't necessarily have real world impact. So and the impacts of that engagement, although real know not game changing. And moreover, and this is a really important point when it comes to this universal ownership of their own net zero investing is that they find that their engagement strategies are associated with positive share price returns to the companies they engage in. And what this really strongly suggests, and this comes out in some of the other research evidence and engagement, is that what these investors are doing is identifying the environmental and social themes where there's a win win with shareholders and when they engage companies on those, that creates a successful outcome.

But the whole point about this sort of net zero aligned investing is because we have this massive externality which is not priced in markets in order to deliver net zero alignment. Actually, companies need to be engaging with some of these heavy emitters to do things that aren't necessarily in that company's interests.

And that's a totally different scenario when you're using engagement to act against the natural incentives that exist within the company, its directors, the fact that executives are paid through stock based compensation, all of these really make it very, very difficult to use engagement in that much more kind of aggressive form, that kind of cuts across the natural incentives that exist within the firm. And moving on to the kind of question of cost of capital, again, you know, there's a decent amount of research that suggests that finance flows can affect share prices and costs of capital, but that doesn't mean that they're necessarily going to have terribly beneficial outcomes in relation to climate change and net zero. So one issue is that the actual magnitudes of these effects are not necessarily that great. So even relatively positive assessments of the impact of divestment on cost of equity, of the order of a couple of hundred basis points.

So that sounds quite a lot. But if you think about a typical cost of capital being in double digits, you're talking about a 20 to 25% kind of penalty in profits as being the equivalent to this kind of investor induced increase in the cost of capital. But, you know, there's been work that's been done by Bob Eccles, Zhao GAO or Shiva RAJPAL, which kind of shows that even $100 carbon tax, which is pretty much the minimum we need to get on to a reasonable net zero trajectory, wipes out the profits entirely if half of companies in heavy emitting sectors. So the scale of what this sort of divestment can do is really underpowered relative to what is necessary.

And then a final point I'd want to make on this kind of cost of equity dimension goes back to the work of Sam Hart's Mark and Katie Shu, which you've referenced. You've interviewed Katie in an earlier version of this podcast, and that paper Counter-Productive, Sustainable Investing, which shows that even if there's an impact from cost of equity, which which, by the way, is kind of uncertain because managers only rarely update their cost of equity assumptions for internal capital budgeting. But even if there is an impact, we don't actually know for sure which direction it's going to go.

So let's suppose we increase the cost of equity for brown firms. What do they do in response to that? Do they cut brand investment? Do we therefore get less carbon emissions? Do we therefore progress to net zero more quickly, or do they cut green investment? Because that's the most speculative at least profitable investment for them and double down on pursuing their core business model and actually become more polluting and dirtier. We end up, I think, with some of these tools, using rather weak tools in a way that has slightly unpredictable consequences. And therefore the idea that we can use these tools to somehow drive the world towards net zero I think is just a fantasy.

Jason Mitchell

So let me get this straight. So even if investors don't have control and even if 1.5 degrees C isn't attainable, shouldn't we still be pushing as hard as possible for it? Where do you see the line being drawn between, I guess, the risk of not being ambitious enough and the hard place you talked about earlier, the risk of greenwashing?

Dr. Tom Gosling

I think this is an area where where investors sort of have got themselves into a little bit of a tricky position because, yeah, for sure I think we all have agency in this sort of climate crisis that we're facing. And, you know, I think the way we have agency to push towards faster decarbonization, I mean, I, I personally think it's great if everybody does that, but investors do need to have particular regard to whether they're doing that in line with their fiduciary duties. And I think that if we go back to when these commitments were made at around the time of the Glasgow cop, I think there was this sort of temporary period of optimism at that point that we had kind of reset the objective, that it was now 1.5 C that we were pushing for, and that making a commitment to invest in line with 1.5 C was simply showing that you were getting on the train and prepared to go on that journey with governments.

I think the problem now is it's become increasingly clear that that that is not the direction that governments are taking. And so this is where I think investors need to kind of have a dose of reality about their role, what their role really is in decarbonization. So investors can't say, oh, governments aren't doing this anymore, so we're going to do it instead. Investors can only support governments on the pace of decarbonization that they choose. And I think that by sticking kind of very in a very committed way to the 1.5 C goal with limited or no overshoot, even though it kind of sounds kind of consistent and laudable, ends up being unrealistic and therefore, I think does push into greenwashing because I think that what it creates is an incentive for corporates and investors, you know, to say they're still on this 1.5 C path while kind of manifestly kind of not being on that path because without governments, they can't be on that path.

So we end up getting a lot of not 1.5 C aligned activity, which sort of, you know, kind of looks like it is, but that really isn't. And this is leading to, I think, things like science based targets, you know, offsetting portfolio decarbonization strategies is really bringing this whole kind of concept of 1.5 C alignment into disrepute.

Jason Mitchell

I'm really curious, what's the reaction you've seen? What kind of responses have have you had about your paper on net zero concerns? Where's the pushback come from?

Dr. Tom Gosling

Have been kind of called in for corrective education by some sustainable investors who just think that what I'm saying is unhelpful is providing, you know, friendly fire and there is a little bit of a sense in the sustainable investing industry that it's a group of people who are on the right side of history and using the power of the financial sector to drive to net zero. And I do understand that, you know, people want to fail in their jobs, that they're contributing to this kind of really important objective. And by the way, I mean, I think it is a really important objective. I mean, my own view is that we're far too complacent about the risks of climate change, which come upon us more and more every day.

I would much rather see us focusing on more aggressive mitigation action in relation to climate change. But I think it's really important, given the scale of the problem, that we're really clear eyed about what is and isn't going to work. I definitely don't want to be viewed as someone who's providing useful ammunition for climate deniers. You know, there is a tendency whenever sustainable investing is and you can critical said for people who are on that side of the debate to kind of need you to jump on it. But I really think we can't let that get in the way of us being clear eyed about what the truth is on some of these things.

And I think at the moment we have a lot of really, really smart people designing a lot of resource to something that isn't really working terribly well. And I think it would be much better if those people were devoting their smartness and their resource either to just making kind of better investment products for clients, which kind of still matters, or maybe to doing other forms of climate action that are likely to be more effective. I think a final issue, which is, you know, why I try to be careful about how I express this stuff because, you know, I am I am a sort of advocate for climate action. I think that there is a defensiveness in the sustainable investing community.

I think they feel under attack some of that attack that we're seeing in the US in particular is, to my mind, completely absurd and mis founded and clearly just politically motivated to create a wedge issue. And I don't think that should stop people in the sustainable investment industry from undertaking all this self-reflection about where there might be a grain of truth about the accusations that are being made and then thinking about what their role can be that is most effective in bringing about change while still aligning with this fiduciary obligation I have to clients, which is just so, so important.

Jason Mitchell

Let's talk about the value of these commitments. Academics, particularly in fields like international relations and political economy, have long theorized about the credibility of commitments and audience costs. In other words, making a commitment and then reneging on that pledge generally carries some form of penalty. Now, if that's true, why do you think corporates and investors are so short sighted apparently about their net zero and as PTI commitments does, reneging on net zero commitments ultimately not carry a penalty?

Dr. Tom Gosling

Well, I mean, this is obviously terrific question, and I'm not sure I could a great answer to it. Here are a few thoughts. So, I mean, it's possible that reneging on these commitments does carry a penalty, but we just haven't got there yet. And making these commitments is a fairly recent phenomenon. And I think only at this time is the kind of evidence building that the commitments aren't being met. So who knows?

I mean, maybe there will be an element of a period of reckoning that comes over the next five years. Another couple of issues are what is the timeframe over which it's possible to know whether these commitments are being met and and he's monitoring it. So I think if you had a situation where, you know, shareholder is start really caring about these commitments to a great degree, they're the most natural source of scrutiny for companies, then you may well see a penalty for companies in failing to meet those commitments.

So you do see if companies make commitments around strategic objectives or financial performance and don't meet them, then generally shareholders would extract a cost. I have a slight fear that there's a little bit of sort of implicit cooperation going on here between investors and companies in that kind of both of them have an interest in sort of making these commitments, but not maybe pushing them too urgently at this point in time. So I'm not 100% convinced that shareholders are going to be the ones that apply that scrutiny. So then you come to sort of civil society more broadly and NGOs, and there is some excellent work going on around the tracking of net zero commitments. And we've seen, for example, from a carbon disclosure project, I mean, they put out work showing that, you know, I think it's something like kind of 95% of companies are not really fulfilling these commitments to a reasonable degree.

The question then, though, is who's going to really act on that information if investors aren't going to act on it? Are consumers going to act on it? Maybe a bit in some industries, but we know that sort of consumer kind of preferences are fairly fickle in this.

So I think we have a problem in this field of net zero that we have very complicated commitments over the very long term where it's quite possible for companies to say they're doing something by buying some renewable energy credits or some offsets or what have you, and there's not a very powerful stakeholder who is obviously incentivized to hold them accountable. So I think there are some differences there in what you said about political commitments, and there are also differences in how corporate commitments operate in areas that are of direct interest to shareholders. Yeah, who is it that's really going to hold the company accountable for that with a big enough stick to make them worried about it?

Jason Mitchell

If government policy is the ultimate driver of climate action, which is still to recognize the enabling power of investors, but can we start to make assumptions based on government policy responses in the context of, let's say, the energy trilemma There's been this narrative where government can juggle all three policy objectives energy security, price affordability and decarbonization. They've had this conversation with with Chris Skidmore about this as well, and an earlier podcast. But evidence here, at least in the UK, seems to demonstrate that net zero ambitions can be to some degree sacrificed certainly for price affordability. Think the sort of policy moves and rhetoric of the UK government over the last couple of months. So is this essentially the abdication of government policy which would in effect dissolve the underlying defense net zero commitments in your mind?

Dr. Tom Gosling

Yes. So I mean, the defense commitment contains the rider that there's an assumption that governments will follow through on policy aligned with 1.5 C, because I think that asset management compliance department has kind of picked up on these potential fiduciary issues kind of quite early on. So make sure that that kind of footnote was in there. I think the problem comes when the commitment becomes defined by that footnote. So I do agree that that kind of could be used as a get out of jail free card to dissolve the commitment. I think it would be a shame if if defense was dissolved.

I mean, I think it's great to get key players in the financial industry coming together to help, you know, figure out share best practice on how we can address one of the most critical issues of our age. I hope instead they use this as an opportunity to to reframe the commitment. I think that the the problem with the defense commitment always was locking on to a specific goal of 1.5 C with limited or no overshoot, which was both, you know, incredibly ambitious, went beyond what had been politically agreed and over which the investment industry really has no control. And really what the investment industry can commit to is leaning into the net zero transition to the greatest degree possible, consistent with fiduciary duty and government policy.

And I think that some element of using this opportunity to reframe that before the defense commitment as it as it says on it says it on the kind of label of the ten before that just simply becomes untenable because there is going to come a point where it's just going to be absurd to claim that you're investing in line with 1.5 C with accident overshoot, unfortunately, and I think that defense needs to get ahead of that. I think that's another lesson from this political context for investors. So, you know, it's often said that, well, our clients want us to act on net zero beneficiaries want us to act on net zero. And unfortunately, I think that some of that commitment to net zero is relatively skin deep when it starts to incur costs. I've always been quite skeptical about this sort of survey type evidence that suggests that, you know, people are prepared to accept a cost of 100 basis points on their return for a more sustainable outcome.

And I'm kind of skeptical for two reasons. One is that that's not really the choice that those investors face, because, as we've discussed, the impact of sustainable investing is really uncertain. But secondly, you know that 1% per annum could make the difference between having a pension pot of €200,000 dollars pounds or 150,000. I mean, you know, the cost implications over the long term can be enormous. And yet what we see politically is that resistance to even quite small costs and disruptions is, you know, is quite high, which is why governments find it quite hard to do this stuff. Right. So I think there's a warning in there that we shouldn't just assume that we're doing what our clients want us to do if we just sort of push on and on and on with this objective.

Jason Mitchell

I keep coming back to this question. I mind what can investors who are obviously bound by fiduciary duty, what can they do if they can't actively try to bring about a climate trajectory that's different from one supported by government policy? You know, we hear that common refrain from both academics and practitioners alike that it's the government's role to address climate change through pulsing regulation. If that's true, what really is the utility of sustainable investors? I do want to come back because I think something that I've heard you say really, really resonates with me, which is sort of you made the point that investors who are unable to influence climate outcomes should instead focus on influencing the environment as enablers to drive climate outcomes. Talk more about that.

Dr. Tom Gosling

Yeah, So I mean, I think this is absolutely key that we need to accept that investors cannot drive climate outcomes for all the reasons we've been discussing the tools I have a two week trying to drive change through investment is like, you know, pushing on a piece of string. You come up against directors fiduciary duties at the company level and also it's a bit like squeezing a balloon.

You might cut some emissions in one place and they, they pop up somewhere else because people just divest or we end up with emissions going into this scrutinized sectors of the economy. So I think investors need to move away from the mindset of directly affecting climate outcomes and instead adopt the mindset of influencing the environment so that better climate outcomes can be achieved. And what that really means is taking the choice to lean into decarbonization and net zero, because we all have agency in whatever job we do, we can we can ignore the net zero trajectory, we can resist it or we can lean into it. What does it mean for investors to lean into it? I think it means three things.

The first one is engagement. So, you know, I was slightly kind of critical of this idea that engagement kind of is going to save the world earlier. But remember, still that the evidence shows that engagement does have impacts at the margins. So we can use corporate engagement to help us lean into the net. Zero transition boards have quite a lot of latitude about how they go about trying to create shareholder value, and boards can choose to try and create shareholder value in a way that ignores the climate crisis or in a way that goes with the grain of solving the climate crisis. And investors can either choose to give boards the space to do that or not. So I think it's useful that we've got European investors who have given, for example, European oil majors to space to try different types of strategy to create value that seem to be more aligned with the objectives of the Paris goals.

But here, I think the way that you need to do that is critical. So it has to be recognized that investor engagement is only going to work if it is consistent with long term value creation in the company. We are not going to be able to use investor engagement to somehow impose a shadow carbon price on on oil companies or heavy emitters. And anybody think about what's happened with investor engagement around European oil majors, I think it has fallen slightly into that trap. So we've had for the last couple of years resolutions trying to get the oil majors around the world to set kind of scope three emissions targets, which are effectively kind of production cut targets.

And I think that's been misguided for a couple of reasons. One is that, you know, production cuts are probably simply going to result in kind of divestments to other producers of the same assets. But more importantly, these companies boards are never going to do things that they think damage the long term value in those companies. And so that that approach was never really going to come off. What if instead, for example, investors had looked at what had been done for kind of tailings dam issue in mining companies and had instead focused purely and aggressively on the focus of methane in the oil majors, because that's something that can be done consistent with the fiduciary duties of the directors, the long term value of those companies, and actually makes a real kind of climate contribution. So I think going with the grain of what creates value in engagement is critical. So engagement is the first thing that investors can do to lead into the climate crisis.

I think the second one comes down to this question of lobbying. I think that here, you know, we know that government policies is essential to enable the transition and investors can influence lobbying in two ways. So so one is what they do themselves. And we do see investors sort of signing up to requests to government to adopt consistent net zero aligned policies so that investment can flow in. And and that's all very laudable. I do sometimes wonder how aggressive that lobbying is or whether it's just letters put out for public consumption.

And my suspicion from talking to people in the industry is that the the all of the kind of forces and dark arts and lobbying will be applied by asset managers where they're faced with potentially being caught up in the EU's sustainable due diligence directive. Right, because they really don't want that. And so they go full bore on resisting that is the really the same power of lobbying, the same resources, the same, you know, CEO to minister contact is that deployed in the push for better climate policy? I kind of suspect not. So I think that the industry could do more that I think the industry can also look at this question of corporate lobbying, which we know particularly from the oil industry, has been an incredibly malign influence on the development of of of climate policy. Now, I mean, if you think that the ESG wars have been kind politically charged in in the US already, I mean, you know, wait till asset managers kind of get into the lobbying question.

It could potentially be a snake pit, but this is where I really like what the Net zero Asset Owners Alliance has done, which is to focus on lobbying alignment, which is to say, you know, we're not going to tell you how to lobby, but we are going to say that if you make public commitments, you need to lobby in a way that's consistent with those commitments.

And I think that's just a basic kind of fair dealing and honesty requirement that could potentially have traction. So I think on the question of policy, investors could do more. And then the third one in this apology was rather long response to your question is about products that align with impact. So we do know that there is a certain appetite amongst investors for products that prioritize impact over return. We also know this is a desperate need for such products. If we look at where, you know, many of the hardest to fund projects are in developing countries that they're just currently an investable for institutions at the moment. So I think investors could work a lot harder to access those portions of their client base that are genuinely interested in having real impact, but also doing the complicated work of, you know, the multi stakeholder work required to develop kind of blended finance and other products that genuinely, genuinely can make a difference in how to finance areas of climate action instead of, I think, coming up with somewhat superficially sustainable products that are suitable for mass consumption. So those would be my kind of three sources to ten on what it means for an investor to lean into net zero.

Jason Mitchell

Super Interesting. Fantastic. I want to come back to the universal owner theory discussion that we had earlier in this podcast. Your soon to be released paper titled Universal Owners and Climate Change, makes the point that universal ownership theory runs into some problems in the context of climate change. A number of academics, I'm thinking Madison Condit's paper externalities and the common owner argue that diversified investors are more than justified in maximizing profits at the portfolio level rather than the firm level. So can you talk about the tension between those two levels, the portfolio and the firm level with regard to fiduciary duty a little bit more, Can a portfolio manager internalize negative externality, say carbon emissions produced by a portfolio company so long as it's offset by the financial gains realized elsewhere in the portfolio?

Dr. Tom Gosling

Yeah. So I think I mean, there are a couple of issues here and I think it's fair to say that I mean, Madison Condon identified kind of many of the tensions that do exist in this universal learning model, but I think the tensions have played a number of levels. So let's start with the institution invested themselves. So can the institutional investor tolerate underperformance in one of their portfolio companies as an offsetting gain elsewhere in the portfolio? The answer to that is clearly yes. I mean, the fiduciary duty of the institutional investor operates at the portfolio level, not at the company level. So, you know, the challenges there come around, whether you actually know with any kind of certainty whether that offsetting has actually happened because that's desperately difficult and you know, also the challenge around whether you actually have the tools to bring that about. But the problems don't arise so much at the level of the diversified institutional investor.

But you can get a problem at the level of the fund family. So this would be, you know, a BlackRock, for example, who has, you know, many different kinds of strategies and funds. So yes, they have their index funds where you might say the universe and ownership logic applies quite well, but they also have energy sector funds as well, you know, which where this universal logic doesn't apply quite so well And so the fiduciary duty obligations apply at the fund level, not at the fund family level. So whilst it's just about conceivable that a BlackRock index fund could apply some universal ownership logic, they could overcome the hurdles about whether it would actually work and whether they were sure that Synopsys would internalize BlackRock as a fund. Family couldn't do that because they have no funds.

He might have quite opposite fiduciary obligations. And now we drop down into the relationship between the company and its investors. And here the fiduciary obligations of the directors are to I mean, this depends precisely on what jurisdiction it's in that you're in. But typically the fiduciary duties of the directors are to run the company in a way that supports its success over the long term and for the benefit of the shareholders of that company. And it's very difficult for those fiduciary duties to be aligned with those directors constraining or damaging the financial prospects of their company in order to benefit the investors portfolio elsewhere.

Firstly, that goes against their fiduciary duty to the company, not just the company's investors, but secondly, a company's investors differ in their objectives. So unless all of the company's investors were these universal owners who wanted the company to run themselves down in order to benefit elsewhere in their portfolio, unless they had assurance that all of the company's investors were like that, it would be very difficult for them to act against the interests of investors who were not in that and not in that position as an investor in the company. So I think that these conflicts between the directors duties and the universal owner logic create an almost insurmountable barrier, I think, to this ever becoming a reality to the extent that would be necessary if universal ownership was going to replicate the impacts of a net zero aligned carbon tax. And I mean, what I'm saying here, you know, I should say, has been very extensively covered by Marshall Kahan and Ed Rourke in that 2021 paper, Systemic Stewardship with trade offs, as well as by Roberto Taylor Ritter in his 2023 paper on the Limits of Portfolio Primacy.

Jason Mitchell

The paper also asked this central question in my mind does a strategy that seeks to limit temperature increases to 1.5 degrees C with limited to no overshoot, does it enhance or hurt niche returns for clients? How do we dimensionalize all the considerations around this question? How much of this question is motivated by political considerations versus financial returns? How do the narrow constraints of financial markets? And by that I mean that they're very focused on cash flows. How do they inherently fall short of this wider climate action objective?

Dr. Tom Gosling

Yeah, I think there's a set of issues that are really kind of foundational to responding to this question. The first is to realize that an outcome that you might get to through a political process and that you consider to be optimal for society may well not apply line with what is optimal for financial markets and returns. And in the case of climate change, I think there are there are three big issues here.

First is when you think about a goal of 1.5 C with limited or no overshoot, that goal takes into account the fact that future generations matter to a very significant degree, probably as much as I say, or close to as much as us. And that tends to lead you to use a low discount rate for discounting future climate damages where financial markets are set up to do quite a different thing, they tend to use much higher discount rates and so will apply much less whites to future generations and the economic damages that affect future generations.

The second is that that political kind of goal on global warming will recognize that there are particularly vulnerable communities, especially coastal communities in the developing world, where the impacts of climate change can be absolutely devastating to their economic and social welfare and the goal therefore applies a strong weight to trying to protect those communities from the worst implications of global warming. Whereas financial markets don't really care about that. They care about what effects cash flows and what effects cash flows is to a very significant degree driven by what is happening in developed markets.

And, you know, the fact that Pakistan was, you know, 50% underwater because of the monsoon flooding recently didn't really make the dollar on capital markets a tool because it wasn't relevant for corporate cash flows in many companies. And then finally, in setting the climate goal, we might well take into account quality of life issues. So you might not particularly want to live in a world where you to live for six weeks of the year purely in an air conditioned environment, because temperatures that exceed the wet bulb limit outside, for example, you may not want to have to live inside or be unable to go out for a job because of, you know, toxins in the air from forest fires. But these, again, nonfinancial factors don't necessarily impact company cash flows.

So financial markets have been set up to intermediate between the savings and consumption preferences of individuals who are largely alive today. And that produces sort of an allocation of investment. It produces a discount rate, which we should have no reason to believe will align with this more kind of political or social goal of limiting global warming to 1.5 C with little or no overshoot. And a consequence of that is that investors pushing for that goal, even if they could achieve it, aren't obviously taking action that would maximize returns declines.

And if they push for that goal, knowing that actually they quite likely won't achieve it, then that raises a very, very serious. What does that mean for that investment strategy in a scenario where actually the 1.5 C go, these are met and quite likely that is exposing clients to risks and costs.

Jason Mitchell

Tom, since you brought up discount rates, I've got one last question and there's been increasing pushback to the investor community regarding long run assumptions and impact of of climate change on portfolio valuations. It's interesting, even the traditionally conservative institute and faculty of Actuaries published a paper called The Emperor's New Climate Scenarios, which essentially makes a case that investors are underestimating the economic of climate change. So if there's an increasing push to integrate climate tipping points, non-linear feedback loops that potentially produce economic losses of even 50% or more to the global economy, how do climate impacts to portfolio returns end up, I guess, almost paradoxically minimizing climate scenarios for investors?

Dr. Tom Gosling

Yeah, it's fascinating, isn't it? I mean, I published a blog on this recent thing which open me up to some criticism and I mean, the blog was called Why Climate Change Doesn't Matter so Much to Financial Markets and and by the way, that wasn't so much a normative statement as just a kind of a statement of fact.

Jason Mitchell

At the time. I do have to say, you seem to be taking a lot of punches for your views.

Dr. Tom Gosling

Yeah, well, you know, I mean, it's I don't mind it. I think it's you know, it comes with the territory, I think, of just trying to shine a light on some of these some of these issues. And actually sometimes I'm wrong, Right. Say sometimes I deserve the punches. So let's also be clear about that. But I think my point on this one was that I think the market in general views climate change as as a long run disaster rather than a short run disaster.

So, I mean, the analogy I use, it's a little bit like being, you know, slowly caught by a slow moving pool of boiling lava as opposed to being killed in the explosion of the volcano the first place. And if that's true, you know, if most of the worst climate impacts are kind of a slow running, boiling the frog type disaster, then it's just kind of logical that markets don't take too much account of them now because, you know, markets discount at whatever 5% real return a year, say stuff that's happening 50 years hence. You know, it doesn't really move the dial very much. And I'm not a climate scientist, but I would say that whilst I understand that the climate risks are very great, it's also probably true that the median scenario is for a slow moving disaster on climate change.

Now, I think what the the paper you referred to from the Institute and Faculty of Actuaries done and some other similar papers do, is to point out to us that there are some really very, very significant tail risks in climate change that could make the reality much, much worse, much, much quicker than the market is currently assuming. And yeah, I mean, and that clearly is plausible, right now. Having said that, I mean, I think that a lot of the very worst tipping points that are identified tend to have long running implications.

So we might pass them today, but that doesn't necessarily mean that within the next ten years the world kind of falls apart and, you know, the world and the economy is is is very adaptable. So it's not it's not completely obvious to me that investors have got this wrong. And they clearly, if climate change impacts accelerate and become much more visibly worse, much more quickly. And I think there's some warning signs in insurance markets that show that this might be happening, then, yes, sure, at that point, you know, the market will react. But I do think there's another kind of cautionary tale for people in the sustainable investing community on this topic, because the fact that there are, you know, horrendous potential implications from climate change is quite often used as a reason why we need to kind of get out of all of these polluting assets because, you know, we're going to have stranded assets in oil companies and what have you. But let's just run through this scenario for a minute.

Let's let's suppose that climate change impacts do get much, much worse immediately. And we have, you know, much worse weather damage. You know, we have crop failures. What is the response of governments going to be? Is the response of governments at that time going to be to double down on climate mitigation policy, which will produce benefits probably 25, 30 years hence? Or will it result in a massive pivot to adaptation? I suspect political incentives will lead to the latter rather than the former. I think with constrained budgets, politicians will be very focused on solving the immediate problems of their citizens today, rather than taking actions that can only have impact over a decade or timeframe. And this is potentially a worrying kind of prognosis, but it does mean that the companies that suffer in that scenario are not necessarily the companies that caused the problem. And that, you know, sometimes I think we want this to end like a Hollywood movie where, you know, the baddies get their comeuppance.

But unfortunately it may not be like that. And I think as investors think about investment strategies that are going to affect that and protect their clients in a number of scenarios, I think we need to be realistic about what the political consequences of rapidly accelerating climate change might actually be.

Jason Mitchell

Absolutely. So it's been fascinating to discuss why investors may need to rethink their net zero commitments relative to their fiduciary duty, what universal ownership represents in the context of climate change, and how engagement at different levels will play a fundamental role in terms of investor influence. So I'd really like to thank you for your time and insights. I'm Jason Mitchell, head of Responsible Investment Research at Mann Group here today with Dr. Tom Gosling from the London Business School. Many thanks for joining us on a sustainable future, and I hope you'll join us on our next podcast episode. Tom, thank you. It's been great to have you on here.

Dr. Tom Gosling

Yeah, thanks so much, Jason. Really enjoyed it.

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