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RESEARCH Smart Beta CONTRIBUTORS Emily Ulrich Senior Product Manager Sustainability [email protected] Martina Macpherson Global Head of Sustainability Indices martina.macpherson @spglobal.com The Climate Change Challenge – From COP 21 to COP 22 Climate change has been one of the most frequently discussed topics of the year on a global scale. Multiple policies have been put in place; at the September 2016 G20 summit, leaders promoted climate change as a main concern of the modern era and cited “green finance” as one of the most effective ways to combat global warming. Interest in green finance (i.e., financial investment related to environmental or sustainable initiatives) has increased significantly. Green bond issuance totaled USD 42 billion in 2015, and issuance for 2016 has already surpassed USD 65 billion YTD.1 Arguably, this discussion kicked off with the December 2015 Conference of the Parties (COP 21) in Paris, during which 197 countries agreed on their aim to keep global temperature rise “well below” 2ºC from pre-industrial times.2 This paper explores the ramifications of that goal and the movement toward COP 22. DEFINING THE CONTEXT FOR COP 21 Green bond issuance totaled USD 42 billion in 2015, and issuance for 2016 has already surpassed USD 50 billion YTD. Despite popular misconception, “COP” does not include the words “climate” or “change.” In fact, it stands for “Conference of the Parties,” which serves as a governing body for the United Nations Framework Convention on Climate Change (UNFCCC). According to the UNFCCC website, COP is the “supreme decision making body of the Convention” and is currently composed of 197 countries. The international political response to climate change began at the Rio Earth Summit in 1992. The resulting Rio Convention included the adoption of the UNFCCC, which came into effect on March 21, 1994. This Convention set out a framework for action aimed at stabilizing atmospheric concentrations of greenhouse gases (GHGs) to avoid “dangerous anthropogenic interference with the climate system.”3 All parties (the participating countries) of the Convention are represented at the COP, at which they “review the implementation of the Convention and 1 “Explaining green bonds,” Climate Bonds Initiative. 2 “The Paris Agreement”. UNFCCC. 3 “First Steps to a Safer Future”. UNFCCC. The Climate Change Challenge – From COP 21 to COP 22 November 2016 any other legal instruments that the COP adopts and take decisions necessary to promote the effective implementation of the Convention, including institutional and administrative arrangements.”4 The main objective of the annual conference is to review the Convention’s implementation. The first COP took place in Berlin in 1995, and it meets annually. Some of the more notable meetings include COP 3, in which the Kyoto Protocol was adopted, COP 11, which produced the Montreal Action Plan, and COP 17 in Durban, where the Green Climate Fund was created. At COP 21 in 2015, for the first time in over 20 years of UN negotiations, all parties aimed for a legally binding and universal agreement on climate change, with the goal of keeping global warming below 2°C. WHAT DOES COP HAVE TO DO WITH CLIMATE CHANGE? The UNFCCC was created as “a framework for international cooperation to combat climate change by limiting average global temperature increases and the resulting climate change, and coping with impacts that were, by then, inevitable.”5 For the first time in over 20 years of UN negotiations, all parties aimed for a legally binding and universal agreement on climate change. COP 21, the 2015 conference, has been frequently mentioned in the media due to its bold declaration to keep global temperature increases below 2°C from pre-industrial levels. The topic, while a hot one, has had some mixed reviews. Critics argue that its aim and reach are not sufficient and that a threshold of 2°C still allows too much destruction and irreversible damage. Others point out that, while many countries have pledged their support, the agreement is not entirely legally binding. This poses some risks, which we will discuss later in more detail. On Oct. 5, 2016, the minimum number of parties (55 countries representing at least 55% of global GHG emissions) ratified the agreement; thus, the socalled Paris Agreement entered into force on Nov. 4, 2016, followed by COP 22, which took place Nov. 7-18, 2016, in Marrakesh. The ratification of the Paris Agreement, within the UNFCCC framework, was particularly significant, because both China and the U.S.—the world’s two largest economies and highest carbon emitters—ratified the agreement.6 The full effect of the Paris Agreement cannot be illustrated without first explaining the context of the Kyoto Protocol. 4 “Conference of the Parties (COP),” UNFCCC. 5 “Background on the UNFCCC: The international response to climate change,” UNFCCC. 6 “The largest producers of CO2 emissions worldwide in 2015, based on their share of global CO2 emissions,” Statista. RESEARCH | Sustainability 2 The Climate Change Challenge – From COP 21 to COP 22 November 2016 THE KYOTO PROTOCOL The Kyoto Protocol was a legally binding agreement adopted in 1995 by the COP. Specifically aimed at developed countries, it held them to specific carbon emission reduction targets within explicit time periods. The first commitment period lasted from 2008-2012, with the second one beginning on Jan. 1, 2013, and set to end in 2020. The Kyoto Protocol’s aim was to recognize the influence of developed countries on climate change (especially in relation to the Industrial Revolution), along with their powerful ability to counteract it. Arguably, developed countries yield greater influence (in terms of leadership) and greater flexibility (in terms of financial resources) to act against climate change than their developing and emerging counterparts. Two of the world’s highest carbon emitters, China and the U.S., were not bound by the Kyoto Protocol. The Kyoto Protocol suffered from many issues. The U.S. signed but did not ratify the protocol, reasoning that confronting climate change requires action from both developed and emerging nations.7 This created a serious problem: two of the world’s highest carbon emitters, China and the U.S., were not bound by the agreement. The first commitment period had 55 members’ signatures, just enough to ratify it. The goal of that period was for industrialized countries to decrease their GHG emissions 5% from 1990 levels. So was the first part successful? Based simply on GHG measurements, the agreement was reasonably successful. According to the UN, emissions of the signatories were 22.6% below 1990 levels, significantly better than the 5% reduction target. However, overall carbon emissions have continued to increase, signaling that the actions of a few still do not cover the many.8 7 “Kyoto Protocol: Why did the US pull out?” BBC. 8 King, Ed, “Kyoto Protocol: 10 years of the world’s first climate change treaty,” Climate Home. RESEARCH | Sustainability 3 The Climate Change Challenge – From COP 21 to COP 22 November 2016 Exhibit 1: The Climate Change Challenge in Numbers 2°C • Earth's average temperature has risen by 0.85°C over the past century and is projected to rise by 3.7°C to 4.8°C by the end of the century. In 2010, world governments agreed to limit the increase in global temperature to 2°C above preindustrial levels to avoid the worst impacts of climate change.* 3,010 Gt CO2 • Cumulative CO2 emissions are getting close to the 3,010 GT "Carbon Budget." It has been estimated that to have at least a 50% chance of keeping warming below 2°C throughout the 21st century, the cumulative carbon emissions between 2011 and 2050 need to be limited to around 1,100 gigatonnes of carbon dioxide (Gt CO2). USD 36 trillion • To have an 80% chance of maintaining this 2°C limit, the IEA estimates an additional USD 36 trillion in low carbon/clean energy investment is needed through 2050—or an average of USD 1 trillion more per year, compared to a business as usual scenario, over the next 36 years. From COP 21 (2015) to COP 22 (2016) • At COP 21 in Paris in December 2015, 195+ nations agreed to combat climate change and unleash actions and investment toward a low carbon, resilient, and sustainable future. The universal agreement’s main aim is to drive efforts to limit the temperature increase even to 2°C above pre-industrial levels. On Nov. 4, 2016, the Paris Agreement entered into force, in time for COP 22 in Marrakech. France's Energy Transition Law, Article 173, makes France the first country to introduce mandatory climate reporting for market participants. Source: International Energy Agency (IEA), “Energy Technology Perspectives 2012: Pathways to a Clean Energy System,” (Paris: OECD/IEA, 2012; Clarke, L. et al., “Climate Change 2014: Mitigation of Climate Change,” Edenhofer, O. et al., Chapter 6, Cambridge University Press, 2014; National Centers for Environmental Information (NOAA), “Global Analysis–2015,” January 2016; UNFCCC, “Historic Paris Agreement on Climate Change,” Dec. 12, 2015. Chart is provided for illustrative purposes. PUBLIC POLICY AND REGULATORY IMPLICATIONS Like the Kyoto Protocol, the Paris Agreement is legally binding. However, it is aimed at all parties in the UNFCCC (including emerging and developed countries). Here, we discuss some recent global actions that may promote the Paris Agreement’s effectiveness (as well as that of the Kyoto Protocol). France has enacted one of the most effective regulatory actions to date. In May 2015, the French finance minister announced that institutional investors in France would be required to disclose how they are managing climate change risk. France's Energy Transition Law, Article 173,9 made France the first country to introduce mandatory climate reporting for market participants, although similar ideas have been considered in Sweden. The requirement applies to market participants with a balance sheet of EUR 500 million or more. Market participants must deliver their first reports, which should cover 2016, by June 2017. 9 “LOIS,” Journal Officiel de la République Française, August 2015. RESEARCH | Sustainability 4 The Climate Change Challenge – From COP 21 to COP 22 November 2016 Many responsible market participant campaigns have begun to push for the global expansion of the Energy Transition Law, arguing that it allows for increased transparency and offers a unique look into the relationship between finance and climate change.10 In fact, a surge of low-carbon policies has emerged between COP 21 and COP 22, even in North America. The Governor of California signed a bill that aims to reduce state carbon emissions 40% below 1990 levels by 2030.11 Over the summer of 2016, the New York City Comptroller released a request for proposal (RFP) on behalf of the city’s pension funds calling for “carbon footprint analysis services and a climate risk investment strategy consultant.”12 Most recently, Canadian Prime Minister Trudeau implemented a minimum price for all carbon emissions, with the national carbon price starting at CAD 10 per ton in 2018 and increasing by CAD 10 per year until 2022, when every ton of carbon will cost CAD 50.13 Regionally, Europe continues to forge ahead. In September 2016, Switzerland became the first country to vote on whether to implement a green economy. This initiative set a goal to decrease Switzerland’s excessive resource consumption—and 36% of voters actively supported it. Similar initiatives are expected elsewhere in the near future.14 BEYOND COP 21 Only 54% of those polled felt that climate change was a “very serious” issue. In light of COP 22 and the ratification of the “2°C” agreement, what else can we expect? Multiple governments and institutions are now responsible and bound to slow down the effects of climate change. However, this may be an unpopular stance. In April 2016, the Pew Research Center polled 40 nations and found that, on average, only 54% of those polled felt that climate change was a “very serious” issue. On average, only 51% of those polled in each region felt that climate change was currently harmful, and just 28% felt that it would become an issue in the next few years. Surprisingly, Latin America expressed the greatest concern in the short term—77% of Latin Americans expressed concern for climate change impacts today. These concerns have bled into corporate policy. In July 2012, Mexico passed the General Law on Climate Change, closely followed 10 Brooksbank, Daniel, “France’s Article 173 should be replicated at EU level, say campaign groups.” Responsible Investor. Oct. 28, 2016. 11 Chang, Alicia, “California extends most ambitious climate change law in US,” Phys.org. 12 Stringer, Scott, “A Carbon Footprint Analysis Services and a Climate Risk Investment Strategy Consultant for the NYC Retirement Systems and Related Funds,” City of New York Office of the Comptroller, June 7, 2016. 13 “Canada’s climate policy: Let the haggling begin,” The Economist, Oct. 22, 2016. 14 Wackernagel, Mathis, “How Switzerland made history with green economy vote,” Global Footprint Network, Sept. 26, 2016. RESEARCH | Sustainability 5 The Climate Change Challenge – From COP 21 to COP 22 November 2016 by the 10-20-40 National Climate Change Strategy, which focuses on eight points of action, with the intended result of decreasing GHG emissions and adopting other climate change preventative measures by 2040.15 This brings us back to the intended consequences of COP 21 and COP 22; while the ultimate goal is admirable, the methods are slightly flawed. The agreement is “legally binding,” but that term is also slightly misleading; it is helpful to outline which parts are and are not legally binding. Terms that are legally binding include the following. • • Developed markets are required to supply a USD 100 billion fund to help emerging markets and developing countries decarbonize. The regular submission and accompanying review of carbon emission targets per each individual country. However, the emissions targets themselves are not legally binding, and each country will determine its own target.16 This poses a much larger issue: how can the “2°C” initiative be enforced if each individual country can choose its own target? What will stop countries from choosing low, achievable targets? The emissions targets themselves are not legally binding, and each country will determine its own target. As of November 2016, 187 countries have submitted their targets, known as Intended National Determined Contributions (INDCs). If the targets are met, it is estimated that global warming will be cut by only 2.7°C, meaning that global temperature increases will remain well above the 2°C target. Despite this flaw, many have pointed out that the 2009 climate change conference in Copenhagen resulted in failure because there were strict, legally binding targets for each country. This led to some of the highest emitters (like China and India) rejecting the agreement. While fighting climate change is clearly a global challenge, it is essential to include those high emitters in these agreements. As illustrated by the conferences in Kyoto and Copenhagen, without participation of the greatest offenders, the impact of any agreement can be limited. 15 “The Global Climate Legislation Study: Mexico,” The London School of Economics and Political Science, Jan. 25, 2016. 16 Kinver, Mark, “COP21: What does the Paris climate agreement mean for me?” BBC News, Dec. 14, 2015. RESEARCH | Sustainability 6 The Climate Change Challenge – From COP 21 to COP 22 November 2016 IMPLICATIONS FOR CORPORATIONS – AND THE ROLE MARKET PARTICIPANTS CAN PLAY Large companies are increasingly required to report on their GHG emissions and other environmental impacts. In a November 2015 report, the Organization for Economic Cooperation and Development (OECD) noted that of the G20 countries, only five— Argentina, India, Indonesia, Russia, and Saudi Arabia—do not have some kind of mandatory climate-reporting scheme in place for corporations.17 Reporting may help companies understand their environmental footprints and can be the first step toward improving environmental performance. The decarbonization of market participants' portfolios is increasingly seen as crucial in the drive to reduce GHG emissions and manage the financial risks from climate change. However, to date, the market participants who provide capital to those companies have not been subjected to reporting obligations on the climate risks they could be facing in their portfolios. In the absence of mandatory reporting, market participants such as pension funds and life insurance companies can use voluntary standards to assess the amount of climate risk in their portfolios and move away from investing in companies that might lose out in the shift to a low-carbon economy. In July 2015, French lawmakers adopted an amendment to France's Energy Transition Law that requires large market participants to make annual disclosures on the following. • • • • “The extent to which they have integrated environmental and especially climate-related considerations in their investment policies. The GHG emissions embodied in their investments. How they contribute to meeting French and international climate objectives. How much of a financial risk they face because of climate change.”18 The decarbonization of market participants' portfolios is increasingly seen as crucial in the drive to reduce GHG emissions and manage the potential financial risks from climate change. This amendment is seen as a pioneering initiative by the Portfolio Decarbonization Coalition, which brings together market participants with the support of the United Nations Environment Programme–Finance Initiative. In a November 2015 report,19 which was partly funded by a European Union Horizon 2020 project called SEI Metrics,20 the Portfolio 17 “Climate Change Disclosure in G20 Countries,” OECD, 2015. 18 “Investors to Assess Climate Risk in France,” European Commission. 19 “Climate Strategies and Metrics,” UNEP-FI, 2015. 20 2º Investing Initiative. RESEARCH | Sustainability 7 The Climate Change Challenge – From COP 21 to COP 22 November 2016 Decarbonization Coalition21 estimated that France's largest market participants hold more than EUR 2 trillion in assets. The report found that mandatory disclosures would “significantly boost the demand for climate metrics” and would help to “set the international standard,” making it easier for other countries to adopt similar rules. INDICES THAT ADDRESS ENVIRONMENTAL FOOTPRINTS How can non-institutions address the threat of global warming? S&P Dow Jones Indices has an entire suite of indices catered to addressing GHG emissions, fossil fuels, and high-carbon emitters. Techniques include a process of reweighting based on carbon emissions, exclusion based on fossil fuel ownership, and excluding those with the highest carbon intensity. As illustrated in Exhibit 2, the indices have performed quite well. The benchmark, the S&P Global 1200, has notably underperformed its carbonefficient counterparts. Exhibit 2: Annualized Returns Comparison of Climate Change Indices 160 S&P Global 1200 Fossil Fuel Free Carbon Efficient Index (TR) 150 140 S&P Global 1200 Fossil Fuel Free Carbon Efficient Select Index (TR) 130 S&P Global 1200 Fossil Fuel Free Index (TR) 120 S&P Global 1200 Carbon Efficient Index (TR) 110 S&P Global 1200 Carbon Efficient Select Index (TR) 100 S&P Global 1200 (TR) 90 Sep. 2012 Sep. 2013 Sep. 2014 Sep. 2015 Sep. 2016 Source: S&P Dow Jones Indices LLC. Data as of September 2016. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance. 21 Portfolio Decarbonization Coalition. RESEARCH | Sustainability 8 The Climate Change Challenge – From COP 21 to COP 22 November 2016 CONCLUSION We expect to see a continued increase in green finance and increasing pressure on corporations and market participants. Based on recent developments, countries, companies, and participants in the investment value chain must find a way to maintain a more carbonefficient and less harmful society. Additionally, many of the highest-carbonemitting sectors have been declining. Oil prices are in the midst of their worst downturn since the 1990s, in part due to an oversupply of oil coupled with a decrease in demand (to some degree attributable to the shift to renewable energy). Looking past COP 22, we expect to see a continued increase in green finance and increasing pressure on corporations and market participants, particularly as these 197 countries look to implement regulations and measures. The recent U.S. elections have created some uncertainty. Hence, the key emphasis in relation to climate change mitigation and adoption strategies must now shift—from global policies and frameworks toward regional implementation of the Paris Agreement goals. Here, investment instruments such as indices can help to guide market participants by providing metrics and frameworks for low-carbon and fossilfuel-free assessments. RESEARCH | Sustainability 9 The Climate Change Challenge – From COP 21 to COP 22 November 2016 PERFORMANCE DISCLOSURE The S&P Global 1200 Fossil Fuel Free Carbon Efficient Index was launched on November 16, 2015. The S&P Global 1200 Fossil Fuel Free Carbon Efficient Select Index was launched on January 11, 2016. The S&P Global 1200 Fossil Fuel Free Index was launched on August 28, 2015. The S&P Global 1200 Carbon Efficient Index was launched on August 20, 2015. The S&P Global 1200 Carbon Efficient Select Index was launched on August 28, 2015. All information presented prior to an index’s Launch Date is hypothetical (back-tested), not actual performance. The back-test calculations are based on the same methodology that was in effect on the index Launch Date. Complete index methodology details are available at www.spdji.com. S&P Dow Jones Indices defines various dates to assist our clients in providing transparency. The First Value Date is the first day for which there is a calculated value (either live or back-tested) for a given index. The Base Date is the date at which the Index is set at a fixed value for calculation purposes. The Launch Date designates the date upon which the values of an index are first considered live: index values provided for any date or time period prior to the index’s Launch Date are considered back-tested. S&P Dow Jones Indices defines the Launch Date as the date by which the values of an index are known to have been released to the public, for example via the company’s public website or its datafeed to external parties. For Dow Jones-branded indices introduced prior to May 31, 2013, the Launch Date (which prior to May 31, 2013, was termed “Date of introduction”) is set at a date upon which no further changes were permitted to be made to the index methodology, but that may have been prior to the Index’s public release date. Past performance of the Index is not an indication of future results. Prospective application of the methodology used to construct the Index may not result in performance commensurate with the back-test returns shown. The back-test period does not necessarily correspond to the entire available history of the Index. Please refer to the methodology paper for the Index, available at www.spdji.com for more details about the index, including the manner in which it is rebalanced, the timing of such rebalancing, criteria for additions and deletions, as well as all index calculations. Another limitation of using back-tested information is that the back-tested calculation is generally prepared with the benefit of hindsight. Backtested information reflects the application of the index methodology and selection of index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities, fixed income, or commodities markets in general which cannot be, and have not been accounted for in the preparation of the index information set forth, all of which can affect actual performance. The Index returns shown do not represent the results of actual trading of investable assets/securities. S&P Dow Jones Indices LLC maintains the Index and calculates the Index levels and performance shown or discussed, but does not manage actual assets. Index returns do not reflect payment of any sales charges or fees an investor may pay to purchase the securities underlying the Index or investment funds that are intended to track the performance of the Index. The imposition of these fees and charges would cause actual and back-tested performance of the securities/fund to be lower than the Index performance shown. As a simple example, if an index returned 10% on a US $100,000 investment for a 12-month period (or US $10,000) and an actual asset-based fee of 1.5% was imposed at the end of the period on the investment plus accrued interest (or US $1,650), the net return would be 8.35% (or US $8,350) for the year. Over a three year period, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.10%, a total fee of US $5,375, and a cumulative net return of 27.2% (or US $27,200). RESEARCH | Sustainability 10 The Climate Change Challenge – From COP 21 to COP 22 November 2016 GENERAL DISCLAIMER Copyright © 2016 by S&P Dow Jones Indices LLC, a part of S&P Global. All rights reserved. Standard & Poor’s ®, S&P 500 ® and S&P ® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global. Dow Jones ® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Trademarks have been licensed to S&P Dow Jones Indices LLC. Redistribution, reproduction and/or photocopying in whole or in part are prohibited without written permission. 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