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Legg Mason Thought Leadership™ ESG: THE PARIS ACCORD ON CLIMATE CHANGE • Adopted Mary Jane McQuillen Managing Director, Portfolio Manager by consensus by all 195 participating member states, the accord promised to reduce members’ carbon output “as soon as possible” and to do their best to keep global warming “to well below 2 degrees C” (2°C) or 3.6°F. • In addition to an ambitious target, the accord featured a longterm goal for emissions; a ratchet mechanism to steadily increase the goals; progress on climate finance for poorer countries; and incentives to reduce emissions. • The accord also has investment implications across many industries, including power generation, energy and industrials. 2 Q 2016 Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal. This material is only for distribution in those countries and to those recipients listed. Please refer to the disclosure information on the final page. IN THE U.S. – INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE PORTFOLIO MANAGER COMMENTARY Fourth Quarter 2015 ESG Investment Program ClearBridge ESG Investment Program On the Environmental, Social and Governance (ESG) Investment front, this quarter we examine the recent Paris Accord adopted in December at the 2015 United Nations Framework Convention on Climate Change (UNFCCC) conference in Paris, France. This was the Mary Jane McQuillen 21st annual Conference of Parties (COP21) and the objective of the conference was to achieve, for the first time in over 20 years of UN Managing Director, Portfolio Manager negotiations, a binding and universal agreement on climate change and carbon pollution, from all the nations of the world. Conference head Laurent Fabius, France’s Foreign One of the most Minister, said this “ambitious and balanced” in the goal notable aspects of the plan was a “historic turning point” of reducing global warming.1 Paris Accord is that it marks the first time the U.S. has agreed to this kind of target. At the conclusion of COP21, the Paris Accord was adopted by consensus by all of the 195 UNFCCC participating member states. In the 12-page Accord the members promised to reduce their carbon output “as soon as possible” and to do their best to keep global warming “to well below 2 degrees C” (2°C) or 3.6°F. A non-legally binding addendum to the Paris Accord included a plan to provide $100 billion a year in aid to developing countries for implementing new procedures to minimize climate change with additional amounts to be provided in subsequent years. Although the UN negotiation process inevitably involves compromises from all sides, the resulting agreement has a number of key attributes that lay a foundation for a global response to climate change:2 •• An ambitious target – governments agreed that the aim is to keep a global temperature rise this century well below 2°C and to drive efforts to limit the temperature increase even further to 1.5°C above pre-industrial levels. •• A long-term goal for emissions – the agreement aims for net zero emissions in the second half of the century. •• A ratchet mechanism – national plans will be updated every five years, thereby steadily increasing their ambition over time. •• Progress on climate finance – the agreement strongly urges developed countries to mobilize $100 billion per year in finance support to help poorer nations reduce emissions and adapt to changes in the climate. •• Incentives to reduce emissions – the agreement recognizes the important role of providing incentives for emission reduction activities, including tools such as domestic policies and carbon pricing.3 2 PORTFOLIO MANAGER COMMENTARY From our perspective, one of the most notable aspects of the Paris Accord is that it marks the first time the U.S. has agreed to this kind of target. It was generally acknowledged that without By seeking to invest the participation of both the in the best-in-class U.S. and China, by far the two largest national emitters of companies in these carbon, the efforts of all other industries…we can participants would be well actively support those intentioned but for naught. market players working to reduce carbon emissions and mitigate anthropogenic climate change. President Obama insisted on America’s essential role in that regard: “…With our historic joint announcement with China last year, we showed it was possible to bridge the old divide between developed and developing nations that had stymied global progress for so long…That was the foundation for success in Paris.”4 Aerial view of Kotzebue, Alaska, USA - an Inuit village facing the imminent prospect of displacement due to rising sea levels, melting permafrost, and erosion. Photo: U.S. Army Corps of Engineers. challenges and risks to human rights resulting from anthropogenic climate change. What also helped in the U.S. participation was that important steps had already been taken to establish national policies to reduce emissions, such as the Clean Power Plant rule from the EPA and the mileage standards for vehicles (both light and heavy). Large U.S. multinationals have increasingly recognized the importance of directly addressing the climate change issues and the need to support solutions. Thus, it is likely that opposition to implementing policy solutions to the carbon emissions problem in Congress is likely to weaken as more leading corporations begin supporting action. Referring to the Paris Accord as “…a stepping stone rather than the end objective for climate change action,” the report highlights the need for greater ambition with regard to mitigation, human rights safeguards for international climate finance mechanisms, financial assistance for developing countries faced with adaptation, and the development of an international mechanism on climate-induced displacement and migration. In addition, the report proposes a number of new human rights-related mechanisms for international coordination and accountability in delivering these outcomes. Less noticed perhaps, but materially important has been the growing emphasis in the U.S. on energy efficiency (in HVAC, lighting, appliances, electric motors, etc.), which helps explain why power demand in the U.S. has been flat despite economic and population growth.5 The report goes on to describe how the Intergovernmental Panel on Climate Change (IPCC)’s Fifth Assessment Report (AR5)6 provides a detailed picture of how the observed and predicted climactic changes will adversely affect millions of people and the ecosystems, natural resources, and physical infrastructure upon which they depend. In addition, we anticipate that the millennial generation’s broad-based acceptance of the scientific observations of anthropogenic climate change, which refers to the impact of the production of greenhouse gases emitted by human activity, coupled with the ethical obligations to those most affected by it yet underserved across geographies, should provide tailwinds to keep the Paris Accord moving in the right direction. The Paris Accord’s carbon emission target is not legally binding and so may be considered more aspirational than enforceable, but it is still an important milestone. On Climate Change and Human Rights Also in December the United Nations Environment Program (UNEP) and Columbia Law School’s Sabin Center for Climate Change issued a new report on “Climate Change and Human Rights” that describes the As stressed in the report is that “near-term harmful impacts include sudden-onset events that pose a direct threat to human lives and safety, as well as more gradual forms of environmental degradation that will present risks to access to clean water, food, and other resources that support human life.” Preceding the IPCC’s latest report, a number of communities took matters into their own hands by petitioning governments to assess and mitigate the effects of climate change in anticipation of increasing climate-related threats to their human rights. For example, in 2007, the Republic of Maldives, an island state in the Indian Ocean, convened a meeting of small island states to request that the Office of the UN High Commissioner for Human Rights (OHCHR) conduct a detailed study on the relationship between climate 3 CLEARBRIDGE ESG INVESTMENT PROGRAM change and human rights. Thus, in 2009, the UN OHCHR became the first international human rights body to examine such a relationship.7 In December 2005, the Inuit Circumpolar Council Canada petitioned the Intra-American Commission on Human Rights based in Washington, DC to seek relief for the Inuit from global warming caused by greenhouse gas emissions from the U.S. The 163-page petition documents existing, ongoing and projected destruction of the Artic environment and culture of Inuit caused by global warming. The new report provides an indispensable basis for climate policy going forward, helping us see in detail how climate change threatens our ability to enjoy our human rights, and also how the exercise of human rights can inform and guide our climate policies. As the report states, “a human rights perspective on climate change not only provides a stark warning of what is at stake - it also gives us a beacon of hope that we can solve this problem together.” Investment Implications The near- and long-term impacts of COP21 and the Paris Accord are not limited to the environmental and political spheres, and will have significant ramifications for the global economy and investment landscape as well. The Paris Accord shows that it is possible for the world’s nations to come together to tackle a global issue like climate change. However, it is important to point out that the commitments put forth by each country, known as Intended Nationally Determined Contributions (INDCs), are non-binding and generally apply after 2020. In addition, these national commitments will need to be increased considerably to achieve the goal of keeping global temperature increase to 2°C, let alone well below that number. So despite the morale boost from the Paris Agreement, ultimately it will still be national policies that will determine the specific emissions reductions and low-carbon incentives by country, sector and facility. The short-term impacts on companies from the agreement itself are not the key issue here, but the agreement will have future implications as regulations are enacted and ratcheted up over time. For example, in the U.S., as noted by one of our internal analysts, the Environmental Protection Agency’s emission and carbon regulations are expected to have a material impact on valuing the power sector. These regulations will increase the operational costs of the power plants with higher emission levels (e.g., older, less efficient coal plants) and require additional environmental spending. Incremental expenditures on environmental retrofits should make smaller, older 4 coal plants uncompetitive and lead to their retirement. Implementation of mercury regulations alone could lead to retirement of an estimated 17% of the country’s coal-fired capacity by 2017. The increasing penetration of distributed solar power generation and utility-scale energy storage will also have a disruptive effect on utilities over the longer term. It is also worth considering that the achievement of a global agreement will likely reinvigorate broad efforts to combat climate change on many fronts and act as a catalyst for private sector expenditure in areas like renewable energy, energy efficiency and smart technologies broadly. In that sense the climate agreement reached in Paris is a positive for sentiment on companies involved in low-carbon technologies and a negative for high-carbon emitters like coal-fired power technology.8 The need to reduce carbon emissions globally has implications across many industries. On a long-term basis carbon regulations and evolving market conditions are likely to affect operating cost structure and capital allocation in sectors like energy and industrials. In the technology sector, significant growth markets exist for technologies like sensors that enable electric and hybrid vehicles, and LED lighting that is 85-90% more efficient than conventional lighting. And in the materials sector, products with attributes like energy efficiency, light weighting and fuel efficiency are increasingly in demand, while industrials sector companies are increasingly developing cleaner and greener industrial products and processes to meet a similar increase in demand. Our Approach When it comes to the industries that account for the bulk of carbon emissions, namely within the energy and mining sector, ClearBridge’s ESG Investment approach is to not invest in companies that are laggards and/or to underweight these sectors as appropriate. Accordingly, the focus would be on managements who have the willingness and ability to advocate for stricter standards, and companies within these industries who are providing solutions and renewable opportunities. Our reasoning behind this choice is twofold. By seeking to invest in the best-in-class companies in these industries – those which are relatively cleaner, more efficient and innovative than their competitors when it comes to carbon and other greenhouse gases – we can actively support those market players working to reduce carbon emissions and mitigate anthropogenic climate change. In our experience (which is in agreement with a substantial body of academic research), these companies also typically represent the better long-term PORTFOLIO MANAGER COMMENTARY investment choice in their given industries, due to a host of factors including longer-term-oriented leadership and management teams, better corporate governance structures, reduced liability risks and superior technology, just to name a few. Furthermore, our integrated approach to active corporate engagement on climate change issues, whereby we advocate in meetings with corporate management teams to advance ESG issues such as carbon emissions disclosure, setting benchmarks on emissions reductions, influencing corporate strategy to be longer term, and improving supply chains – enables us to utilize the influence we bear as institutional investors and fiduciaries as a positive force to help improve companies’ outcomes with regard to carbon emissions. Doyle, Allister; Lewis, Barbara (December 12, 2015). “World seals landmark climate accord, marking turn from fossil fuels”. Reuters. Thomson Reuters. Pfeifer, Stephanie (December 16, 2015). “Did COP21 Meet Investor Expectations?” Institutional Investor Group on Climate Change, MSCI ESG RESEARCH INC, (MSCI Webinar COP21 Dissected). 3 United Nations Framework Convention on Climate Change (December 2015). “Paris Agreement”. 4 President Obama (December 12, 2015). “President Obama’s Statement on Climate Change”. White House Briefing Room. 5 Vandenberg, Tim. Washington Analysis. Direct communications. December 2015. 6 IPCC, Climate Change 2014: Impacts, Adaptation, and Vulnerability, Contribution of the Working Group to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change (Cambridge University Press 2014). 7 Knox, John H. “Linking Human Rights and Climate Change at the United Nations.” Harvard Environmental Law Review. July 2, 2009. 8 UBS Global Research, US Electric Utilities & IPPs, COP21: Distilling the Essence of the Framework (Call Transcript), December 21, 2015. 1 2 5 CLEARBRIDGE ESG INVESTMENT PROGRAM About the Author Mary Jane McQuillen Managing Director, Portfolio Manager, Head of ESG Investment • 19 years of investment industry experience • Joined predecessor firm in 1996 • Professional organization memberships: Sustainable Investment Security Analysts Committee, New York Society of Security Analysts (NYSSA); UN PRI Public Equities ESG Integration Working Group; Investor Responsibility Research Center Institute (IRRC), Board of Directors; Sustainable Investment Research Analyst Network (SIRAN) - Steering Committee; United Nations Environment Program Finance Initiative (UNEP FI) Asset Management Working Group (AMWG) • MBA in Finance, Columbia Business School • BS in Finance from Fordham University 6 This page intentionally left blank Brandywine Global Clarion Partners ClearBridge Investments EnTrustPermal Martin Currie QS Investors RARE Infrastructure Royce & Associates Western Asset Legg Mason is a leading global investment company committed to helping clients reach their financial goals through long term, actively managed investment strategies. • Over $669 billion* in assets invested worldwide in a broad mix of equities, fixed income, alternatives and cash strategies • A diverse family of specialized investment managers, each with its own independent approach to research and analysis • Over a century of experience in identifying opportunities and delivering astute investment solutions to clients leggmason.com IMPORTANT INFORMATION: All investments involve risk, including possible loss of principal. 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