Freddie Woolfe, Equities Analyst, Sustainable Investing, reviews what was and wasn’t achieved at the UN’s COP 26 climate summit and the implications for the market.

A key focus for Glasgow was the emissions gaps between current climate policies and country level commitments and the goal of limiting global warming to 1.5 degrees Celsius above pre-industrial levels.

Emissions must fall by 45% by 2030 from the 2010 baseline, whereas existing commitments would increase them by 13.7%. On a temperature basis, current policies are consistent with temperature increases of 2.6-2.7 degrees, with current binding pledges taking that trajectory down to 2.1 degrees.

But importantly, the full set of long-term country level net-zero targets would, if met, get the world to 1.8 degrees. The key therefore is the deliverability and the irreversibility of these targets.

Climate policy pressure increasing

We have long maintained that this decade is key for climate policy development to secure a 1.5 degrees pathway. At the negotiations there was significant emphasis on the emission gap to reach 2030 targets, and the need to get the emission trajectory down significantly. Countries are also being asked to return with updated, more ambitious targets next year, suggesting pressure is ratcheting up significantly in line with the rapidly evolving civil and political focus on the environment.

Co-operation has also been a key theme of the negotiations, with China and the US, the two largest emitters, reiterating their intention to co-operate on climate action, which could be a real game changer.

This increased impetus highlights the evolving risks for those companies that are not aligned with delivering net zero by 2050 but also the opportunities for those that are leading the transition both in how they operate and in how they can help others to decarbonise through their products and services.

Internalising environmental costs

We are strong advocates of financial markets pricing in environmental externalities to direct capital flows in support of real-world decarbonisation. Good progress was made on addressing outstanding points around Article 6 of the Paris Agreement, setting the structure for international carbon offsetting, which ultimately should result in a more coordinated global and effective carbon pricing mechanism. Pleasingly, the scheme will reduce the number of new credits in the market over time; this should play a key role in providing additional incentives to decarbonise as well as offering a global business model for nature-based solutions.

Reducing major drivers of carbon emissions

Another widely noted outcome was the introduction of text in the final agreement on fossil fuel subsidies and coal. There has been much discussion about how this wording was diluted from the initial ambitions, but we mustn’t ignore the progress in even referencing these carbon sources in the text as currently governments plan on producing twice as many fossil fuels as is compatible with the 1.5 degrees carbon budget. We expect this ambition to ramp up over time. Interestingly, during COP Goldman Sachs released its research that the difference in cost of capital between hydrocarbon and renewable projects has widened by over 10 percentage points in the last five years, suggesting the market is aware of the impact of the low carbon transition on these industries.

Important progress was also made on deforestation, with more than 130 countries including Brazil and Indonesia committing to end and reverse deforestation, a major driver of carbon emissions, by 2030. Methane was also a big focus, with over 100 countries pledging to cut methane emissions by 30% by 2030 against the 2020 baseline. This is particularly important as methane has 80 times the warming power of carbon.

A just transition

For the first time the just transition was baked into the agreement, acknowledging the importance of equity in the way that the burden of addressing climate change is spread and making sure that climate policies do not exacerbate the inequalities. It was, however, disappointing that while compensating vulnerable nations for loss and damage caused by climate change has started to enter the dialogue, no further commitments were made on financing by richer nations to lower-income countries.

COP 26 didn’t deliver everything, but a lot of progress was made. The trajectory toward firmer more coordinated climate action is clear. The time frame for achieving this has sped up significantly. We are not yet on the path for 1.5 degrees, but we have significantly increased the momentum behind it. Next year’s negotiations will be important to continue ratcheting up the pressure ahead of the next global stocktake of carbon emissions in 2023.

The imperative for the market to internalise carbon emissions and other environmental issues into the approach to evaluating and valuing companies has never been higher, which we believe creates some exciting investment opportunities in those companies leading the transition to a more sustainable world.