What’s the story: Should investors flip the script regarding the energy transition? (Part 3)

This is part of a 3-article series. You’re reading Part 3. Here is Part 2 and Part 1.

“Sometimes reality is too complex. Stories give it form.” Jean-Luc Godard

“The value of challenging narratives is not simply to find the best explanation of what is going on. It is to test the weakness of proposed plans of action, and to secure robustness and resilience.” John Kay and Mervyn King, Radical Uncertainty

Introduction

This is the last in a series of three articles about climate change and the energy transition. And about ‘reference narratives’, or stories. The stories that we, often unwittingly, have in the back of our mind as we try to work out how to assess the impacts of climate change, or what we can do about it. 

In the first two articles, I explained what a ‘reference narrative’ is, and I discussed two common energy transition narratives: the market-led transition narrative and the policy-led transition narrative. In this final article, I’ll provide a brief recap of what was discussed in the first two articles and will contrast the two narratives in order to conclude which one is most aligned with ‘the facts’. 

The facts, as I see them, are taken from a set of books about climate change – about solutions to climate change in particular – by experts on public policy, economics, and energy systems. The books that I would most recommend from this larger collection are listed at the bottom of this article.

Narratives, narratives, narratives

I’m happy to refer you to earlier articles for the details, but if you’re keen to find out how the story ends below, a quick recap of reference narratives, the market-led narrative, and the policy-led narrative:

Reference narratives are the stories that we hold in the back of our mind – stories about how we expect things will unfold, in this case, about how we as society will address climate change. Often, we’re not very conscious of what specific narratives we’ve adopted and are referencing, and we tend not to proactively test or regularly update them. Yet they inform our views on who we expect to act on climate and on how they should act, and they inform how we assess climate-related risks.

The first common reference narrative is the market-led narrative, which holds that the dynamism and innovation of companies and investors can substantially solve the climate problem without government intervention. Central to this narrative are transition plans, where companies detail how they will decarbonize their operations. Investors play a key role because, through the allocation of capital, they can enable green technologies and shrink dirty industries, and through engagement, can hold companies to account on their transition plans. Adding up all this activity will make the global economy net zero over time. A major constraint in this narrative is the availability of data on transition plans and on who is responsible for emissions, which leads to the need for disclosures.

The other common transition-related narrative is the policy-led narrative, in which story it is government policy and interventions (or lack thereof) that determine the speed and nature of the transition. This is mainly because the energy transition implies a substantial transformation of much of the global economy, which involves switching to technologies that are not yet economically viable, and which often goes against the interests of incumbent actors. Through laws, regulations, taxes, subsidies, and state-led R&D, governments can create the right economic incentives for markets to organize resources in a way that enables the transition. The key constraint in this narrative is the political power of carbon-dependent interests, who have proven able to weaken or even block climate policies in virtually all developed economies. 

What’s the story

In comparing the two narratives, it should first be noted that they are highly binary – they offer two completely different scripts on how we as society will tackle the climate problem. Of course, this is intentional, to be slightly provocative, but also to drive home the central point of these articles: that different narratives can lead to radically different expectations, actions, and outcomes. In reality, there are likely many more than two narratives, and they will feature elements of both.

But while these narratives probably don’t exist in a ‘pure’ form, in my experience, many organizations and people do subscribe to 80-90% to the narratives as outlined here. For example, many climate-related investor policies and industry initiatives revolve around commitments to assessing company transition plans, disclosures, divesting, or portfolio decarbonization, and do not reference the role of governments, regulations, and policy (or these are only mentioned as afterthoughts or in footnotes and disclaimers). As such, the market-led narrative appears to be the most popular reference narrative in investor and sustainable finance circles, underpinning investor policies, risk management and engagement approaches, collaborative initiatives, and marketing. And, importantly, underpinning the time spent by sustainable investing professionals.

Then, I promised to test both narratives against the ‘facts’, as taken from the set of books about solutions to climate change by experts on public policy, economics, and energy systems, that I’ve listed below. 

My conclusion can be quite simple: the policy-led narrative wins the day. 

Based on my reading of these experts, the policy-led narrative offers the most realistic set of expectations and assumptions around delivering the energy transition and meeting Paris goals. Indeed, in these publications, I could find a few statements suggesting that these experts see an important role for voluntary private sector action. There are virtually no recommendations for more or better transition plans; for more or better disclosures of emissions; for more target-setting by companies or investors; for the pursuit of Paris-aligned operations or portfolios; or for more divestment of carbon intensive companies or investor engagement with fossil fuel companies.

And this seems to be borne out in real life: it is hard to point to a highly significant contribution to the transition that has been made by voluntary action as opposed to by the private sector responding to incentives set by governments and technology innovations.

Tell me why

The detailed narratives that I’ve written up in articles 1 and 2 already provide lots of hints as to why the policy-led narrative is the more ‘correct’ one. But the key factor to zoom in on is the constraints listed in both narratives: (1) the key constraint in the market-led narrative is lack of data and disclosures that will allow us to see where risks and win-win opportunities lie and act on them; (2) the key constraint in the policy-led narrative is that an energy transition goes against the interests of many incumbents, who also have substantial political power and have proven able to influence or block climate action.

Think about the first constraint: the history of entrepreneurship, innovation, and financial markets shows that if there are, in fact, profitable win-win investment opportunities to be found, investors will not be held back by the lack of data or sit on the sidelines for twenty years while we come up with the right disclosure frameworks. Is the lack of data and disclosures really such an important constraint to enabling the energy transition? It seems doubtful.

At the same time, regarding the second constraint, it is easy to observe that there are many sectors that have a financial stake in the way that we have organized our entire economy around fossil energy sources, and are reluctant to see changes to the status quo that will impact profits, returns, careers, jobs, or (political) power. And this doesn’t only apply to fossil fuel companies; this applies equally to automotive businesses, chemical manufacturing, heavy industries, agricultural interests, and many other sectors. And this also extends to labor: not only do many company managers and shareholders have an interest in keeping things the way they are, many workers do too, and in fact, labor unions in many of these sectors have also been successful in gaining access to policy design, and substantially watering down or even blocking climate policies. Pretending that this constraint does not exist means expecting large parts of the global economy to voluntarily give up profits, returns, jobs, or power in exchange for the energy transition. This, to me, seems wishful thinking.

Of the two narratives, the policy-led narrative is the only one that acknowledges this second constraint and proposes a way to deal with it: collective action on behalf of all of society, based on trade-offs made through democratic processes, and using the legislative, regulatory, policy and fiscal toolboxes we’ve given to our elected representatives to deal with exactly these kinds of tragedy-of-the-commons issues.

So what? 

Does any of this matter for day-to-day investor practices? I think it does, in a number of areas.

• Risk management. If you subscribe to the market-led narrative, you’d look at a company’s carbon intensity, at its emissions metrics, and at how credible its transition plan is, to assess how much investment risk there is. Whereas if you subscribe to the policy-led narrative, you’d look at the likelihood of policy impacting that company’s competitive environment or business model: are (carbon) taxes on the way? Or subsidies, or government-led investments in new technologies? You may conclude that your most risky investments are not the most carbon-intensive ones – this depends mostly on the policy interventions that are coming at them and how they’re structured. Sustainable finance professionals often describe highly carbon intensive companies as ‘stranded assets’; while intuitively this reasoning seems right (“addressing climate change is so urgent that these activities simply must become redundant”) it’s good to keep in mind that some intervention will be required to make assets stranded. Finally, also keep in mind that, for the entire economy to be Paris-aligned, not every individual company needs to be Paris-aligned. As such, a company’s Paris-alignment, to the extent this can even be measured, is a very poor risk indicator.

• Engagement. If investors subscribe to the policy-led narrative, does that mean they can stop engaging? Of course not. Stewardship is a core responsibility that comes with being an investor and is shown by research to be the most effective way for them to contribute to real-world outcomes. But it does mean engaging in a different way – recognizing the limitations of what a single company can do to influence economic systems; recognizing that it will be exceedingly challenging to persuade a company to undertake activities that are not (yet) economically viable, or to give up profitable business lines; and recognizing that the more achievable the engagement ‘ask’, the more likely the engagement is to be successful. Investors should focus on what Tom Gosling and I call the ‘zone of discretion’: where capabilities and financial interests intersect. Engaging with an oil company with the goal of transforming it into a wind energy company? Highly unlikely. The typical oil company has neither the capabilities nor the financial incentives. Asking an oil company to address methane leakage? Potentially viable. And while we’re on engagement, investors should also consider policy advocacy – engaging with governments. Policymakers will want to hear from investors which measures they should implement that would in fact change economic incentives and change the competitive environment of the sectors they invest in in ways that enable the energy transition.

• Lobbying. If you accept the policy-led narrative, you’ll agree that a key factor holding up the energy transition is the political power of incumbents, in particular carbon-dependent industries. Countering this should surely have an impact and should be considered by investors looking to mitigate climate-related investment risk or contribute to solutions. In his book Carbon Captured (see also the list below), Matto Mildenberger argues we need to first disrupt the political power of carbon polluters before we can effectively reshape economic incentive structures. And, in fact, it has become more common for investors to ask companies to be transparent on lobbying practices, or even ask them to stop lobbying against climate action policies altogether. This is welcome, but investors should not underestimate what will be needed to disrupt the power of incumbents, or the strong commercial incentives for companies to influence policy – getting companies to stop influencing politics is a bit like getting lions to stop eating zebras. Mildenberger believes that this political power can only be disrupted by shaping broad, inclusive political coalitions – investors who want to help accelerate the transition should ask the question of the extent to which they might be able to contribute to this.

• Transition plans. Does it make sense for companies to have a transition plan? Of course; while it doesn’t necessarily need to be labeled “Transition Plan”, every company, in its strategy setting process, should consider how well it is positioned to confront challenges and opportunities arising from relevant external factors: industry developments, new competitors, technological advances, geopolitical changes, economic cycles, and demographic shifts. Climate change and the energy transition, for many industries, will feature in this top 10 list, and so having a plan for how to navigate them will be helpful. That said, investors should approach transition plans with a dose of skepticism: plans that suggest that the company will become Net Zero or Paris-aligned simply by pursuing profitable opportunities and without the need for enabling policy should be taken with a grain of salt. Equally, transition plans that suggest the company will shift to new (low carbon) businesses or technologies where it has no competitive edge or financial interests are unlikely to be credible – the old rules of corporate strategy and governance still apply; it might sound good from a transition perspective, but investors will want to know “why this shift? do you have the capabilities, culture, incentives to make it a success?” In addition, a solid transition plan will identify key policy drivers relevant to that company’s industry as well as several long-term policy scenarios and how the company would respond in those policy environments. Finally, having a great map is not a guarantee that you’ll arrive at your destination – similarly, having a great transition plan is no guarantee that the company will transition, let alone that its entire industry will transition. And the long-term viability and success of each company will depend on myriad factors besides climate change and the transition.

• Contributing to solutions. Investors who buy into the policy-led narrative and who also want to contribute to the transition will see that the most powerful contribution they can make is to facilitate public policy interventions. This starts by publicly endorsing the policy-led narrative (for an example of how to do this, see the next bullet point), not overstating what they can do on their own, and by managing clients’ and other stakeholders’ expectations. Other ways to contribute are to engage with companies and governments, as detailed above. Impact investing is, of course, a final way to contribute, but, as discussed here, in line with the policy-led narrative in many cases this will require investing in technologies and activities that cannot yet be deployed on a commercial basis and are therefore unlikely to satisfy institutional investor requirements. In other words, those investors will need to consider either compromising on their risk and return requirements or contributing proactively to these investments through public-private partnerships (e.g., with government agencies or development finance institutions) or by contributing to or investing in blended finance solutions.

• Investor policy statements. Investors may wish to clarify which reference narrative they subscribe to in their climate policies or sustainable investing statements. If that is the policy-led narrative, sample text could include the following: “Based on our reading of experts in climate change, technology, economics, and public policy, it is our view that the speed and nature of the energy transition depend mostly on the role that governments will play. This is out of recognition that the transition requires a substantial transformation of many industrial sectors, which involves switching to technologies that are not yet economically viable, which in turn requires laws, regulations, taxes, subsidies, and government-sponsored R&D in order to create the right economic incentives that will enable this transformation. Investors and the private sector will play a critical role in deploying resources to align with these revised incentives, and can choose to lean into or against the transition, but cannot by themselves drive the needed change. One of the main barriers to effective climate policy is the political power of carbon-dependent interests, who can often weaken or even block climate policies in most developed countries. At the same time, low-carbon industries are nascent, fragmented, and politically weak.” 

In conclusion and final thoughts

In these articles, I’ve discussed the importance of reference narratives and have outlined two common energy transition narratives. I’ve also observed that – judging by investor policy statements,  investor actions and industry initiatives – many investors appear to subscribe to the market-led narrative, whereas judging by what experts in technology, economics and policy are telling us, the policy-led narrative is more aligned with reality.

It’s interesting to note that in many private conversations, institutional investors do often emphasize the crucial role of governments and policy, and observe that we should not overstate the contribution investors can make, which seems more in line with the policy-led narrative. On balance, it is my impression that many investors, at least personally, subscribe to the policy-led narrative, but the investor policy and industry initiative language ends up being largely aligned to the market-led narrative.

I feel it’s time to clear up this confusion – investors need a reasonably accurate, fact-based, and realistic narrative, not only about what causes climate change, but about how society may solve climate change, and how likely this is. Similarly, stakeholders – clients, policymakers, investee companies – deserve to know what they can expect in terms of investor behavior and what thinking it relies on. I have argued here that the policy-led narrative is the ‘correct’ one, judging by what technology, economic, and policy experts have written. 

I believe that an honest appraisal of these two narratives would result in investors both doing things differently and doing different things, compared with the portfolio of activities that arises from the market-led narrative. 

This should lead to investment and other decisions that are most likely to result in the best possible outcomes, for investors and for broader society alike. 

illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.

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Sources

Of the various books I’ve read about climate change and the energy transition, I’ve found these to be most accessible and insightful, and together I feel they offer a fact- and science-based narrative on how we as society should engineer the energy transition:

• Climate Matters, John Broome (University of Oxford)
• Making Climate Policy Work, Danny Cullenward (University of Pennsylvania, American University) and David G. Victor (UC San Diego)
• How to Avoid a Climate Disaster, Bill Gates
• The Entrepreneurial State, Mariana Mazzucato (University College London)
• Carbon Captured, Matto Mildenberger (UC Santa Barbara)
• More and More and More, Jean-Baptiste Fressoz (Imperial College, Centre National de la Recherche Scientifique)
• Short Circuiting Policy, Leah Stokes (UC Santa Barbara)
• Sustainable Energy – without the hot air, David JC MacKay (Cambridge University, Fellow of the Royal Society, Chief Scientific Advisor to the Department of Energy and Climate Change, UK)

Acknowledgements

I’d like to thank Tom Gosling at the London School of Economics and Political Science (LSE) who was a valuable sparring partner in fleshing out the ideas set out here. Also I’d like to thank Royal London who made it possible for me to do the thinking and allocate the time needed to write these articles.

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