KOREA CAPITAL MARKET INSTITUTE

Carbon neutrality and ESG
 
The global community has been moving towards the common goal of carbon net-zero. Since the globe reached the consensus of reaching carbon neutrality in the 2015 Paris Agreement, ESG management and investment have been a major economic trend in the market and the industrial as well as business sectors. What’s particularly encouraging is the shifting trend towards the new ESG management paradigm in the industrial and business sectors that used to be quite passive about climate change initiatives amid concerns about high costs of decarbonization. As the physical risk of climate change has recently materialized with the emergence of a carbon trade barrier, the current move towards ESG management appears to be something completely differentiated from the short-lived buzzword of green management a decade ago after the Kyoto Protocol. Such a trend is expected to become stronger as the agenda of carbon neutrality by 2050 takes shape into more concrete implementation plans.
 
Climate change and ESG management in the industrial and business sectors have been bringing about significant changes to ESG investing. Particularly noteworthy among those is climate activism. Global institutional investors have more than before directly targeted carbon issues in their shareholder activities. Although climate activism is not a new notion to global pension funds, the recent move is different on several fronts. Compared to compliance-oriented environmental shareholder activism in the past, post-Paris shareholder activism targets carbon itself, and is differentiated in terms of the scale, strong solidarity among activists, and clear and concrete objectives. With that being said, this article tries to examine some cases of climate activism to find out the overall trend as well as the recent characteristics and changes, from which to derive some implications for fiduciary activities of Korea’s pension funds.
 
 
Climate activism: Climate Action 100+
 
Climate activism is a fiduciary activity an investment firm requires its investee firm to formulate a concrete, firm-level target in line with the global agenda of carbon neutrality by 2050. Simply put, carbon itself became the target of shareholder activism after the 2015 Paris Agreement and the 2017 Task Force on Climate-related Financial Disclosures (TCFD) recommendations by the Financial Stability Board. The California Public Employees’ Retirement System (CalPERS) played a leading role in this. At the height of the Paris Agreement in 2015. CalPERS reviewed carbon footprints of over 10,000 global listed firms it invested to find only 80 out of those firms emitting over 50% of the global carbon emission. Slightly later in 2017, it partnered with five global ESG investor networks¹⁾ to launch an initiative called Climate Action 100+ (CA100+) in 2017. The initiative aims to exercise shareholder rights to encourage more firms to be engaged in the target set forth in the Paris Agreement. What is notable of this initiative is its designation of large emitters as a systemically important carbon emitter²⁾ that would be the central target of its shareholder activities. That kind of carbon approach stems from CalPERS’ long-held shareholder engagement strategy using its focus list program for the sake of governance improvement.
 
As of 2020, CA100+ designated 167 firms as systemically important carbon emitters. With the total market cap reaching $8.4 trillion, those firms are estimated to account for about 80% of the global carbon emission. The highest 100 emitters of those in aggregate would be the world’s third largest emitting country after China and the US. This is why CA100+ views curbing emissions from those firms as a critical factor in reaching the goal of global carbon neutrality by 2050. The list of systemically important carbon emitters consists of firms in various industries including 39 oil and gas firms, 23 mining and steel firms, 31 utility firms, 25 manufacturing process firms, 26 shipping firms, and 14 consumer goods firms. Three Korean firms are also included in the list.
 
With the initial intention and clarity in the goal, the Climate Action 1000+ initiative is being endorsed and participated by a rapidly growing number of institutional investors. For three years after the launch, a total of 545 institutional investors participated in the initiative as of 2020, and their AUM in aggregate reached $52 trillion, a half of the global asset management market. The list of participants includes most of the global giant pension funds such as world’s largest pension fund GPIF, the US’s largest pension fund CalPERS, Norway’s largest pension fund ABP, Australia’s retirement pension fund (superannuation), the UK’s retirement pension fund NEST, and private sector asset managers including BlackRock, SSGA, and Vanguard. No Korean asset manager has been confirmed being on the list. 
 
 
How could carbon be the target of shareholder activism?
 
From the investment theory perspective, the current situation of carbon being the target of shareholder activism is hard to swallow. It actually took a long period of time before governance—a concept whose theoretical framework is rooted firmly in agency theory—became the mainstream investment issue. This was only possible because agency theory is backed by long-accumulated empirical evidence about the correlation between firm value and governance. Although the correlation between carbon emission and firm value is supported by neither theoretical background nor empirical evidence, institutional investors managing roughly a half of global assets under management perceive carbon as a critical issue in practice. Such a fact could have stemmed from two factors. First, from the perspective of trade theory, carbon regulation quickly became part of the non-tariff trade barriers, beginning to affect the performance of investment managers. Although the Paris Agreement is not legally binding, this could serve as a trade barrier, perhaps stronger than any non-tariff barriers at a time when many regions and countries one after another are unveiling schedules of carbon regulations such as a carbon border tax, a carbon tax, a carbon regulation on internal combustion engines, a ban on selling cars with that engine, a ban on single-use plastics, etc. According to a recent empirical analysis,³⁾ a firm that voluntarily discloses climate change risk is more likely to see its firm value increase. 
 
Second, the recently observed phenomenon is deeply related to the nature of climate change risk that is systemic, undiversifiable by the traditional means of investment risk management, and with high externality. This is significantly different from individual and distributable governance or social risk, which makes it possible to be reflected in valuation via either discounts or premiums. The physical risk arising from climate change is disastrous and unpredictable. Moreover, the risk of transition to the post-carbon era makes portfolio diversification more difficult. There is an estimation that the post-carbon movement would cost the global internal combustion engines industry several trillion dollars in losses (stranded assets). That nature inherent in climate change is deeply related to the recently observed phenomenon where carbon becomes the primary target of shareholder activism, going beyond the mere portfolio strategy for ESG integration. However, a critically important issue raised here is whether the manifestation of such shareholder activism falls under the range of fiduciary duty or not. The CA100+ initiative sees it as part of fiduciary duty as CalPERS clearly states in its investment philosophy that any investment decision taking into account stakeholders’ interest should also have interest aligned with fiduciary responsibilities. On top of that, low-carbon activism is relevant to two investment philosophies of CalPERS. The first is that “long term value creation relies upon the effective management of three forms of capital: financial, physical, and human.” Second, “risk to CalPERS is multi-faceted and not fully captured through measures such as volatility or tracking error.” 
 
 
Climate activism: Focus areas and outcomes
  
Every action taken towards shareholder activism begins with information disclosure. In particular, ESG data are different from standardized accounting information in that they are qualitative and there are more than one disclosure standards due to the lack of demand.⁴⁾ From the qualitative perspective, most ESG data consist of numeric information such as the amount of carbon emission and the emission intensity. 
 
But more in-depth information is required to assess carbon from the investment perspective. Furthermore, low-carbon activism concerns not just about carbon itself, but the carbon emission under the context of global compliance towards carbon neutrality by 2050. More concretely, investors require multi-dimensional information on the emissions-reduction target, implementation strategies, governance accountability at the global, national, industry, and firm levels. The CA100+ initiative is that line of shareholder activism calling for disclosure of such information. More specifically, the initiative requires target firms to disclose materiality indicators such as governance accountability, goals, and implementation strategies for carbon neutrality. This is not only a step forward from the disunited standards merely focusing on simple information, but also a more concrete version that from the perspective of institutional investors gives substance to the TCFD recommendations the FSB proposed for financial firms’ management of climate change risk. 
 
CA100+ disclosure consists of information on governance, reduction targets, and implementation strategies. The governance part—unlike other existing standards—explicitly distinguishes the board and the management, requiring each to serve their respective roles and responsibilities. Detailed reduction targets are set for four phases: the final target by 2050, the long-term target from 2036 to 2050, the mid-term target from 2026 to 2035, and the short-term target by 2025. The initiative also requires concrete details with regards to implementation strategies, such as a plan for capital allocation for carbon neutrality. 
 
Out of 167 focus companies, about 43% disclosed that their implementation target is to reach carbon neutrality by 2050 or sooner as of 2020. This marks a meaningful outcome given the short period—three years—after the inception of the initiative. Among Korean players, SK Innovation is one of those firms.⁵⁾ Moreover, 38% of the firms set and disclosed their mid-term target and 51% set their short-term target. Regarding governance, 78% reported the accountability of their board. However, there has been no report about whether those firms established and disclosed their financial plans as part of implementation strategies (CA100+, Progress Report, 2020).  
 
The firms that are unfaithful about information disclosure are faced with diverse shareholder engagement policies. For example, shareholder proposals managed to bring changes to Exxon Mobil. When the global oil company had not reported its Scope 3 emissions data, CalPERS voted against the nomination of directors in May 2020. This, however, failed to change the course. In August 2020, CalPERS filed a shareholder proposal requiring the firm to disclose the emissions data, Exxon Mobil finally succumbed and disclosed its carbon emissions data in January 2021. Korea’s KEPCO is also facing shareholder engagement as Dutch firm APG and Japanese firm Sumitomo Mitsui Trust Investment (both being CA100+ signatories) are carrying out fiduciary responsibilities, asking KEPCO to withdraw its investment in coal power projects (CA100+ website). APG was recently reported to have sold all of its stake in KEPCO. 
 
 
Implications for Korea
 
This article overviewed institutional investors’ strategies regarding climate change, with the focus placed on shareholder activism. It was found that institutional investors have been adopting carbon neutrality as their key shareholder activism agenda at a pace faster than expected, and that heavy carbon emitters are in line with that trend, unveiling their emission reduction plan one after another. This is primarily because the global consensus is shifting towards reaching carbon neutrality by 2050 and cutting projected emissions in half by 2030. Another reason is that every stakeholder in this issue sympathizes with concerns about the aggregate impact of climate change on the economy and investment due to the issue’s systemic and non-distributable nature and other aspects like stranded assets. 
 
Korea is no longer free from that trend although it is still too early to tell how far and well the trend is received by Korean institutional investors’ shareholder activism that is taking its baby steps. Recently, controversies arose about the delay in the roadmap mandating ESG data disclosure first unveiled in 2019. Korea’s energy intensive industry structure with its energy, steel, and petrochemical sectors emitting high levels of carbon dioxide could face a higher transition cost compared to other economies. This could partly explain the Korean government’s mid-term reduction target is one-fourth of the current level by 2030—just a half of the global target, while on the other side declaring carbon neutrality by 2050. 
 
However, carbon consideration now deeply concerns domestic demand. With carbon neutrality now being a global agenda, the race for decarbonization and low-carbon regulation among nations, industries, and businesses is inevitable for export-driven economies. Most of the CA100+ systemically important carbon emitters are firms in Europe and North America, except for 3 Korean firm and 29 Asian firms (excluding Korean firms). Shareholder activism led by North America and Europe mainly targets large corporations in the markets in those continents, which reflects CA100+ signatory investors’ determination towards carbon neutrality. 
 
ESG management became a buzzword in shareholders’ meetings in 2021, and this is increasingly viewed as a paradigm shift, which is quite meaningful for Korea. Given that the core elements of ESG management include ESG governance, implementation strategies and publicity, this is perfectly in line with shareholder activism that requires similar elements such as governance, targets, and implementation strategies. The experience, expertise, and infrastructure Korea is now accumulating in the area of fiduciary responsibilities are expected to help ESG management activities to properly oversee, valuate, and thus give substance to carbon neutrality strategies in Korea. 
 
Given the overseas trend on climate activism, I propose the followings about how Korea’s fiduciary activities should pan out. First, institutional investors with high global exposure are advised to participate in CA100+ for strengthening their experience and partnership. Japan’s GPIP has been already the signatory of the initiative since 2018. Second, it is worth calling for investee firms to comply with TCFD recommendations. This is perfectly in line with publicizing ESG management strategies and outcomes. Third, it would be helpful if Korea’s pension funds emulate CA100+ by selecting and managing systemically important carbon emitters (focus list) out of Korea’s investee firms. Last but not least, a regulatory environment where climate change agendas can be discussed at shareholders’ meetings would be an important precondition to shareholder engagement. This will empower shareholder engagement tools such as shareholder proposals and dialogues that could be otherwise ineffective. Before Korea forms the ripe regulatory environment for shareholder proposals, pension funds should seek for ways to communicate with large carbon emitters on a regular basis as part of their fiduciary responsibilities via tools such as “focus areas” adopted by large-scale pension funds.
 

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1) CalPERS’s ESG strategies consists of shareholder activism, partnership, active engagement in ESG regulation, and ESG integration. Under the partnership strategy, it established the CA100+ initiative with five investor networks such as the UN PRI, IGCC, IIGCC, AIGCC, and CARES.
2) This is reminiscent of the post-crisis prudential regulation where financial authorities designate large-scale financial firms as systemically important financial institutions for overseeing the capital regulation.
3)  A more recent empirical study finds that a firm voluntarily disclosing climate change risk is likely to see its firm value increase (Flammer, C., Toffel, M.W., Viswanathan, K., 2021, Shareholder Activism and Firms' Voluntary Disclosure of Climate Change Risks).
4) For example, the UN PRI sets out information disclosure principles, while the GRI presents ESG disclosure standards for all organizations. The SASB also provides business reporting standards for US firms. The World Federation of Exchanges offers its own standards for listed companies.
5) SK Innovation pledged to achieve Green Balance 2030 and carbon neutrality by 2050.