Climate and profitability? The whole ball game, now.

Speakers on a finance panel at COP28 this week (including Ray Dalio, Rama Variankaval, Chuka Umunna, and Jason Channell) reiterated the view that climate solutions must be profitable if the financial industry is to be able to support them (see news article here).

This echoes a longstanding position of the investment industry that it can only help on climate challenges to the extent that opportunities are a 'win-win' - good for planet and profit.

In contrast, I would urge investors concerned about climate change to reflect that the essence of the sustainability challenge today is that we must now do many things that are humanly possible but not necessarily good for profits or economic growth. That has become the whole ball game.

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The difficult truth is that the 'win-win' and 'green growth' meta-strategies of the last 2 decades have failed to alter GHG emission trajectories anything like fast enough. The hope that new technologies would displace fossil fuels simply has not happened – they are proving additive rather than substitutive. While market-led technological substitution has happened many times through history, that does not guarantee it will always happen fast enough, if at all. Alas, that seems to be the case today. Writ large, we have a 'stop doing' problem (i.e. stop emitting GHGs) that is not yielding to our first-choice 'more doing' instinct.

The central problem of market-led environmentalism is that it fails to tackle the core driver of our unsustainable trajectory: namely, that the measurement of economic profit to which global capital allocation responds is constructed in a way that ignores climate and other ecological factors. Because of this neglect, every day the financial markets are open sees us grossly misallocate capital against human long-term interests. If nothing changes, the markets will open tomorrow and we will collectively repeat the error again.

The question investors must ask themselves is: what does profit even mean?

Not 'how is it calculated?', which is easy enough, but 'what does it mean?'

What does it mean to report a profit of $x million, if known social and ecological costs are not included in the calculation? What is a 'profit' if it is not fully costed? What sort of 'value' is a CEO or CFO articulating - and so legitimizing - when they report such a number? What sort of 'value' are investors normalizing when they punch profit figures into their spreadsheets? What sort of 'value' is the financial press daily reinforcing when it publishes profit numbers without any qualifiers or health warnings about how they are calculated?

The sustainability problem in a nutshell is that today's 'generally accepted' measures of profit that direct our making of the world are not fully costed.

It's a difficult thought to pursue, for if profits are not fully costed, do we want them to be higher or lower? Indeed, at the level of the whole economy, if higher corporate profit depends on higher externalized cost, as it seems to, we should want corporate profits to be lower, no?

There are legions of intelligent business and finance professionals who have not been prompted to reflect on the meaning of 'profit' and 'net income', to which their considerable efforts and talents nonetheless remain yoked. Students at business schools might usefully press their finance professors on what profit means.

In this sense, the sustainability crisis is truly a crisis of meaning. As we engage with and transform the matter and energy of the world, today's market-led cultures are overwhelmingly induced to act in accordance with economic values that do not faithfully reflect our understanding of the world. Questioning of these values is suppressed by widespread institution of 'fiduciary duty', which excuses investors from having to think too hard about the consequences of allocating capital in a cost framework that continues to deny reality.

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In contrast, climate scientists who still seek to work with numbers that reflect the real world have become increasingly concerned about nonlinearities and discontinuities in the climate system. I wish the chart below was clearer/better understood because it represents one of the key conclusions of the last 20 years of climate science, namely that tipping points constitute greater risks at lower temperatures than was understood in 2001.

The leftmost column shows that in 2001, IPCC scientists believed that 'large-scale discontinuities' might only occur with 3 to 5C of warming. But as research into 'discontinuities' has deepened over the last 20 years, so scientists have steadily lowered their predictions of when discontinuities may occur. The current view on the right is that moderate discontinuities may occur between 1 and 2C and more severe risks from 2C upwards. The very latest report on tipping points, from Global Systems Institute, University of Exeter this week, suggests we are close to breaching five tipping points right now.

Compare the dates of that research progression with the periods in which market-led environmentalism emerged: CSR and SRI (from 1990s), ESG (from 2004) and 'green growth' (from 2006).

The juxtaposition highlights that 'win-win' and 'green growth' strategies emerged at a time when it was thought there was more turning room available than is now understood. In addition, we now have twenty years' evidence that these strategies have not led to much displacement of fossil fuels at all.

The grim picture is both that the climate challenge is greater than we first recognized AND we have made less progress than hoped.

As such, the investment industry can no longer afford to think of the climate challenge as an agreeable market opportunity in which it would be nice to make some risk-adjusted returns. It must be seen as a moral obligation to do whatever can be physically done before it is too late.

That requires much more radical thinking from investors than we have seen to date, starting with acceptance that many actions we might take to prevent climate disaster will foreseeably interrupt economic growth and profit as currently measured, precisely because those flawed, meaning-less, measures are the core drivers of the problem.

This need not mean ‘degrowth forever’, but it probably means ‘degrowth for some period’. The analogy investors can readily access is that of a corporation that recognizes it must restructure to survive in a world that has changed – a difficult and painful process in which it must, well, ‘deprofit’ for a while as the only way to survive at all.

Corporate restructuring experts typically draw S-curve charts to explain the predicament. As the external environment changes to rule out the original business-as-usual expectation, it is eventually recognized there is only one viable path forward. Corporate survival depends on accepting reality fast enough and acting in accordance with it.

This is effectively now the situation for the whole global economy. The sustainability challenge has the same ‘restructuring’ form, only much larger and likely much longer. To believe we can become sustainable only by doing those things that offer an attractive risk-adjusted return is to resist the innate costliness of such a momentous challenge in much the same way a corporate board will initially resist advice it must restructure.

The key in both cases is recognizing and accepting that ‘the problem with the present is that the future is not what it used to be.’ That thought is resisted because, even though the future has never happened, we encode expectations of the future in our brains and having to alter expectations in unfavourable ways - having to 'lower expectations' - triggers neurological changes that are felt as irritation, pain and even grief in the present. That neurological process is echoed in current asset prices encoding expectations of future profits, but if we have to lower our expectations of future profits, that triggers a painful decline in asset prices today. The instinct to avoid that pain sees us clinging on to previously-established expectations and striving to make those expectations come true. Yet the profit expectations encoded in many asset prices are increasingly at odds with forecasts of climate tipping points.

Gradually, the situation becomes one of choosing between chaotic decline or managed transition. The real difficulty of the future changing unfavourably is that it hurts in the present.

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One form of solution – that might square with the panel speakers' comments about profit – is that we need an economy in which only genuinely sustainable projects pencil out to a risk-adjusted return. But investors will understand that requires much higher carbon taxes and stiffer regulations against fossil fuels and fossil-fuel dependent activities than we have yet implemented, with obvious implications for near-term growth and need for redistributive compensation measures, inter- and intra-nationally.

But it is the acceptance of the costliness of what could be done that is the obstacle the influential financial world is stuck on. That's the whole ball game, now.

Continued insistence that climate solutions be good for growth - or only be pursued to the extent they will not compromise profit or growth - is to double down on 'win-win' thinking that has demonstrably proved insufficient. It is increasingly a form of 'tipping point denial'.

To quote Ray Dalio's Principle II.1.1.2: "Truth—or, more precisely, an accurate understanding of reality —is the essential foundation for any good outcome." I agree. The difficulty of course is that some truths are much harder to accept than others. The process of accepting difficult truths requires collective effort and resolve. The truths now surfacing from climate science are turning out to be far more difficult than the 'inconvenient' they were trailed as two decades go. They are desperately difficult.

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There is certainly a vast amount of capital that could be directed to climate solutions, but current rules and regulations mean much of what could physically be done is not 'profitable' as we currently do the sums. So, either we need mass deployment of capital at below market-return rates to counter the flaws in current measures of profit and/or we need to change rules and regulations so there is a dramatic shift in relative profitability of investments in favour of those that are genuine solutions. The latter is the superior option because it also addresses the 'stop doing' nature of the climate challenge. It will choke off investments to those technologies that remain the problem and will induce behavioural changes that do not permit of investment solution.

All this is physically and humanly achievable, but quite obviously disruptive and costly. What the climate scientists are indicating is that such changes are nonetheless necessary and urgent.

Recognition of the climate crisis has happened on this generation's watch. We might rue our misfortune that such challenges have arisen. Or we might reflect, as the longest-lived and most prosperous generations ever to have lived, that we face a challenge commensurate with our good fortune and inherited capacities. 

The sustainability crisis presents investors not simply with difficult investment decisions in their day job, but with the transcendent question of what they might do as human beings to help tackle systemic problems, particularly given the influence the finance sector wields within a modern market society.

Respected and financially-literate figures that explained and confronted the present incompatibility of many climate solutions with current measures of profits and growth, out loud and on-stage, might yet make a major difference. They might help reframe sustainability from being a 'win-win' to being a 'must do', whatever it takes.

(cc: Alastair Marsh and Natasha White, writers of original news article)