As global policymakers discuss the implementation of the Paris Agreement at the United Nations Climate Change Conference in Marrakech, investors should consider how so-called ‘transition risk’ impacts their portfolios, says Stephanie Maier.
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On November 7, the bustling Moroccan city of Marrakech will host the twenty-second conference of parties to the United Nations Framework Convention on Climate Change (UNFCC), where policymakers will discuss how they can meet the targets set out in the historic Paris Agreement, which was negotiated at the COP 21 summit in December 2015 and took effect in November 2016. The agreement commits governments to hold global temperatures at less than two degrees Celsius above pre-industrial levels, and to pursue efforts to limit the increase to 1.5 degrees.
The ratification of the agreement came about much more quickly than many observers had expected: 191 UNFCC members, including the US, China and the European Union, have agreed to its terms and set Nationally Determined Contributions (NDC) to emissions reduction targets. This represents a significant step forward in the battle against climate change. Limiting human-induced global warming will help curb extreme weather events, protecting communities and ecosystems from irreparable damage.
Investors should also welcome the swift ratification of the Paris Agreement. According to research Aviva Investors commissioned from the Economist Intelligence Unit (EIU),1 a rise in global temperatures of five degrees between 2016 and 2100 would inflict $7 trillion of losses on investment portfolios discounted to present day value, more than the total capitalisation of the London Stock Exchange. This isn’t just because floods, wildfires and droughts will damage physical assets, but also because environmental changes will result in weaker economic growth, which will have knock-on effects on financial markets. The EIU’s research makes clear that if the temperature rise is restricted to below two degrees Celsius; these projected losses would be considerably reduced.
Nevertheless, the transition to a low-carbon economy is unlikely to be smooth, and it may bring new investment risks. As the attendees of the UN conference in Marrakech thrash out plans to achieve the objectives of the Paris Agreement, they are likely to hone in on the nitty gritty of regulation and policy. While these negotiations won’t grab the headlines as the Paris Agreement did, they will be just as important – and investors should pay close attention.
In a 2015 report, the UK Prudential Regulatory Authority identified three principal climate-related risks to the insurance industry, and these have broader relevance across the financial markets. As well as physical risk to investment assets from climate change, the report cites liability risk, which is related to the potential effects of compensation claims on carbon extractors and emitters, and transition risk, which refers to the impact measures to tackle global warming will have on companies and markets.
Transition risk is perhaps the most pressing for investment organisations over the short and medium-term. Transition risk falls into three broad categories, including the implications of policy and regulation, technological innovation and their impact on broader demand and supply dynamics. The effects will differ across and within different asset classes, and it is worth noting these drivers may result in both negative risks and opportunities for investors. The most pressing challenge is clearly the potential for a significant and rapid re-pricing of assets.
The Paris Agreement implies significant policy and regulatory measures are needed at both national and regional level. The estimated aggregate greenhouse gas (GHG) emission levels in 2025 and 2030 resulting from the Intended Nationally Determined Contributions are not yet consistent with the goal of limiting the global average temperature increase to less than two degrees Celsius. As a result, we expect further tightening of climate policy that will impact the energy, transport, industry and agriculture exposed sectors.
As Bank of England Governor Mark Carney pointed out in a 2015 speech on transition risk, companies likely to be affected — principally those in the natural resource and extraction sectors, but also those in power utilities, chemicals and industrial goods — make up 30 per cent of the FTSE 100 index of the largest UK-listed firms. Globally, such companies account for a third of equity and fixed-income assets. The implications for companies’ valuations and investor returns are therefore significant.2
Meanwhile, the transition to a low-carbon economy is spurring technological developments that are profoundly altering the investment landscape. The drive to decarbonise has catalysed the development of new technology that can have a transformative and disruptive impact on the traditional dynamics of many economic sectors. Examples already exist in areas such as solar PV (or photovoltaic systems), which in some regions has reached grid price parity with the cost of the local electric grid; the development of energy storage solutions that address the intermittency challenge associated with renewable energy generation; and the transformation in functionality and economics of electric vehicles (see boxed text, below).
The third category of transition risk concerns the dynamics of supply and demand. New policies and technologies — along with ongoing shifts in cultural attitudes as increasing numbers of people become aware of the risks of climate change — are likely to boost demand for green products and services, and to hit others that are considered damaging to the environment. Environmental, social and governance (ESG) factors will become ever more important, and investors or companies that disregard them will be left behind.
The role of transparency in understanding climate risk
So how can investors position themselves to mitigate the risks— and take advantage of new investment opportunities – that arise as the world shifts to a low-carbon economy? Clearly, it will be important to incorporate transition risk into existing organisational procedures. As a first step in this direction, investors will need to develop a comprehensive picture of their portfolio companies’ climate-related exposures. Unfortunately, many firms still fail to divulge the sort of detailed information that would make this possible.
Thankfully, new initiatives to encourage better standards of disclosure are in the offing. December 2015 saw the launch of the Task Force On Climate-Related Financial Disclosures (TCFD) under the auspices of the Financial Stability Board. Chaired by former New York City Mayor Michael Bloomberg, the task force aims to help companies understand the kind of disclosures needed by financial markets in order to measure and respond to climate risks. The TCFD will develop recommendations for voluntary disclosures related to physical, liability and transition risk for investors, lenders, insurers and other stakeholders, and is set to announce its first set of recommendations in December.
We welcome this development. While the risks of adapting to a low-carbon future pale in comparison with the risks of doing nothing to tackle climate change, transition risk will present investors with various challenges over the coming years and decades. Much remains to be done, but initiatives such as the TCFD will provide companies and investors of all stripes with vital tools with which to devise strategies to cope with the shift to a low-carbon future.
Case study: transition risk and disruption in the car industry
The automotive sector represents an illuminating case study for how transition risk is playing out, as new regulation, technology and changing supply-and-demand dynamics are already reshaping the car industry. Take the growing popularity of electric cars: while the electric vehicle market remains small, at below one per cent of new car registrants, it is already having a disruptive effect.
Top-down regulation to support electric cars, introduced by governments mindful of carbon emissions targets, is playing a key role. China, for example, aims to become a leader in the production of electric and hybrid vehicles. It is offering purchase incentives intended to increase these cars’ overall market penetration and building widespread charging infrastructure.
Meanwhile, the European Union’s Green Car Initiative, a public-private partnership, is supporting research and development into clean energies in road transport, which is delivering advances in battery technology. Battery costs have fallen by 73 per cent since 2008 to $268 per kilowatt hour and are likely to drop still further over the coming years.3
With supportive regulation and rapid technological advances, demand for electric vehicles amongst consumers is rising fast. Three days after electric car-maker Tesla unveiled its new Model 3 on March 31, 2016, pre-orders hit 276,000; more than 2.5 times Tesla’s total vehicle sales since 2012. This figure is particularly impressive given that pre-orders require a deposit of $1000 and the vehicles won’t be delivered until late 2017 at the earliest.
The rapid emergence of electric vehicles as a viable commercial proposition is having wide-ranging financial effects, and not just on those manufacturers that remain wedded to the internal combustion engine. According to a report from Fitch Ratings, the rise of electric vehicles is a “resoundingly credit negative for the oil sector [as a whole], as transport accounts for 55 per cent of oil consumption…in an extreme scenario where electric cars gained a 50 per cent market share over 10 years, about a quarter of European gasoline demand could disappear.”
Fitch’s report warns of a potential “death spiral” as investors sell holdings in oil companies, making it more expensive for them to raise financing.4
The effects of transition risk can also ripple out far beyond the obvious energy-related sectors. For example, prices for cobalt metal, a key component in lithium-ion batteries, are expected to increase 45 per cent by 2020 due to soaring demand for electric vehicles, according to consultancy CRU Group. This represents an opportunity for companies involved in extraction of the commodity. And new technology developed for electric vehicles may also have applications in renewable energy sectors, helping wind and solar power generators to overcome longstanding ‘intermittency’ issues and compete on a more even footing with traditional utilities.
1 EIU, ‘The cost of inaction: recognising the value at risk from climate change,’ 2015
2 Mark Carney, ‘Breaking the tragedy of the horizon – climate change and financial stability,’ September 2015
3 Fitch Ratings
4 Fitch Ratings, ‘Disruptive Technology: Batteries,’ October 2016