25 August 2021
Climate change is becoming an increasing concern for investors around the world. This is being driven by greater awareness of its impact, increased regulation and regulatory reporting. More companies are also recognizing climate change as an existential threat and viewing decarbonisation as an opportunity.
The effects of climate change are only just starting to become evident in the data. The main scenario envisages a slow but orderly transition. This path assumes that the worst predicted effects of climate change do not happen, as mitigation measures limit the effects, creating less damage than the worst-case scenarios suggest. This is consistent with global warming being limited to between +2.1°c and +2.3°c above pre-industrial averages by 2100, driven by the cumulative effect of government regulation (with limited global coordination), advances in technology, and by corporates adapting to build more resilience.
Markets are expecting governments to be cooperative internationally, though in a fragmented way. This will prevent an early move to net zero but do enough to avoid very negative outcomes. Technological advances that reduce energy intensity will play an important role in decarbonisation. Markets expect corporations to improve their resilience to climate change. This may be insufficient to achieve a safe level of warming but is still important in avoiding the worst-case scenarios.
The role ofGovernment
So far, the strongest multi-lateral agreement to tackle climate change is the 2015 Paris Agreement. Governments pledged to limit global warming to +1.5°c by 2100. However, they are not currently on track to meet this target. It is no secret that current trajectories show that the world in aggregate is emitting approximately double that level, and this is what is currently priced into the markets.
A unified agreement on regulation to tackle greenhouse gas emissions is not expected but individual nations (and blocs) are, nonetheless, still making progress towards limiting emissions. The absence of a strong multi-lateral framework means that there is a fragmented approach to regulation and disclosures, taxes and carbon pricing mechanisms. This leads to friction and protectionism among countries, creating opportunities for bad actors to game the systems.
The role ofcorporations
As public awareness of responsible investing has grown, the role of corporations in achieving this has increased. The resilience that is needed to avoid worst-case outcomes is expected to come from corporations. Markets want greater corporate disclosure so that investors can make more informed decisions and engage more actively with companies to bolster corporate resilience and preparation for climate change. Although greater disclosures are valuable, they are not enough on their own. This means that markets are pricing in corporate actions as risk mitigation rather than a force to limit global warming.
The role of energy intensity
How is energy generation, traditionally supplied by fossil fuels, expected to change? The market expects that considerable progress will be made away from fossil fuels but that progress will be uneven across regions, with renewable energy accounting for two thirds of electricity generation by 2030.
Though market pricing implies that the worst-case scenarios will be prevented, high uncertainty exists regarding what will happen over the next few decades. This could lead to negative surprises (and maybe positive ones too), though the probabilities are skewed more negatively, given the difficulties in meeting the Paris agreement targets.
Due to the extent of uncertainty on this issue, investors are urged to explore different climate change scenarios. This will allow them to understand the potential impact of the various pathways and help them take a robust strategic view when it comes to investment decision-making.