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It’s a scary world for asset owners right now. Historically low interest rates are helping drive down returns with unmatched liabilities, against potentially the greatest recession ever, with politics reducing the productivity of globalisation and the looming climate transition waiting to stunt any recovery. Governments must now decide if their stimulus dollars will promote a green transition in both the energy and land systems or add to the problem. And asset owners must second guess the impact of their decisions and anticipate further disruptive intervention.
The recent report Pathways to Net Zero commissioned by the PRI brings to a head a hectic phase of climate scenario development by various agencies, leaving many asset owners and managers confused as to what to do next. It’s almost expected that investors need to develop capacity and an understanding of these scenarios. Otherwise, it’s essential for an asset owner to route it through their managers and mandates. In simple terms, the level of return at stake in getting this transition right or wrong is clearly so great for money managers that bets must be made on a pathway, in addition to the admirable longer-term targets towards net zero.
"Discussions, particularly with equity managers, can be difficult where large incumbent players reside, and the low-carbon economy is underrepresented. There simply aren’t that many Teslas and Orsteds in public markets"
Use of scenarios has been limited at best by both companies and investors. Followers of energy companies were not surprised that, once pressed by AGMs, many put forward their own scenarios which, predictably, show little reduction in demand for their own products – although exposed companies are waking up to the realities.
Asset owners have been driven by the Taskforce on Climate-related Financial Disclosures and advisers to run the first wave of scenarios as resilience tests against their portfolios, most likely using the International Energy Agency as a reference, which leaves out details on land use. The results are often disturbing, but ultimately these investors have allocated low probability to most of the Paris Agreement-aligned temperature constrained pathways, even whilst committing to the end result as an ambition. This can have the unintended consequence of limiting mitigation actions in their portfolios.
This begs the question now: What do asset owners actually believe will happen? Notwithstanding the range of uncertainties from US elections and geopolitics to technology curves, they will have to nail their colours to a mast, and one that now includes possibly earlier peak oil than the 2030s, and a massive green stimulus in the EU. For asset owners who want to piece together this puzzle, the Inevitable Policy Response framework, commissioned by the PRI, presents a Forecast Policy Scenario spanning both energy and land use systems and predicting sudden and forceful climate policies being announced in 2025 for the late 2020s. Persuading asset managers to not wait until the last minute to take action will require a delicate balancing act.
For those who agree that governments are no more likely to watch climate change damage their populations and economies than they are a pandemic, without a forceful response, the inevitability is clear. Therefore going early makes perfect sense given that investors’ surveys show that most of their peers agree with a likely disruptive outcome.
Asset owners have had a taste of what a sudden shock looks like and many are keen to make sure this isn’t repeated. If a critical mass of low-carbon asset owner leaders based mostly in Europe can move the existing two speed energy economy into overdrive and accelerate the world pace of transition, then the benefits will be high – and the priority is avoiding the obvious physical impacts of climate change. If anything is likely to put a brake on a COVID-19 recovery, it is this. On the flip side, an early response driving the massive capital injection for a rapid energy transition with greater job intensity, fairer distributed energy systems, major restructure of land use systems and planned just transition support for workers and developing nations would allow for longer term growth.
The PRI report provides asset owners and their managers with a complete picture to approach this tangled world of scenarios and link the three key themes of targets, stress tests and forecasts. The barriers to adopting a forecast that essentially disagrees with short-term markets are significant, and often as much cultural and human than technical. But for those asset owners who have already built capacity and are integrating an Inevitable Policy Response framework into their strategies, they can at least avoid further portfolio pain.
We can define asset owners into five groups:
- The aligners – committed to the long-term targets and goals of the Paris Agreement
- The target-setters – committed to an ambition or targets-like ‘Net Zero by 2050’
- The stress-testers – prepared to look at the risks of temperature-constrained scenarios, but mostly seeing low probability for anything that might impact their portfolio short to medium term.
- The forecasters – investors following a high probability scenario like IPR’s Forecast Policy Scenario, and mitigating at an early stage; and finally
- The price takers
We should be wary about this last group – asset owners who have faith in their external asset managers to unilaterally guard against the Inevitable Policy Response. They may want to create deeper discussions about those risks, and the setting of mandate incentives and benchmarks should be high on the agenda.
Discussions, particularly with equity managers, can be difficult where large incumbent players reside, and the low-carbon economy is underrepresented. There simply aren’t that many Teslas and Orsteds in public markets. The search for opportunities in other asset classes then becomes the main game to create challenges for those rigidly sticking to a strategic asset allocation approach, rather than those investing in a more thematic way.
The forecasters are already overweight low carbon and prepared to bet against broader markets. 2025 and the late 2020s might seem like a long-term bet but, like pandemics, these things have a habit of turning up at unpredictable moments.
Asset owners have had a taste of what a sudden shock looks like and many are keen to make sure this isn’t repeated.
Julian Poulter is a Partner at Energy Transition Advisors, which helped create the Inevitable Policy Response. He is the former CEO of the Asset Owners Disclosure Project