Investors peering through the fog of scenarios

Julian Poulter reflects on the updated Inevitable Policy Response

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Incredibly, it's been over five years since the Financial Stability Board established the Task force on Climate-related Financial Disclosures (TCFD). This groundbreaking initiative has raised the bar inexorably amongst companies and investors alike, fuelling the scenario analysis era. It has driven investors to U-turn and start looking forward in time for clues on future returns in the energy transition in order to replace the unreliable reams of historical data that have provided little insight as to the current remarkable acceleration of this transition.

It is now broadly accepted this is going to be one of the deepest and longest industrial transitions in history, with huge returns available for those riding it successfully and a likely wide disparity between the successful transition investors and the unaware. Even a passive perspective might hold its risks as volatility impacts those who want to cross fingers and hope rather than take on the challenge.

Clarity of vision on climate change has always been difficult for investors, but help arrived back in 2019 with the launch of the Inevitable Policy Response (IPR). This aggressive forecast was treated in some investor circles with scepticism, but it actually turns out to have been conservative – with a number of geopolitical, institutional and technological drivers responsible for accelerating the transition into areas previously seen as tail risks. The 2021 update of the IPR forecast has now hit the shelves underpinned by unique input from 200 climate policy experts worldwide with a range of implications for all investment actors from trustees to analysts, from asset consultants to benchmark providers.

This time around, the IPR addresses the shift from a sharp – and therefore volatile – 2025 market repricing event, to the earlier, slightly steadier (but still aggressive) acceleration that is clearly underway across policy and markets. Gone is any question of ‘if’, replaced by ‘how’, the need for navigation and the capacity to understand the detail. 

With a range of surprises since IPR was launched in 2019 – COVID, a Biden Administration and Democratic Congress in the US, and many Net Zero commitments including from China, to name a few – investors are now asking where the next batch of surprises might come from, and which might be of forecast grade probability? 

Top of the list is the potential impact of Carbon Border Adjustment Mechanisms, being led by the EU, which will strike fear in the heart of laggard governments and drive investors to analyse impact all the way from sovereign bonds to local equity market impacts. Likewise, with widespread and effective carbon markets (unlikely before 2023, but far more certain to arrive by the mid 2020s) and with the EU carbon price having passed $50/tonne, even conservative voices are extolling the virtues of this more efficient market mechanism to complement the range of direct sector policies that IPR forecasts. 

As some investors rush to catch up with the implications of these developments, having already lost money on many aspects of the transition, others are already deep into the IPR forecasts and the possibilities of 2021. It’s the year of COP26, the UK-hosted climate summit in November, but it is likely to also include Net Zero announcements from the US, India and Australia. These are set to be accompanied by a chorus of new Net Zero investors looking to set aggressive short-term targets and engaging with policymakers forcefully to ensure that investments to meet those targets are supported by policies that provide, naturally, a financial return! Whilst it may appear to some that this is the tail wagging the dog, we are in a unique era where institutional drivers interact with geo-political and technological ones to accelerate change. 

This interaction is especially true for the land use issue – perhaps the elephant in the transition room, as forestry offset commitments from oil and gas companies are accompanied by debate on Brazilian intransigence and thinking from real asset teams on how to efficiently get exposure to this key but complex opportunity. 

Understanding transition dynamics was the core business of a few leading pension funds a decade ago, then some large insurers a few years ago. Now, it has public market players sprinting in all governance directions, in all asset classes, in all sectors, to position their investments. Whilst some sectors may look at least partially priced in, there are others that are not so clear. The spectre of corporate balance sheets being used to provide transition capital and the transition strategies of some exposed companies makes anything less than detailed analysis a guessing game. This is a game now tailormade for asset managers and investment banks using realistic scenarios such as IPR as inputs, with asset owners scrutinising their manager selections and seeking comfort that traditional asset allocation can be successfully tempered into a more flexible and profitable approach.

Whilst asset owner leadership around climate, particularly in alternative asset classes, has always been clear, they have successfully overseen a flood of major asset managers arriving to the party with a mandate to integrate IPR-like thinking into climate strategies, investment decisions, asset allocation and very soon into benchmarks. 

IPR will release its ‘value driver data pack’, based on its Forecast Policy Scenario, before COP26. This will allow investors to plug the IPR forecasts in directly to their valuation and risk models. If the last two years is anything to go by, the transition outlook will already be very different, even before the COP starting bell has rung. Investors be warned.

Julian Poulter is a Partner at Energy Transition Advisors