As global policymakers discuss the implementation of the Paris Agreement at the United Nations Climate Change Conference in Marrakech, investors should consider how ‘transition risk’ impacts their portfolios.
The ratification of the Paris 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 (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. While further US domestic climate-related policy looks limited post the Trump election win, we continue to see supportive policy signals from China and the EU.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.
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.
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.
Stephanie Maier is Director of Responsible Investment Strategy & Research at Aviva Investors.
(1) EIU, ‘The cost of inaction: recognising the value at risk from climate change,’ 2015