In part 1, we introduced net-zero investments as a clearly communicable and measurable goal for moving towards sustainable investment. In part 2, we discussed how investors are able to reduce investments down to ethical choices using the framework of net-zero.
As we have touched on in part 1 and 2, an investor is able to use the clear goal of balancing CO2 emissions and absorption by 2050 or sooner by appraising companies and investments with respect to the concept of net-zero. We’ve discussed how that is beneficial with respect to ethical choices but how does it work when it comes to the uncertainties thrown up by the transition to a net zero world?
Uncertainty Created By Moving To A Net-Zero World
Let’s do a very crude thought experiment. If someone asked you to make a one-off 30 year investment in an industry today, would you put the money into coal mining? If you believed that the world will need to significantly reduce its CO2 emissions and become net-zero by 2050, then you probably would not make that investment.
What about the other end of the spectrum and a 30 year investment in the healthcare industry? It is highly likely that healthcare will still be needed and it is unlikely to be as affected by a shift to a net-zero world when compared to many other industries. There may be some changes – for example, disposable plastics and medical supplies from biosources, hospitals powered by renewable energy with battery back-ups systems – but from a net-zero point of view, climate change related factors will probably not alter the fundamentals of the business, i.e. treating patients. That is not to say that the health system might not be radically different in the future, but climate change will not play as large a part in that change compared to other industries.
Aerospace Example
OK then, what about a slightly more ambiguous industry and a 30 year investment in airlines, aerospace manufacturers, or airports? It is reasonable to assume that in 2050 people will still want to travel long distances. However, there is a large unknown as to what that demand will look like. Shifts due to the COVID-19 pandemic have exposed large businesses to the advantages of video conferencing and shown it to be a feasible way of working, potentially providing business’ with an excuse in the future to suppress air travel in the face of cost savings and climate commitments. Cultural concepts like ‘flygskam’ or ‘flight shaming’ could also change consumer demand [1].
Even if demand for these companies’ products will still exist in some form, can you be sure that they will have successfully adapted to a net-zero world in other ways?
Currently there is no commercially viable technology to directly replace most types of commercial aircraft. At time of writing ultrashort haul flights (<30 mins) using 10 seater planes is technically feasible [2], but there is a long way to go before anything that looks like a Boeing 737 or a Airbus A320 is electrified. So, in order to meet the deadline of 2050, aircraft are going to have to go through a huge redesign in order to reduce emissions sufficiently.
Biofuels are continually touted as a potential technical solution [3]. However, that creates its own feedback loop since the biofuels grown will be at the mercy of climate change, introducing more uncertainty.
Another level of uncertainty is government regulation. If aerospace emissions cannot be brought down to sensible levels then governments and regulators may take steps to force companies to change. They may even have to purposefully suppress demand to meet net-zero commitments [4].
Transition Risks
There are many risks confronting businesses in the face of climate change. The risks we have described above fit into the ‘transition risk’ category: demand shift, regulatory changes, and technological changes. There are other risks which can be classed as transition risks, e.g. reputational damage and stranded assets. See appendix 1 for an overview of all risk types.
All business could potentially be affected by the physical risks of climate change. The transition risks, however, are not evenly spread. Some industries (e.g. healthcare) will be much less exposed to these risks whereas others (e.g. coal, aerospace) tick all the boxes for demand shift, regulatory changes, technological changes, reputational changes, and stranded assets.
Investment Horizons
Obviously, few people invest in individual stocks and shares over a 30 year time period without reviewing them periodically, and any stocks exposed to transition risks may go through multiple hands before any of the risks come to bear. But as time goes on and these risks become more acute and that will eventually have a bearing on the value of the stock.
As we have stated in previous blogs in this series, target emissions will have to fall steadily from now onwards in order to meet the Paris Climate Agreement targets of limiting global temperature rises to 1.5 or 2℃, not continue as they are and abruptly stop in 2050. Neither can we wait until the market revalues the stock and prices in climate change.
Furthermore the effect will not be uniformly applied across all fossil fuel or heavy fossil fuel using industries. Some industries will be affected sooner than others, electricity generation and electric cars have already been greatly changed by the Great Decarbonisation. Whereas other industries are yet to see major change (e.g. shipping).
Bond maturities can easily extend over a 30 year time period, and any one of the risk categories could dent a firm’s ability to repay the principal. Mortgages neatly fit into this time frame as well.
Fund managers will therefore have to increasingly take on board these risks factoring in evaluating their portfolio.
Conclusion
By incorporating the concept of net-zero into investment strategies fund managers are able to face up to a large amount of risk surrounding the climate emergency. This is not just risk due to the extreme weather events, but other uncertainties: regulatory changes, consumer demand shifts, technological disruption.
By considering and planning for net zero it provides a neat way of wrapping up a lot of analysis of various risks in one bundle.
In the next blog in the series we will be looking at how net-zero could be applied to different investment horizons and different industries.
Appendix
1 – Climate Change Investment Risks
There is plenty of existing analysis on risk of climate change to all businesses, with an extra attention paid the insurance industry due to the expected increases in claims for damage due to extreme weather events [5, 6, 7, 8, 9, 10].
There are many different breakdowns of how climate risk will affect businesses, but they can be broadly classified into the following three categories:
- Physical Risks:
- Direct impact of extreme weather events
- Indirect supply chain disruption
- Transition Risks:
- Demand shift
- Regulatory changes
- Technological changes
- Reputational risks
- Stranded assets
- Financial and Stability Risks:
- Increase demand for compensation
- Political stability risks
- Government sovereign debt
2 – Net-Zero Investment Assessment
How one can go about judging an investment to be net-zero or on track to become net-zero has been discussed in the previous blog. This focuses on three areas of a companies or investments approach towards becoming net-zero:
- Innovation – is the company investing in R&D to meet their net-zero goals?
- Ambition – is there genuine drive from corporate leadership to meet the net-zero goals?
- Measurable Action – have clear short, medium and long term targets been set with clear pass or fail criteria?
There are many existing strategies to incorporate a varying amount of transition risk into an investment portfolio [11, 12]. However, much of this analysis focuses on the mathematical pricing of risk of existing assets, mainly by pricing in carbon emissions.
But these are not forward looking models that do not take into account a company’s intentions. Companies’ forecasting and forward guidance is shifting all the time. Take for example BP’s latest reappraisal of its assets.
References
- https://www.bbc.co.uk/newsround/49032117
- https://www.bbc.com/future/article/20200617-the-largest-electric-plane-ever-to-fly
- https://www.iea.org/commentaries/are-aviation-biofuels-ready-for-take-off
- Allwood, J., Azevedo, J., Clare, A., Cleaver, C., Cullen, J., Dunant, C., Fellin, T., et al. (2019). Absolute Zero. https://doi.org/10.17863/CAM.46075
- EY, Climate change: The investment perspective, 2016, https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/banking-and-capital-markets/ey-climate-change-and-investment.pdf
- https://www.bankofengland.co.uk/knowledgebank/climate-change-what-are-the-risks-to-financial-stability
- https://www.cambridgeassociates.com/insight/risks-and-opportunities-from-the-changing-climate-playbook-for-the-truly-long-term-investor/
- Swiss Sustainable Finance, Measuring Climate-Related Risks In Investment Portfolios, 2019 , https://www.morganstanley.com/ideas/climate-change-investing-risks-threats-opportunities
- https://www.morganstanley.com/ideas/climate-change-investing-risks-threats-opportunities
- Philipp Krueger, Zacharias Sautner, Laura T Starks, The Importance of Climate Risks for Institutional Investors, The Review of Financial Studies, Volume 33, Issue 3, March 2020, Pages 1067–1111, https://doi.org/10.1093/rfs/hhz137
- Benedetti, Davide and Biffis, Enrico and Chatzimichalakis, Fotis and Lilloy Fedele, Luciano Ruben and Simm, Ian, Climate Change Investment Risk: Optimal Portfolio Construction Ahead of the Transition to a Lower-Carbon Economy (October 7, 2019). Available at SSRN: https://ssrn.com/abstract=3281390 or http://dx.doi.org/10.2139/ssrn.3281390
- Impax Asset Management, Carbon risk for investors: Building a “Smart Carbon” portfolio, 2016