oil derricks - Financial Risk of the Low Carbon Transition

Climate transition increasing risks for unprepared investors

Climate transition increasing risks for unprepared investors 1024 683 Mantle314

The COVID-19 crisis is reinforcing for companies and investors the importance of preparing for global systemic risks. While it is difficult to foresee a global pandemic, investors should not be surprised when the well-documented risks of the global climate crisis impact their investment portfolios.

In a recently published Mantle314 research paper for the University of British Columbia, we highlight for investors how climate change science and risks translate into financial impacts. The report looks specifically at the energy sector, which contains some of the most high-risk companies because of their significant contribution to global greenhouse gas (GHG) emissions from their ongoing production of fossil fuel products. The paper also examines climate risks across other sectors – risks investors will need to consider in order to build portfolio-wide resilience to the low-carbon transition. Whether the transition to a low-carbon economy is gradual or rapid, the eventual outcome remains the same: demand for fossil fuels will decrease over the long-term.

Failure of the Paris Agreement may lead to an abrupt low-carbon transition

The 2015 Paris Agreement set a global consensus to keep the average temperature increase to “well below” 2 degrees Celsius by 2050, and to pursue further efforts to limit the increase to 1.5 degrees Celsius. With human activities already having increased warming levels above 1 degree Celsius and a growing body of research into the impacts of tipping points in the earth’s climatic system (e.g. permafrost thawing and releasing trapped GHG emissions), it is becoming clear that a gradual and voluntary response will not achieve the goals of the Paris Agreement. An abrupt and disruptive low-carbon transition to avoid the most severe physical, economic, and social consequences of climate change is increasingly more likely.

A carbon budget may lead to stranded assets

Warming outcomes, such as a 2 degree Celsius increase, can be translated into carbon budgets which quantify the amount of emissions that can be released into the atmosphere in total, by country or by sector. When the current proven reserves of the world’s top fossil fuel companies are budgeted to avoid dangerous climate change, the result is a large amount of unburnable product currently sitting on balance sheets and in capital spending plans. The threat these potentially stranded assets pose to the global climate system may be a so-called carbon bubble. For investors looking at long-term and stable returns, the risk of a market correction, based on the science underlying climate change, undermines the viability of current fossil fuel company valuations.

The transition is well underway

While stranded assets, on a large scale, remain a theoretical outcome of the low-carbon transition, political, technological and financial shifts are driving changes in the market. Policies such as the phase-out of coal-fired power plants, bans on internal combustion engine vehicles, and carbon pricing schemes directly incentivize a transition away from fossil fuels as an energy source. Technological improvements and the increased adoption of renewable energy and electric vehicles are driving their costs on par, or lower, than their fossil fuel-powered alternatives. The continuing growth and improving economics of these technologies, as well as their role in improving energy efficiency, is forecasted to cause the increasing displacement in demand for fossil fuels. In finance, credit rating agencies and banks are responding to climate risk by increasing the cost of credit for fossil fuel companies, while some banks have stopped financing certain companies or projects altogether.

In addition, the wider financial markets are beginning to account for climate-related financial risks. Climate disclosure frameworks, such as the Task Force on Climate-related Financial Disclosures (TCFD), are emerging as best practice for companies and investors to disclose how they are managing their climate-related risks and opportunities and integrating them into investment decisions. Central banks are developing strategies to integrate climate risks into prudential stress tests on large banks and insurance companies. Meanwhile, green taxonomies (e.g. the European Union’s taxonomy to classify environmentally-friendly economic activities) and low-carbon indexes and benchmarks are excluding high-emitting fossil fuel companies from financing or ‘green’ investment products. The managing of climate-related risks by financial market participants helps foreshadow an increasingly difficult environment for fossil fuel companies to continue with their business-as-usual approach.

Incumbents are not prepared

With the risks highlighted above, one question begs attention: are fossil fuel companies ready to transition their business models to meet the global goals? Research shows that this isn’t the case. Fossil fuel companies continue to allocate significant capital expenditures to fossil fuel producing projects and allocating low levels of capital to alternative energy projects. Over the long-term, the majority of planned projects will not be economically viable if the global climate goals are to be met, highlighting the significant risk of future asset write downs across the industry. This business-as-usual approach indicates these companies are not taking steps to protect their long-term value.

Current remuneration of fossil fuel executives further entrenches the business-as-usual approach. Companies continue to incentivize their senior executives to increase production and explore for untapped reserves. As the low-carbon transition accelerates, fossil fuel companies’ lack of forward-looking strategies reduces their ability to protect their long-term value.

What can investors do?

As fossil fuel incumbents continue to support a gradual-transition scenario, assuming steady, long-term demand for their products, the market shifts underway point to a potentially rapid and disruptive transition for fossil fuel companies. Understanding these risks can serve as a foundation for building climate change management into an investment portfolio. While the UBC report focuses on the fossil fuel industry, the magnitude of the low-carbon transition will have impacts across sectors as businesses work to (or fail to) decarbonize. Other climate impacts such as physical risks and adaptation measures should also be taken into account.

To manage your climate risk, investors can begin by asking some questions:

  • How are my investment managers thinking about climate change in their risk management and investment processes?
  • How effectively are my investment managers or portfolio managers engaging with company management teams on their climate risk?
  • Do my analysts understand climate risks and, if so, what tools or data are they using in their analysis? Do they know how to assess and evaluate a portfolio company’s climate-related disclosures?

Contact us to start managing your climate risk

If you’re interested in starting to manage your climate risk, please reach out to the Mantle314 team. We’ll be happy to help!