COP26 ended with a slew of pledges from the private and financial sector. Among them was the Glasgow Financial Alliance for Net Zero (GFANZ), whose signatories have agreed to align their portfolios to achieve net zero by 2050. The group controls a sizable chunk of change – with cumulative assets amounting to $130 trillion. The Net-Zero Banking Alliance (NZBA) was also launched at Glasgow, controlling a collective $66 trillion in assets. While these initiatives have been met with some criticism, they demonstrate an acknowledgement that adjustments in business models are essential if the world is to transition to a low-carbon world.
But let’s not kid ourselves, transformational change is no easy task. It requires transition risk planning and implementation within the context of uncertainty. Transition risks are broadly defined as the risks associated with the adjustment towards a low-carbon economy. These transition risks can stem from regulatory changes, technological innovation, or changing consumer preferences, which can lead to a repricing of financial assets and liabilities or a reduction in the competitiveness of high-carbon technology and infrastructure. In the real economy, this can lead to growth in some industries and job losses in others. That’s why there is the need for a ‘just transition’, where the benefits are broadly shared and ample support is provided for those negatively affected.
Based on the recently released stress test methodology of the European Central Bank (ECB) and the Network for Greening the Financial System (NGFS) scenarios, the best-case scenario is an orderly or planned transition. One that is characterised by the well-calibrated and timely implementation of policies. The most extreme scenario is a hot house world scenario, where limited policy action lead to significant global warming and increased physical risks. In between is a disorderly transition scenario where the implementation of policies is delayed and introduced suddenly. It is characterised as unexpected and chaotic, where firms do not have time to modify their portfolios and business activities.
An orderly transition requires two things: predictable policies and efficient markets, in order to create a predictable transition path where markets can incorporate price changes and help firms absorb the financial impact. This will also allow for investments in obsolete high-carbon assets to slowly re-allocate to greener low-carbon assets without shocking the financial system. Ultimately, the market just needs clear policy signals to position itself strategically.
One can dream: clear policies and efficient markets
In a sector that often shies away from government regulation, corporates are calling on governments to develop policies that can support a transition that is measured, gradual, and transparent – which can elicit market confidence. If policies are clear, market players can anticipate these regulatory changes and price them in the market through lower valuations. In an orderly transition, changes in prices will simply reflect adjustments made to reallocate investments towards low carbon/carbon neutral opportunities. If policies were vague and non-committal, asset repricing could be more abrupt and fluctuations in prices will reflect the noise from uncertainty.
At the same time, signals from prices reflect how efficient a market is. The efficient market hypothesis (EMH) considers a market efficient if prices of financial assets ‘fully reflect’ all available information. Otherwise, market failures, or the inefficient distribution of goods and services, can lead to a mispricing of financial risk. For example, some studies consider transition risks in the context of mispriced carbon-intensive assets. Once markets start pricing in the different transition risks of holding carbon-intensive assets, it could lead to disruptions – from stranded assets to making certain production processes obsolete.
This can be avoided with better information. Climate-related disclosures, standards and reporting frameworks can lead to more accurate valuations (i.e., if climate risks are factored in the price of financial assets, it would offer a premium for investors to hold assets more exposed to climate risk). To caveat, pricing in climate risks has been difficult to do, but there is a growing literature providing some evidence that equity markets, bond markets and real estate markets are starting to price climate risks.
So are we on track for an orderly transition?
When it comes to policy clarity, ratcheting up individual country commitments through the Nationally determined contributions (NDCs) points toward greater commitment to taking climate action. Politicians are not known for their clarity. Political commitments are also often different from actions, and there are many instances of policy-makers going the other direction. For example, the energy crisis in China has prompted the country to open up new coal production, threatening to undermine its commitment to reach peak carbon by 2030. This sends mixed signals to the market. On the global stage, the watered-down language of the Glasgow Climate Pact, the absence of key countries like China, India, Australia, and the US in the pledge to end the use of coal power, and having no deadline to phase out coal or remove fossil fuel subsidies, weakens market confidence.
In terms of greater transparency to help markets become more efficient, the Task Force on Climate-related Financial Disclosures (TCFD)’s 2021 status report reveals over 50% of firms disclosed climate-related risks. Some countries have also made disclosures mandatory (e.g., see New Zealand and the UK). To add, climate stress testing for banks has been done in the Netherlands and France, with others in the EU, the UK, Australia, Singapore and Canada to follow. These are all steps in the right direction to better price climate and transition risks in financial markets. However, there is still some way to go. 50% of climate disclosures still means there is another 50% left, and there is also the matter of thinking about disclosures linked to nature.
Moves to hedge against climate risks is already top-of-mind for many investors. For example, to mitigate investors’ exposure to climate risk, they may choose to divest their investments from the fossil fuel industry. The trend of divesting from fossil fuels has gained traction over the past few years, with many pensions, endowments and other major investors joining the movement with commitments of almost $40 trillion in value at the time of writing. Divestment has become a contentious issue, with proponents against it suggesting that removing your seat at the table will not solve the issue. Initiating change within carbon-intensive companies will be more difficult without any leverage over these companies (see the success of shareholder activism with Engine No. 1 and Exxon).
An orderly transition will depend on the capacity of policy-makers to make clear and predictable policies that can incentivise markets to act efficiently. Vague policies and patchy disclosures threaten to make the transition less than orderly. Moreover, the further we are from climate targets means more drastic measures will be needed in the future to meet climate goals and markets might not have time to adjust.
Looking ahead, policy-makers need to send clear signals and deadlines need to be firm. Well-functioning capital markets should be able to create incentives to reward investments aligned with climate goals and penalise those that are not. Activities and instruments to ensure this can include:
- Climate disclosures that facilitate the movement of capital to climate-positive/neutral investments and increase accountability.
- Capital market instruments such as green bonds that allocate investments towards ‘green’ projects.
- Green taxonomies to prevent greenwashing and to facilitate the flow of investments towards sustainable activities.
- Asset-allocation strategies that purposely invest in climate-smart investments.