7 minute read 9 Mar 2017
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How the role of green finance is addressing climate change

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US Americas

Multidisciplinary professional services organization

7 minute read 9 Mar 2017

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Investors are now looking to diversify portfolios and integrate climate change risk into decision-making. We explore five key questions.

Signed in December 2015, the UN’s Conference of the Parties (COP) Paris Agreement limiting climate change to less than two degrees suggests that governments around the world are starting to play their part in transitioning to a low-carbon world. At the same time, implementation of unsubsidized low-carbon technologies is becoming cost-competitive compared to more traditional technologies.

These dual forces are acting as both a stick (increased regulatory and market risks in particular high-impact sectors) and a carrot (decreased risk profiles or superior returns in companies with exposure to low-carbon technologies) for investors in the global economy. Proactive investors may realize that the risks of diversifying their portfolios into emerging technologies can be outweighed by the risks of not responding to these signals and continuing to invest in companies operating in a business-as-usual mode.

Relying on a “stick” alone to underpin new investments can be problematic due to continued regulatory volatility in addressing climate change. The questions are whether a “carrot” can be sufficient to support investment and whether “green finance” can unleash more capital to support this emerging market. We explore five key questions about the relationship between green financing and climate change.

Question 1: What difference might policy interventions make?

Although the signing of the Paris Agreement and the subsequent submissions of countries’ Nationally Determined Contributions (NDCs) created a strong platform for government action, there remains significant uncertainty on the level of commitment to policy intervention. Despite this uncertainty, what is generally accepted is that parties are keen to prepare their economies for a shifting investment landscape.

The International Energy Agency (IEA) sets out three climate change scenarios in its annual World Energy Outlook 2016 [1] publication:

  1. Current Policy scenario
  2. New Policy scenario (assumes all NDCs are implemented)
  3. The 450 scenario: a “two-degree consistent” scenario that targets maintaining atmospheric carbon dioxide (CO2) at less than 450 parts per million

Most market observers would suggest that given the strong support of the Paris Agreement in most countries, continuing on the Current Policy scenario is unlikely. This implies that the New Policy scenario could be considered “probable” rather than just “possible.” The additional policy interventions proposed in the NDCs that support the New Policy scenario will likely drive market incentives; however, the IEA clearly shows that there is currently a significant gap in proposed policies to enable a 450 scenario trajectory.

Question 2: What could happen if the world’s governments decided to take further steps and adopt the 450 scenario?

Interestingly, the IEA estimates that, under the 450 scenario, the total investment in energy supply from 2016 to 2040 would actually be lower than under the New Policy scenario. Instead, investments are shifting significantly to renewables and energy efficiency projects from fossil fuel projects. It is this wave of monetary reallocation away from energy supply projects that a growing number of investors are becoming concerned about and led to the coining of the term “stranded assets.”

Cumulative global energy supply investment by type and scenario, 2016–40 (US$ billion, in 2015 terms).

 

NPS

450 scenario

Difference (%)

Fossil fuels

26,626

17,263

-35%

Renewables

7,478

12,582

68%

Electricity networks

8,059

7,204

-11%

Other low-carbon

1,446

2,842

97%

Total supply

43,609

39,891

-9%

Energy efficiency

22,980

35,042

52%

This analysis tells us the additional investment required to enable the 450 scenario potentially may not be greater than that required to fund the New Policy scenario, in which case it is much more likely that governments will take “some” further action or “significant” further action instead of maintaining the status quo. The implication for businesses is that establishing strategies that better prepare them for the market conditions that underpin a 2oC world may be needed.

Question 3: Has the market reached a tipping point?

The options available for investors to deploy capital are almost infinite, so comparison at a macro level between low-carbon investments and the market as a whole are not particularly useful. However, when we consider particular industries, a picture of risk and return can emerge. A number of individual sectors are likely to be disproportionately impacted by climate-change-related drivers. Power generation, oil and gas, mining, transport, heavy industrial manufacturing (e.g., chemicals, iron and steel, cement) and commercial buildings all face risks to their future competitiveness.

The most obvious sector ripe for disruption based on a response to climate change is the power generation sector, and there is a lot of data that suggests that the tipping point has already been reached.

In 2016, twice as much global funding in the power generation sector was directed into renewable energy as fossil fuels. [3] This occurred as coal consumption globally is beginning to decline based on decreasing consumption in OECD countries and a flattening of demand in China. [4] This disruption to the power generation sector has flow-on effects to its supply chains and supporting industries.

Analysis of other sectors is not quite as straightforward. For example, investment opportunities exist in sectors such as transport fuels or commercial property, while industries like cement, iron and steel, and chemical manufacturing are much more dependent on policy drivers to support low-carbon technologies.

What the analysis tells us, unfortunately, is that the answer to our original question of “Have we reached a tipping point?” is “It depends.” When considering an investment, understanding what to invest in and when requires a nuanced assessment of the market drivers that is particular to the industry, the location and in some cases the actual assets. What is clear, however, is that failing to consider the market drivers related to climate change can put investments at risk across a range of industry sectors — with or without policy intervention.

  • During several auctions for new renewable energy capacity held in 2016 and 2017, utility scale solar was priced at a levelized cost of energy (LCOE) of below US$40/MWh in India, UAE, Chile, Mexico and the US. This is a 50% reduction in the cost of solar power in a year.

    Similarly, wind power auctions in Morocco, Brazil, Mexico and Chile in 2016 also produced bids below US$40/MWh. This compares to a cost of super-critical coal generation estimated at US$40 to US$90/MWh.

    Some of the price decreases are due to clean energy subsidies, but these subsidies explain only a fraction of the cost reductions, and utility-scale solar and wind are now at a competitive cost advantage to fossil fuel technologies.

Question 4: How have investors responded so far?

In the lead-up to the Paris Agreement, international commitments relating to climate change were led by proactive institutional investors. These initiatives and other new green markets have significantly increased in size over the last two years. The main examples of these include:

  • The Portfolio Decarbonization Coalition (PDC) that was set up in late 2014 aims to mobilize a critical mass of institutional funds to drive decarbonization. Currently PDC members have committed more than US$600 billion to decarbonization, with the member base still growing.
  • The Montreal Pledge was launched in September 2014 and required signatories to measure and publicly disclose the carbon footprint of investment portfolios on an annual basis. The Pledge has now been signed by 120 asset owners and fund managers with more than US$10 trillion under management.

The debt market has also innovated with the significant growth of the green bond market, which has emerged from relative obscurity a few years ago to become a rapidly growing asset class today.

EY has taken a deeper look at what these emerging trends may mean in each asset class in the current and future state as investors integrate climate change risk into their investment decisions:

Asset class

         Current state

         Future state

Debt

  1. This is largely delivered through Green Bonds.
  2. They were first issued by the World Bank and the European Investment Bank in 2007, with corporates following in 2013.
  3. Growth has been rapid since that time.
  4. Main drivers have been reputational benefits and improved diversification in an investor base.
  5. There is evidence of a small pricing benefit over traditional bonds in secondary market. [5]
  1. As cost of renewables and low-carbon technologies falls and regulation increases in emissions-intensive sectors, green projects are now often considered as lower risk over the longer term.
  2. This could lead to further price advantage in the primary and secondary markets.
  3. It is increasingly likely that bond portfolios will include green bonds as an asset class due to the ease of identifying green credentials.

Equity

  1. Greater disclosure has been driven by the Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosures (TCFD) Recommendations. [6]
  2. Over 140 policymakers from around the world signaled support for the recommendations, calling on all stock markets to ensure listed firms embrace the new guidance on climate risk disclosure.
  1. Climate risk disclosures are likely to become standard practice to allow for better comparability between disclosures.
  2.  Not reporting on climate risk transparently will likely mean facing divestment or increasing shareholder activism.
  3.  Equity portfolio managers will likely report on financed emissions or may use poor disclosures as negative screening.

Specialist investments – infrastructure and property

  1. Infrastructure is a nuanced asset class when considering climate change risk and opportunities.
  2. Infrastructure investments are generally long term, require significant capital and have large physical footprints, meaning climate change risks are more likely to impair asset values.
  3. There is growing concern about risk of stranded assets in the infrastructure sector due to physical and transition climate change risks.
  4.  Climate risk disclosures in the sector are largely immature.
  1. Assets and supply chains should be periodically reviewed for possible changes in technology, regulation and consumer behavior that could impair certain parts or all of the supply chain.
  2. Climate scenarios mapping the physical changes from climate change should be leveraged to provide insights into the risks facing assets located in different geographies.
  3. New infrastructure will likely need to be built to support emerging technologies (e.g., electric car charging points, utility-scale battery storage and high-speed electric rail), creating green finance opportunities.

Specialist investments – clean technology funds

  1. Cleantech funds are an emerging investment area, where all funds are directed into technologies that benefit from a two-degree pathway.
  2.  Investments have been mostly renewables, but diversity of investments will increase as other technologies become cost-competitive, such as electric vehicles and battery storage.
  1. So far, this asset class has been a niche market; however, investors are likely to increase investment due to a lower risk profile or superior returns due to direct exposure to increased climate change action.
  2.  If traditional sectors do not improve strategic understanding of impacts of climate change, then there is the potential for this asset class to grow and fill any market gaps.

Question 5: What could this mean for businesses in sectors outside the investment world?

In our increasingly interconnected world, all businesses will likely feel the effects of these changes occurring in the investment space. The cost of capital for company bonds will likely shift depending on their alignment with a two-degree world. On the equity side, companies’ reporting requirements and disclosures will likely increase as business face pressures on three fronts:

1.    Shareholder activism: institutional investors and activist shareholders are pushing for climate risk disclosures, and these requests are likely to focus on aligning disclosures with recommendations from the Financial Stability Board (FSB).

2.    Increasing regulation: in 2016, the French Government passed legislation requiring the finance sector to report on climate change risks. With the release of the FSB’s Final Report on Recommendations of the TCFD in June 2017, it is anticipated that further regulation may be introduced, consistent with these recommendations, by either governments or exchanges.

3.    Growing legal implications: a number of lawsuits have already been filed against organizations with respect to not making adequate disclosures on climate change risks.

Although no company has yet faced legal or financial penalties in relation to its action or disclosures on climate change risk, the increasing attention on the issues has led to a broadening of the definition of fiduciary duty (e.g., the French regulatory framework (Article 173) and the Australian Prudential Regulation Authority (APRA) published a speech and referenced a legal opinion made by the Centre for Policy Development and the Future Business Council on company directors’ legal obligations to consider the impacts of climate change). [7]

In conclusion

Action on climate change has been in political limbo for decades in one area of the world or another. An internationally consistent approach to regulating greenhouse gas emissions and curbing climate change has not surfaced and looks less likely to occur than in the past. However, since the signing of the Paris Agreement, it appears we are now entering a new era where governments have set the long-term target and investors are responding to the financial challenge. This means that capital markets are likely to play a part in any transition in the short to medium term to get ahead of any significant transformation. 

Businesses that don’t prepare for the changes in financial markets may face increasing future capital costs compared to peers. Identifying the opportunities from these changes and preparing a strategy for integrating them into your business could help build competitive advantage. This process may involve assessing capital expenditure items that could be packaged into green bonds and assessing current climate change risk disclosures against the FSB’s recommendations. As investor action increases on this issue, a 2oC alignment strategy will likely become standard practice for businesses looking to tap capital. 

    1. World Energy Outlook 2016, International Energy Agency, 2016.
    2.  Ibid.
    3. Global Trends in Renewable Energy Investment 2017, Bloomberg New Energy Finance/United Nations Environment Program, 2017.
    4. Wind and Solar are Crushing Fossil Fuels, accessed 19 June 2017.
    5. Green Bond Pricing in the Primary market Q4 2016 Snapshot, Climate Bond Initiative, March 2017.
    6. Recommendations of the Task Force on Climate-related Financial Disclosures, Task Force on Climate-related Disclosures, December 2014.
    7. Australia’s New Horizon: Climate Change Challenges and Prudential Risk Geoff Summerhayes, APRA, 17 February 2017.

Summary

Businesses should begin to prepare for changes as capital markets respond to climate change.

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By

US Americas

Multidisciplinary professional services organization