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Climate change and stranded assets

Graviton Partners
| Investment Landscape, Investments

Predictions about the trajectory of climate change are worsening.

The 2015 Paris Agreement laid plans to restrict global warming to no more than 1.5 degrees Celsius above pre-industrial levels by 2100. But we’re moving too slowly; scientists think warming in the 2–4 degree range is now more probable.

In line with that estimate, the International Panel on Climate Change (IPCC) has sea levels rising by 1.1 meters by the turn of the century.

For non-beachfront dwellers that might sound like a high tide rather than a catastrophe. But consider that 30% of the world’s population – and by extension, its economy – live in low-lying coastal regions that would struggle to keep those pushing waters at bay. What would it look like if, say, New York or Mumbai had to flee for higher ground? Chaotic and destructive, if not catastrophic.

So what though? 2100 seems very far away for us mortals, and if a few Clifton 4th beach houses have their gardens flooded when the moon is full, so be it, some may think.

For investors though, there’s an immediate incentive to start taking climate change seriously. Ironically, it has to do with the assets we invest in being left high and dry.

The world isn’t fair

Why should developing countries prioritise the move to clean energy when the developed world is largely responsible for causing climate change in the first place?

It’s a contentious question. The obvious answer is that the effects of climate change could care less about the random borders we’ve drawn and who deserves what, and it’s the poor who bear the brunt of extreme weather conditions. Another is that, at least in countries like South Africa, investing in renewable energy is economically feasible thanks to our whipping winds and stubborn sunshine, not to mention the jobs it can create.

But perhaps the most compelling motivation for developing markets to erect solar and wind farms comes down to the following line of reasoning:

1. Much of the demand for our goods and services comes from developed markets (DM).
2. DMs will increasingly demand goods that are produced by emission conscious supply chains.
3. If a country and its businesses cannot meet that requirement, they may be left stranded.

Let’s get this straight – the very countries that pumped the atmosphere full of greenhouse gases may soon desert us economically if we don’t comply with their emissions-related regulations? Yes, exactly.

This dynamic raises a host of questions for forward-thinking investors: how seriously is the developed world taking climate change; what actions are they likely to take; and how will those decisions impact asset prices?

Floods and fires

Just as a bomb blast in Bagdad cannot hope to stir the same emotion as a shooting in Seattle, so too with climate-related weather events.

If it feels like the climate change discourse has suddenly ramped up a notch, it’s because 200 people died in a flood in Germany, millions of hectares and thousands of structures have been razed by rampaging Californian wildfires, and the water level in Lake Mead is 150 feet below where it once rested. The first world now has real problems. Naturally, urgency has followed.

Because the release of carbon dioxide has been scientifically proven to be the primary culprit of global warming, countries and businesses will increasingly be held accountable for their CO2 emissions.

Investors need to work to understand how this focus on decarbonisation will manifest so that they can avoid allocating money to ‘dirty’ assets/investments that might find themselves stranded by an accelerating global consciousness around the impact of CO2 emissions on climate change.

The carbon markets

Arguably the most effective way to reduce CO2 emissions is through the establishment of carbon markets. There are two types in existence today:

Regulatory compliance market: Emitters must account for their greenhouse gas (GHG) emissions by law and adhere to ‘caps’ on how much they are allowed to emit.

Voluntary market: Emitters buy carbon credits on a voluntary basis to offset their GHG emissions, usually as part of their corporate social responsibility (CSR) initiatives.

For the purposes of our discussion, the regulated markets are relevant, the largest of which is the European emissions trading scheme (EU ETS) – you can see the recent movement of its € price of carbon per tonne in the graph below:

EU carbon price

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Why is the EU ETS price of carbon rising so sharply? Largely, it’s a supply and demand story. Stricter climate change regulations – which are only getting stricter – means that EU companies and state-owned entities are allowed to emit less and less carbon, i.e., the supply of EU carbon allowances is decreasing.

But the ‘market’ allows emitters to purchase additional allowances (in auctions or from other companies) so they can release more CO2 than they would otherwise be allowed to. In some instances, it makes economic sense for them to do so. But past a certain price, this strategy becomes an unprofitable one. Where is the price of carbon headed?

It’s estimated that only 20% of global carbon emissions are regulated today, resulting in a global carbon price of around $3 per tonne, according to this IMF article. A medley of researchers is calling for a price of somewhere between $60 and $300 per tonne, by 2030, if the world is to achieve net-zero emissions by 2050. The idea of a minimum global carbon price is being explored.

That a greater percentage of CO2 emissions will soon be covered and restricted by market forces seems certain. And because it takes emitters longer to transition to clean energy sources than it takes policymakers to set lower carbon caps and reduce allowances, a higher carbon price seems inevitable/necessary to balance the supply/demand equation.

Keep the baby, throw the stubborn carbon out

At Sanlam Investments, we emphasise the fusion of ESG risks into our investment processes that are financially material; emitting large quantities of carbon dioxide falls squarely into that bucket. But as is so often the case when investing, the trajectory of a variable – in the context of future performance – is sometimes more important than its absolute level at a given point in time.

South Africa is a good example of this dynamic at a macro level. We have the natural resources to clean our dirty energy mix. And the public and private sectors look to be collaborating towards that end more so than in the past. If we can make the transition successfully and timeously, it could attract substantial investment and drive growth; that’ll be good for returns.

In the same vein, companies that currently have a large carbon footprint are not necessarily uninvestable.

As investors, we need to scrutinise the intentions and subsequent actions of businesses around the issues of decarbonisation and climate change. Those not taking them seriously, or that spew lip service, should be viewed with caution. They risk becoming stranded in a global economy that has arguably reached an inflection point when it comes to dealing with climate change.

It’s all connected

The levels of poverty and inequality in our country are dire to the point of despair. Surely, then, climate change is not a priority? There are two faults in this understandable line of thinking, the first more obvious than the second:

1. Transitioning to cleaner energy will create jobs, opportunity, and hope.
2. Climate change is here, and it will impact the poor the hardest.

We need not debate the first point. The second is true because it will take resources to adapt to the effects of climate change that the poor simply don’t have. Wider inequality will result, an outcome we just cannot afford.

In addition to allocating capital in a way that will help rein in global temperatures, each of us can play an individual role in the fight against climate change. It starts with raising awareness. Below are a few interesting talking points you can use to get the conversation going in your circles of influence:

• An estimated 45 000 people in SA perish each year because of our poor air quality.
• 200 companies are responsible for 2/3rds of all GHG emissions.
• Watching Netflix for 30 minutes releases 1.6kgs of CO2, versus 20g if renewable energy is used.
• Solar panels will likely become recyclable once more of them reach their end-of-life.
• The cost of nuclear reactors is going up, not down.
• Roughly $750 billion was invested into clean energy transition globally in 2020.
• Agriculture and land use are responsible for 1/4th of all GHG emissions.
• Crops grown to produce cocoa, natural rubber, soy, beef, and tropical timber and pulp carry the largest biodiversity/deforestation risk.

As important as it is to avoid investing in stranded assets, we also need to make sure our people, communities, and environment are spared the same fate.

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