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Three Climate Tipping Points Shaping Markets

As the earth approaches a climate-change tipping point, three other tipping points could help drive positive action. How should investors position to help create maximum change?

Climate-change research often speaks of a “tipping point” that, once breached, could accelerate the pace of climate change. Yet, even amid our world’s perilous approach towards this critical threshold, some hope may be emerging, namely other tipping points in social, economic and policy realms that could help tilt the scales back in the earth’s favor.

With the consequences of climate change unfolding right now across the planet, more investors are realizing that they must act now.

Taken together, these tipping points will have profound implications for how we approach climate change. For investors, they mark significant touchpoints in terms of managing portfolio risk and being part of the climate-change solution.

Tipping Point #1: Policy

We are edging closer to the tipping point for substantial government action and policy, an important milestone if we are to mitigate the effects of climate change. Recently, two reports gained attention for their updated predictions, which proved sobering:

First, the Intergovernmental Panel on Climate Change’s 2018 report1 concluded that the threat of climate change is so significant and so immediate, we have just 12 years to make unprecedented changes to keep global warming to less than 1.5°C above pre-industrial levels. Above this level, the predicted consequences would be far reaching and catastrophic.

Second, the UN Emissions Gap Report in 2018 highlighted “an enormous gap between what we need to do and what we’re actually doing to prevent dangerous levels of climate change.”2

Until now, many governments and politicians have missed the opportunity to deal proactively with the challenge of climate change. But mounting pressure from global bodies, such as the UN, as well as better-informed citizens, may now move us toward another tipping point—a shift in attitudes and priorities that presage material changes to national and global policies designed to slow climate-change momentum. 

Tipping Point #2: Social

We are also reaching a social tipping point, as polarized attitudes and inaction on climate change create social divisions. The lack of progress on combating climate change has led to louder cries for action. However, at the same time, efforts to address climate change have caused hardships and led to protests.

Consider France, where the populist gilets jaunes, or “yellow vest” movement, began as a protest against government plans to raise fuel taxes tied to fulfilling its commitments under the 2015 Paris Agreement to combat climate change. Ultimately, the prolonged social unrest in Paris and other parts of France has caused the government to abandon its fuel-tax policy—at least for now.

We have been factoring these Paris protests into our investment considerations due to their threat to political stability and potential effect on European economic growth.

Yet, the consequences of inaction are even more severe. Around the world, floods, droughts, fires, hurricanes, the hottest summers on record and, paradoxically, worsening winters and snowstorms are increasing mortality rates and creating havoc for industries and communities. This will likely exacerbate social tensions, leading to further friction and polarization between different regions and within disproportionately affected segments of the population. Emerging markets, which are less able to adapt to climate-related changes, will likely suffer the most.

Bottom line: Greater numbers of people realize that inaction is simply not an alternative anymore.

Tipping Point #3: Economic

When it comes to economic tipping points, in many ways, the future is already here. The cost of renewable energy has fallen dramatically in many parts of the world. In the U.S., solar and wind energy are $54 and $51 per megawatt hour, respectively—now competitive with coal, at $66 per megawatt hour. Both are less than a third of the cost of nuclear. For now, however, natural gas remains the least expensive source of energy.

Average Levelized Cost of Electricity in the U.S. without Subsidy for 2017
(Renewable sources are within competitive range of goal and natural gas)

Source: Global Trends in Renewable Energy Investment 2018, Frankfurt School - United Nations Environment Programme (UNEP) Collaborating Centre. $MWh indicates the U.S. dollar cost per megawatt hour of energy.

Subsidies and low borrowing costs have powered the growth of alternative energy from solar and wind. However, more government policies will be needed to support further growth. The International Energy Agency (IEA) predicts that 70% of future global energy investments will be government-driven.3 Such investments will be critical to ramping up what has already been a notable increase in renewable energy production.

We should also consider the technological advances in renewables. More electric vehicles (EVs), for example, are on the roads, as they get cheaper and offer a greater range of choices. EVs are also more energy efficient and emit less greenhouse gases than internal combustion engines, even if the electrical energy source to charge the batteries originates from fossil-fuel production.

For applications that require high energy density like large trucks4, hydrogen has the potential to emerge as a complementary technology. It would require a significant build-out of infrastructure, but Japan, China and California are increasingly competing in this space. Japan, in particular, has been investing heavily in hydrogen and the country’s push to lead the world as a “Hydrogen Society,” will be showcased during the 2020 Tokyo Olympics.

A final point worth noting is that while China is widely known to be the world’s largest coal consumer, it also leads new investment in renewables. In fact, China is already dominating in every area of new alternative energies and accounts for 40% of the global stock in EVs, as of 2017—the most of any market in the world.5

Who Are the Biggest Consumers of Renewable Energy?
(Renewable energy consumption in major markets, 2017 and 2023)

Source: http://www.iea.org/renewables2018 Published October 8, 2018. The share of renewables in total final energy consumption in the European Union is calculated using the methodology outlines in IBRD World Bank and IEA (2015), Global Tracking Framework (GTF) 2015. The exact calculation and inclusion of specific energy flows may differ from those outlined in the EU Directive 2009/28/EC. Mtoe is million tonnes of oil equivalent.

Investor Demand and Implications

How should investors respond to the potential disruption to the energy and auto sectors across different regions from these political, social and economic tipping points? Indeed, so many investors are now asking that same question, that a fourth tipping point—market demand—has arisen. Over the past few years, investors have been increasingly demanding greater incorporation of environmental, social and governance (ESG) considerations in their investments.

While fossil-fuel companies clearly face headwinds, the impact on other sectors shouldn’t be ignored. Climate-change-related issues can also increase political uncertainty, with broad implications that investors should consider as part of their portfolio asset allocation process.

Within sectors, we believe in the value of differentiating between companies. For example, within the energy sector, it makes sense to distinguish between oil and gas companies with poor climate risk management and those with stronger ESG scores.6 One solution we have found to address this, while preserving global diversification, is to remain sector neutral. We do this by keeping sector weights in line with those of the equity indices that we follow, however, within those sectors, tilting our portfolio holdings toward higher scoring, more ESG-friendly companies.

With the consequences of climate change unfolding right now across the planet, more investors are realizing that they must act—not only to manage the rising risks and protect their portfolios, but seize the opportunities presented by these disruptions to be part of the myriad of solutions that shape our future.

Adapted from the Investment Insight “Three Climate Tipping Points Shaping Markets Today." For more information, ask your Morgan Stanley representative or visit Morgan Stanley Investment Management. Plus, more Ideas from Morgan Stanley's thought leaders.

Risk Considerations

There is no assurance that the strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. The use of leverage may increase volatility in the Portfolio. Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes

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