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Five Sectors That Cannot Escape Climate Change
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März 23, 2020
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März 23, 2020
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Five Sectors That Cannot Escape Climate Change |
As the reality of climate change becomes inescapable, we are seeing governments respond more decisively to climate issues. In our view, one of the biggest risks that investors face is that financial markets are not pricing in the effects of policy responses to climate change fast enough. By seeking to identify areas where changing policies will eventually affect market pricing, investors can start to manage associated risks and tap into opportunities.
A risk that is both significant and likely
As managers of multi-asset risk-controlled portfolios, assessing and managing risk is at the heart of everything we do. We judge the risks posed by climate change as highly significant, and we are not alone: According to the World Economic Forum’s latest Global Risk Report, climate action failure is cited as the top risk when measured by “impact,” and comes in second when measured by “likelihood” over the next 10 years.1 For the first time, environmental concerns have topped the survey’s list of long-term risks (Display 1).
Source: World Economic Forum, The Global Risks Report 2020, Global Risks Perception Survey, 2019-2020. Survey respondents were asked to assess the likelihood of the individual global risk on a scale of 1 to 5, 1 representing a risk that is very unlikely to happen and 5 a risk that is very likely to occur. They also assessed the impact of each global risk on a scale of 1 to 5, 1 representing a minimal impact and 5 a catastrophic impact.
Under the current commitment level, global temperature is on track to increase by 3 degrees Celsius by the end of the century.2 That is twice what climate experts warn is the limit to avoid severe economic, social and environmental consequences.
Policies are evolving, albeit unevenly
Climate-related disasters have cost $650 billion to the global economy over the past three years.3 Hurricanes, droughts and wildfires are eliciting regulatory responses, which in turn are pricing in the risks. But regulatory responses vary widely across regions:
Five sectors with clear winners and losers
Using tools such as the Sustainability Accounting Standard Board’s materiality matrix® and the PRI-backed Inevitable Policy Response, we identified five sectors with the largest spread between potential winners and losers from climate-related policies and market disruptions. These are sectors where diligent research can help identify the types of companies that are likely to benefit—or suffer—from shifting policies surrounding climate change.
1. FINANCIAL SERVICES: AT THE HUB OF TRANSITION
Through lending and capital market activities, it is easy to see how the financial industry can either facilitate or hinder the transition to a low-carbon economy. If an unpredictable and catastrophic climate event were to occur—a so-called green swan—it could trigger a financial crisis that would affect the value of virtually every financial asset. But even less-extreme events can have major impacts through a range of physical, transitional and liability risks, including stranded assets, bad loans and lost asset value.
Challenges
One major hurdle facing financial services firms is the quality and comparability of data needed to assess “scope 3” emissions, which include all indirect emissions that occur in their value chains. For insurers—all of whom cite climate change as a risk factor—only 60% have developed models9 to monitor its effects on their actuarial assessments.
Leaders versus laggards
Banks are beginning the process of better understanding climate change risks as it relates to lending and exposure, including probabilities of default from brown assets that are at risk of carbon mispricing. And many have shifted lending towards green assets. With the green transition representing $50 trillion in investment over the next 30 years and $3-10 trillion in operating earnings, decarbonisation could present a material economic opportunity for those on the front line.10
Similarly, insurance companies with strong climate-change strategies will be better able to control premium risks while capitalising on the growing need for insurance protection from catastrophes, such as the recent Australian wildfires.
Financial services firms that neglect to do the hard work of assessing climate risks cannot hope to manage them. Those that fail to capitalise on the trend towards green investment and the need for protection against “green swans” are at risk of losing market value.
2. METALS AND MINING: A NIMBLE STRATEGY IS CRUCIAL
A distinguishing feature of metals and mining companies is the long lifespan of their facilities and assets. As a result, these companies need to consider environmental risks far into the future, including post-closure.
Challenges
Climate-related concerns have already led to sharp reductions in production and increases in costs. Political pressures continue to disrupt the industry.
Leaders versus laggards
Nonetheless, mining companies can to some degree choose their own futures. As significant users of energy, they have the ability to shift their energy mix or install new renewables capacities.
With the global transition to lower carbon alternatives, miners can also seek to secure new sources of revenue. For example, the EU’s Green Deal will drive a shift towards electric vehicles (EVs) and an overall greater product mix of renewable energy. This is estimated to lead to an increased demand for lithium by 67% and for cobalt by 82%.11
Companies that manage to be nimble in shifting energy sources and acquire a foothold in delivering the required metals in the new low-carbon economy are more likely to survive than those that fail to adapt.
3. OIL AND GAS: ASSETS COULD BECOME STRANDED
To meet the Paris Agreement’s goal of limiting global warming to less than 2 degrees Celsius in this century, fossil fuel projects that are already planned will need to be curtailed or abandoned.
Challenges
Despite regulatory pressures, oil demand is estimated to grow by 1 million barrels per day each year until 2025.12 There is sufficient carbon in known deposits of fossil fuels to breach the 2 degrees Celsius goal. Similarly, current planned projects, if completed, will result in global warming that exceeds the 2 degrees Celsius target.13 To stay within the 2 degrees Celsius threshold would entail stranding 30-50% of existing oil and gas reserves—a commitment that would require an increase in carbon prices and more stringent regulations on a global level.
Leaders versus laggards
The global reach, technical sophistication and massive balance sheets of many of the large oil and gas companies presents an opportunity to lead the transition to a low-carbon economy. Currently, renewable investments represent less than 1% of their capital expenditures (Display 2).14 Forward-thinking companies could devote more of their capital budgets to developing renewable energy sources.
Source: IEA, Capital expenditures on new projects outside of core oil and gas supply by large companies, absolute and as share of total capex, 2015-2019.
European oil companies, for example, are diversifying to prepare themselves for the transitioning economy by acquiring startup EV-charging companies and utilities. Companies that fail to diversify their revenue streams may find that their investments in developing oil and gas reserves may eventually end up as stranded, nonproductive assets.
4. UTILITIES: A CARBON ADVANTAGE
Given that global electricity demand is predicted to increase by 1.5% p.a. for the next 20 years,15 the decarbonisation of electricity generation is central to achieving net-zero emissions. In 2018, energy from low-carbon sources—hydro, nuclear, solar, wind, biomass and other renewables—represented over 25% of global electricity generation.16 This trend is set to increase to 93% by 2050 as renewables become cheaper than thermal coal and other fossil fuels (Display 3).17
Source: Morgan Stanley Research.
Challenges
In Europe, regulations, coal phaseouts and increasing carbon prices could cause billions in potential asset write-downs, while China, India and Southeast Asia are still heavily dependent on coal-powered utilities to meet rising energy demand. Similarly, nuclear is expected to grow in a limited number of markets, such as China, but around 23% of global nuclear power will be decommissioned by 2030, predominantly in Europe and Japan.18
Leaders versus laggards
Early adopters in renewable power generation will gain a “carbon advantage” that should enable them to gain market share from competitors. Utilities shifting towards a low carbon mix will have greater access to financing through sustainable debt issuance, which is set to exceed $400 billion across the market in 2020, driven by climate action.19 Meanwhile, companies with high carbon costs may struggle to secure financing from banks, insurers and investors, which are increasingly rejecting investments in coal.
5. AUTOS: SHIFTING PRODUCT MIX
In September, we examined the trends shaping the auto industry in our article, Peak Car—or Just Bumps in the Road? Since then, excluding the near-term impact of the coronavirus, we have started to see a stabilisation in car sales in China and Europe (Display 4). Nevertheless, automakers’ product mix is going through a major shift.
Source: Bloomberg, Morgan Stanley Wealth Management, 22 January 2019.
Challenges
From 1 January 2020, EU passenger cars face a new emission target of 95g CO2/km,20 with steep fines for exceeding this level. In 2018, fleet emissions among EU manufacturers averaged 121g CO2/km,21 so reaching the new target is only possible through a large-scale rollout of EVs. It seems unlikely automakers will be able to reach a sufficiently high EV penetration to avoid penalties.
Leaders versus laggards
The global surge in demand for EVs benefits EV battery manufacturers, particularly those in Korea, where they have strong links with automakers, and Japan, where manufacturers are developing solid-state battery technologies that are seen as the next big breakthrough. Auto manufacturers unable to achieve scale in electric vehicle production are likely to struggle. Original-equipment manufacturers that are not meeting CO2 emission targets will also see a decrease in profitability in their traditional business lines, such as the internal combustion engine.
Summary: The advantage of looking ahead
Climate change is a present risk we deem both significant and threatening. The adoption of climate policies across the globe are affecting the viability and profitability of many sectors. Five in particular—financial services, mining, oil and gas, utilities and autos—are experiencing the bulk of the disruption.
In our view, market pricing for many companies in these sectors has not kept pace with the rapid advance of policy changes. For our clients, this issue presents a window during which we can position their portfolios in advance of a potential market re-pricing. It could mean removing coal producers from our portfolios or overweighting areas where we see promising climate-related investment trends. In making these decisions, we continually look ahead to anticipate which types of companies stand to gain or lose from evolving climate policies.
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 and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. 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-capitalisation 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.
ESG Strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favour in the market. As a result, there is no assurance ESG strategies could result in more favourable investment performance. Earnings before interest and taxes (EBIT) is a measure of a firm’s profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses.
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Managing Director
Global Balanced Risk Control Team
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