Given the increasingly disruptive force of climate change-related weather events, the commitment of countries and companies across the globe to achieving net zero carbon emission by mid-century promises to be one of the themes driving investment markets over the coming decades. The push from policymakers poses risks to those in carbon-intensive sectors who lag, but may also open opportunities for enablers and innovators.

Recognising the importance of both capturing related opportunities and mitigating the increasing risks, the Global Balanced Risk Control team has developed an approach that seeks to capitalise on these changes. Our science-based approach decarbonises our portfolios’ core exposures according to the 1.5°C scenario, aligned with the most recent Intergovernmental Panel on Climate Change (IPCC) recommendations and targets net zero emissions for our equity exposure by 2050. We complement this approach by assessing companies’ ESG and Low Carbon Transition scores. This is implemented whilst maintaining our core time-tested approach to asset allocation.

In this piece, we look at how countries and some key sectors are responding to the challenge, and we also discuss potential solutions for investors.

Taking the temperature: the current climate

The recent report by the Intergovernmental Panel on Climate Change IPCC on the physical effects of climate change¹ comes as governments update their Nationally Determined Contributions (NDCs) in an attempt to achieve the Paris Climate Accord goals to limit global warming to well below 2°C from pre-industrial levels, and preferably to 1.5°C by 2050. The IPCC’s message is unambiguous; human activity, particularly the combustion of fossil fuels, is heating the planet and causing increased extreme weather events. The economic and social consequences of greenhouse gas (GHG) emissions have long been projected to be devastating. As early as 2006, the Stern Review on the Economics of Climate Change,² estimated the ongoing cost of inaction on climate change to be equivalent to 5%-20% of global GDP p.a.³ The IPCC demands urgent action, as without sustained reductions in emissions over the coming decades we will likely exceed 2°C global warming before the end of the century. In fact, in almost all emissions scenarios, global warming is likely to hit 1.5C “in the early 2030s”. The commitments required to limit emissions will profoundly affect the highest-emitting business sectors. While we cannot be certain of the outcomes, we should analyse how the most highly exposed sectors are managing the risk and uncertainty.

Country level policy responses – Greater ambition, but still not enough

Key to achieving the Paris Climate Accord goals are the NDCs and mid-century goals. The increasing number of countries committing to net zero emissions by mid-century is a bright spot in climate policy.  At COP26 in November 2021, governments are expected to update their NDCs for the first time since the Agreement was signed in 2015. As of August 2021, 107 countries have submitted new NDC targets. However, many do not match up to the ambition required to achieve the Paris goals. Furthermore, a number of countries have still not submitted any targets at all.

We now provide an update on the policies of some key countries in the climate transition:

CHINA: QUEST FOR GLOBAL CLIMATE LEADERSHIP VERSUS THIRST FOR GROWTH

China’s remarkable economic growth means it now emits more than a quarter of global emissions, so its actions to reduce emissions over the next decade will be crucial to limiting global warming. China recently announced its aim to achieve net zero before 2060⁴ and to increase non-fossil fuel-generated energy to 25% of total energy consumption by 2030. To help achieve this goal, China intends to double wind and solar capacity to 1,200 GW by 2030. While coal has shown a downward trend in China’s energy mix, recent developments signal a misalignment between climate targets and policy.  The 10% year-on-year increase in coal consumption, and the development of new coal powered plants in the first half of 2021 demonstrate a conflict between China’s economic stability and climate goals. Uncertainty over China’s path will remain until the country officially submits its NDC.

Another key component of China’s plan is the introduction of the world’s largest national emissions trading scheme, in terms of emissions traded, which came into force in July 2021. Whilst the price is low compared with more mature schemes such as that of the EU ($60 in July versus China’s opening price of approximately $7), it should facilitate companies migrating from existing regional schemes throughout China. While we do not believe the current price is high enough to discourage coal usage, this could change if we see any upward price pressure. China’s scheme will initially cover 40% of national emissions⁵ (15% of global emissions), but this is expected to expand over time.

US: CLIMATE U-TURN TO BUILD BACK GREENER

President Biden has made tackling climate change a cornerstone of his policy agenda. On 20 January 2021, he reinforced this commitment by re-joining the Paris Agreement and soon after pledged to reduce net US emissions by at least half by 2030 (50%-52% lower than 2005 levels), before hosting the Leaders’ Summit on Climate. Biden clearly intends to take a lead role and align the US with their resubmitted NDC target of net zero by 2050.

To an extent, US businesses were already driving change even under the Trump administration, with reductions in emissions averaging about 0.4% per year over the last decade, driven mostly by the shift from coal to renewables.⁶ The Biden administration pledges to accelerate the transition by spending billions on clean energy-related infrastructure and energy efficiency improvements. This spending, alongside extensive tax credits for renewables and an ambitious clean energy standard, should support his claim of a clean energy revolution in the US.⁷ However, the larger reconciliation bill containing many of the Democrats’ climate initiatives will need to win the approval of a number of hesitant Democratic senators, including Joe Manchin of West Virginia, who chairs the Senate Energy and Natural Resources Committee. In 2019, West Virginia was the second largest coal producer in the US and coal made up 91% of the State’s electricity mix.⁸

EU UPS ITS AMBITIONS WITH “FIT FOR 55”

Europe has long seen itself as a leader in tackling climate change and continues to make strong progress. European Union (EU) GHG emissions fell by 24% between 1990 and 2019, while its economy grew by approximately 60%⁹. In December 2019, the EU adopted the European Green Deal to advance the goal of net zero by 2050. In July 2021, the European Commission proposed “Fit for 55”, an extensive legislative package to support a more ambitious, shorter-term cut in GHG emissions of at least 55% by 2030. We believe carbon prices through the EU Emissions Trading Scheme (ETS) are already disincentivising the use of cheaper coal; in 2019, following a sustained higher allowance price, Europe saw a larger decline in the use of coal.¹⁰

INDIA: YET TO GET ON BOARD WITH NET ZERO COMMITMENTS

India’s emissions have grown steadily over the past decade and it is now the world’s fourth highest emitter, behind only China, the US and Europe. However, India’s per capita emissions intensity is 60% lower than the global average and about seven times lower than that of the US. Developing nations such as India have contributed comparatively little to global emissions and may justifiably feel aggrieved in having to adopt stricter climate change targets.¹¹ At the July 2021 G20 Energy and Climate Joint Ministerial Meeting, India signalled it would soon strengthen its existing commitments but cautioned that developed nations should move towards net zero sooner than 2050, to free up ‘carbon space’ for developing nations to grow.

However, India’s emissions growth and the burdensome physical effects of climate change on the nation,¹² evident for example in changing rainfall patterns, highlight the need to contribute to lowering global emissions. Despite rapid growth and falling prices for renewables (solar being around 14% cheaper than coal),¹³ the Indian government is encouraging more coal mining and production. Uptake from the private sector has been slow, highlighting difficulties in funding new coal deployment globally.¹⁴

JAPAN BACKING ITS AMBITIONS WITH INVESTMENT IN NEW TECHNOLOGIES

Japan recently announced measures to support its net zero goal by 2050, and to reduce GHG emissions by 46% by 2030 from 2013 levels. While Japan already benefits from an energy-efficient economy, some heavy industrial processes require high-temperature which could prove stubborn to further decarbonise. To combat this, Japan plans to invest heavily in hydrogen and carbon capture, utilisation and storage (CCUS) technologies.

In addition, Japan’s transition plan will see natural gas’s contribution to electricity generation almost halve from 2019 levels of 37%, to 20% by 2030. This is notable, as Japan is the largest global importer of liquefied natural gas, for example representing around 21% of global imports in 2020.¹⁵ Similar drops in coal usage will be offset by highly ambitious deployment of renewables which could make up 38% of Japan’s electricity mix by 2030. This may serve as a warning for producers who see gas as the natural replacement for coal in the medium term.

UK: HALFWAY TO NET ZERO

The UK was one of the first major economies to legislate a net zero target by 2050, despite having notable oil and gas reserves – around 10-20 billion barrels of oil equivalent.¹⁶ Winding down UK oil and gas production may help to achieve the nation’s climate goals; however, we note controversial plans to approve a new North Sea project.¹⁷ Nevertheless, in 2020, the UK was halfway to meeting its 2050 net zero target, having reduced emissions by more than 50% from its 1990 levels. A large contributor is a shift in the energy mix towards renewables, a shift which since 2015 has been supported by the UK’s Carbon Price Support. This support, which is effectively a tax, was found to have accelerated coal’s decline in the UK’s electricity mix by over 90%.¹⁸ This demonstrates how effective a robust carbon pricing mechanism is in aiding the transition away from coal.

SECTOR CARBON FOOTPRINTS: PROGRESS AND CHALLENGES

Against this somewhat uncertain policy backdrop, companies will be expected to adapt their businesses. A recurring theme is the need for transitioning from fossil fuels, particularly coal and oil, to renewable sources, as well as long-term improvements in electrification and energy efficiency. We believe this is key to aligning with national ambitions. However, like national initiatives, the rate of change remains stubbornly slow, necessitating an immediate policy response to reduce emissions in the short term to avert climate disruption.

Utilities

Electricity and heat generation make up 31.9% of global GHG emissions,¹⁹ and this figure is only likely to grow. To lower emissions, the transition to clean renewable energy in our electric system needs to accelerate. As a result, utilities are one of the most exposed sectors to carbon pricing risk, making their transition plans an essential part of their value proposition.

The step-up in the EU’s net zero ambition and the Biden administration’s clean energy standard are likely to lead to further tightening in the global carbon markets and regulations, with significant implications for the utilities sector. According to the Transition Pathway Initiatives’ (TPI’s) State of Transition Report 2021, global electric utilities have reduced their emissions significantly, primarily due to reductions in the use of coal and increased use of renewables. US utilities are on track to meet their 2030 targets, but TPI found they will miss 2050 targets at current rates.²⁰ Emerging economies remain reluctant to phase out coal. Coal is the dominant fuel in both China and India’s electricity mix, representing 58% and 51% respectively.²¹ The sector needs continued large-scale investment, but companies should benefit from first mover advantages.

We believe the current policy traction will be a tailwind for those utilities that have embraced the energy transition early on. Due to the cost advantages of renewables, utilities across the world should continue to phase out fossil fuels, especially coal, while accelerating solar and wind deployment to meet near-term reduction targets. These efforts to decarbonise their energy mixes will be key to how we assess utilities’ comparative advantages. Utility companies’ Scope 1 emissions tend to be comparatively high. We believe those that can decarbonise their portfolios in an efficient manner can reduce their carbon pricing risk and may use their resources more efficiently. Over the long term we believe a utility company will be more profitable if it makes more efficient use of its own resources, so we can expect companies with low scope 1 carbon intensity to outperform.

Oil & Gas

NET ZERO TARGETS RARE

It will become increasingly important for oil and gas companies to be disciplined in their capex plans as the energy transition accelerates, positioning themselves for the long term. Setting net zero targets is still rare in this sector according to Climate Action 100+, and even fewer include Scope 3 emissions in their plans.²² Addressing Scope 3 emissions is crucial for the Oil & Gas sector as 85-90% of lifecycle emissions occur as fossil fuels are combusted. We note that the IEA recently recommended that exploitation and development of new oil and gas fields must stop this year if we are to reach net zero by 2050.²³ This is broadly in line with UCL research from 2021 that estimated 60 percent of global oil and gas reserves must be left unexploited by 2050, though a portion of those fuels could be produced in the second half of the century.²⁴ This raises risks for investors. Considering the typical oil and gas project generally have a life span between 15 and 30 years, capex decisions now may result in value destruction and stranded assets over the life span of the project. We believe investors should monitor investee companies’ capex plans carefully. Reducing Scope 3 emissions over the long term may signal a company’s commitment to sustained sustainable value.

LEANING ON CARBON CAPTURE, UTILISATION AND STORAGE (CCUS) AS A SOLUTION

Instead of reducing Scope 3 emissions from the combustion of their products, the industry has leaned towards increased capital expenditure on speculative technologies to assist them in exploiting their reserves. The oil and gas industry accounts for more than 35% of overall spending on CCUS,²⁵ and we believe spending will accelerate. US majors have led investment in this technology. While capturing carbon may well play an important role in meeting global climate goals, the gap between what is required and what is possible remains large. We therefore remain cautious as overreliance on future utility of these immature technologies to achieve climate targets could further delay emissions reduction. In lieu of feasible, climate stress-tested investments, and without significant strategic shifts, we believe oil and gas companies may be better served using cash to deleverage and increase distributions to shareholders.

Transport

DRIVEN BY REGULATORY PUSH

Transport represents about 24% of direct CO₂ emissions from fossil fuels, of which road vehicles contribute about three quarters.²⁶ Automobile manufacturers already face numerous national and supranational vehicle fleet emissions and fuel efficiency regulations, including in large economies such as Japan, China and the European Union. An increasing number of governments including Japan, Spain, the United Kingdom and Canada have announced dates by when the sale of new internal combustion cars will be banned. These regulations, combined with rapid advances in battery technology,²⁷ should drive demand for electric and hybrid vehicles.

ELECTRIC VEHICLE (EV) SALES MUST ACCELERATE

Growth in sales of electric cars has strengthened over the past decade, with global stocks of electric passenger cars passing 5 million in 2018, an increase of 63% from the previous year. However, this is still only about 2.6% of global car sales and roughly 1% of the global fleet in 2019.²⁸

To achieve net zero, it is estimated that zero emissions vehicles will need to make up about 60% of global new car sales by 2030.²⁹ This will likely require sustained policy support and further advances in innovation to achieve cost parity. Given the size of the opportunity, we expect to see automobile manufacturers further transitioning towards electric fleets. This scaling up and increased cost competitiveness could help sustain growth in sales and push us towards decarbonisation. Over the next decade we believe heavy emission-tied fines and loss of market share will penalise manufacturers who do not prioritise the transition, while policy initiatives and investment flows continue to reward those that lead the way.

Financials

While the financial sector can play a large role in determining our path to net zero³⁰ through its direct and indirect influence on the economy, many areas of the financial sector remain intertwined with fossil fuel interests and funding.³¹ However, the investments required for a green global economy are enormous. With the proliferation in national net zero targets and climate measures amongst large economies,³² we are likely to see additional regulation in the financial industry. We believe this carrot and stick approach is driving the industry’s interest in various net zero initiatives.

The financial sector is impacted by climate change in several ways. Firms that are particularly exposed to more carbon-intensive businesses through their loan books or investment portfolios may be poorly positioned if regulation or technological change renders these sectors less viable. On the other hand, those that seize the green opportunity can enjoy the potential for increased revenues and the reputational benefits that come with being a green enabler. We believe it is important to consider which institutions are leaders or laggards by analysing financed and portfolio emissions as well as how financial institutions influence their customers and investee companies to align on a net zero pathway.

Conclusion

As the window for addressing climate change rapidly closes, we believe the world will continue to step up with bolder climate action. We believe the market will reward innovation and penalise inaction. An attempt at continued high-carbon growth is likely to be value destructive as a result of increased technological and regulatory change. Innovation in low-carbon solutions will be the critical driver of both economic growth and strong emissions reductions. Considering this, we believe investors will continue to demand their portfolios are aligned to both mitigate the risks and potentially capture the opportunities that the low-carbon transition presents.

¹ https://www.ipcc.ch/report/ar6/wg1/

² N. Stern (2006), The Stern Review Report: the Economics of Climate Change.

³ https://webarchive.nationalarchives.gov.uk/ukgwa/20100407163608mp_/http://www.hm-treasury.gov.uk/d/Summary_of_Conclusions.pdf

⁴ www.carbonbrief.org/qa-what-does-chinas-14th-five-year-plan-mean-for-climate-change

⁵ https://icapcarbonaction.com/en/news-archive/742-china-launches-operational-phase-of-national-ets , July 2021

⁶ UNEP - Emissions Gap Report 2020

⁷ www.joebiden.com/climate-plan/

⁸ West Virginia Profile (eia.gov)

⁹ www.ec.europa.eu/clima/policies/strategies/progress_en

¹⁰ https://www.eea.europa.eu/highlights/climate-action-in-europe-eu

¹¹ UNEP – Emissions Gap Report 2020

¹² www.worldbank.org/en/news/feature/2013/06/19/india-climate-change-impacts

¹³ https://www.woodmac.com/press-releases/india-leads-with-lowest-renewable-cost-in-asia-pacific/

¹⁴ www.reuters.com/world/india/no-bids-over-70-indian-coal-mines-up-auction-2021-07-09/

¹⁵ IGU World LNG report - 2021 Edition

¹⁶ https://www.ogauthority.co.uk/data-centre/data-downloads-and-publications/reserves-and-resources/

¹⁷ https://www.bbc.co.uk/news/science-environment-56503588

¹⁸ https://www.ucl.ac.uk/news/2020/jan/british-carbon-tax-leads-93-drop-coal-fired-electricity

¹⁹ Source: Climate Watch, based on raw data from IEA (2020)

²⁰ www.transitionpathwayinitiative.org/publications/82.pdf?type=Publication

²¹ Source: IEA

²² www.climateaction100.org/progress/net-zero-company-benchmark/

²³ www.iea.org/reports/net-zero-by-2050

²⁴ Welsby, D., Price, J., Pye, S. et al. Unextractable fossil fuels in a 1.5 °C world. Nature 597, 230–234 (2021).

²⁵ www.iea.blob.core.windows.net/assets/4315f4ed-5cb2-4264-b0ee-2054fd34c118/The_Oil_and_Gas_Industry_in_Energy_Transitions.pdf

²⁶ https://www.iea.org/reports/tracking-transport-2020, May 2020

²⁷ www.about.bnef.com/blog/battery-pack-prices-fall-as-market-ramps-up-with-market-average-at-156-kwh-in-2019/

²⁸ www.iea.org/reports/electric-vehicles

²⁹ BNEF EV outlook 2021

³⁰ For those banks that disclose CDP found that financed emissions are over 700x larger than reported operational emissions – The Time to Green Finance

³¹ In the 5 years since the Paris Agreement was adopted, the world’s 60 largest private sector banks financed fossil fuels with $3.8 trillion according to Rainforest Action Network

³² Half the world economy now under some sort of net zero commitment - https://www.businessgreen.com/news/4010947/half-world-economy-eyeing-net-zero-transition-analysis

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.  Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events.  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. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. 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. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.

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 favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance.