Three Climate Tipping Points Shaping Markets Today
February 19, 2019
“We choose to go to the moon . . . because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win.” – John F. Kennedy
Climate change research generally examines “tipping points” or critical thresholds that, once breached, could accelerate the pace of change. But even today, we are approaching many tipping points that cannot be ignored. They are playing out not only in the environment, but also in political, social, economic and investment realms.
Tipping point #1: Political
We are edging ever closer to the political tipping point. Reaching it will be important if we are to mitigate the effects of climate change. Recently, a number of reports gained attention for their updated predictions and proved rather sobering:
Display 1 plots the projected global greenhouse gas (GHG) emissions under various scenarios; we are predicted to overshoot the 1.5°C goal if we do not do more to reduce emissions.
Governments’ responses show many are burying their heads in the sand. During the December 2018 UN Climate Conference the U.S., Russia, Kuwait and Saudi Arabia argued that the IPCC report should not be “welcomed”, but merely “noted”. While the headlines surrounding the November 2018 White House report3 focused on the potential reductions in U.S. GDP by 2100, President Trump expressed scepticism. Either way, any potential curtailment of GDP should make investors and citizens sit up and take notice.
Until now, many governments and politicians have largely ignored their responsibility to proactively deal with the challenge of climate change. We think mounting pressure from bodies such as the UN, as well as from better informed citizens may now be moving us towards another tipping point, which would mark a shift in attitudes and priorities.
Tipping point #2: Social
What if we just do nothing? The consequences of inaction are potentially severe: floods, droughts, fires, hurricanes, snowstorms and the hottest summers on record are already increasing mortality rates and creating havoc for industries and people. This is likely to exacerbate social tensions and could lead to further frictions and polarisation within society, as different regions and segments of the population are disproportionately affected. Emerging markets, being less able to adapt to climate-related changes, will likely suffer the most.
Entire islands are being swallowed by rising sea levels. The island Republic of Kiribati in the Pacific Ocean has bought land in Fiji to relocate its citizens, due to rising seas. Yet Fiji, itself is under threat, relocating coastal villages inland. These are not the only climate refugees. On a much longer term horizon, the World Bank estimates that climate change could ultimately lead to 140 million internal migrants in Sub-Saharan Africa, South Asia and Latin America.4
Some governments have also been facing pressure. Protests around the world, calling for action on global warming, have intensified, but social unrest related to climate change is complicated. In France, the populist ‘gilets jaunes’ movement began as a protest against rising fuel taxes, which the government had intended to help fulfill its commitments to tackle climate change under the Paris Climate Agreement. This led to a counter movement by the ‘red scarves’ who are demanding an end to the violence. Ultimately, the social unrest led to President Macron abandoning the policy. We have been factoring in these French protests in our investment considerations due to the political instability and its potential impact on European GDP.
Clearly, the climate-related social tipping point presents social divisions. Not addressing climate change can lead to outcries for action, yet addressing climate change can cause hardships that lead to protests, such as the ‘gilets jaunes’ movement. Doing nothing may delay unrest briefly, but climate change will ultimately increase suffering, climate refugees and social unrest regardless.
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 (Display 2) which is now competitive relative to coal at $66 per megawatt an hour. Both are less than a third of the cost of nuclear, though for now gas still remains the least expensive source of energy.
Subsidies and low borrowing costs for the initial required capital expenditure have helped solar and wind growth. However, with rising interest rates led by the U.S., and the majority of energy investment outside the U.S. being U.S. dollar-denominated, we will need government policies to support further growth. The International Energy Agency (IEA) is predicting 70% of future global energy investments will be government-driven.5 Clearly, we are seeing a significant shift in energy production, with a notable increase in renewable energy (Display 3).
We should also consider the technological advances associated with renewables. There are increasing numbers of electric vehicles (EVs), which are getting cheaper, while offering a greater range of choices. EVs are also more energy efficient and therefore emit less GHGs than internal combustion engines, even if the electrical energy source is from a fossil-fuel. However, EVs require batteries, which have low energy density and are heavy.
For applications that require high energy density,6 like lorries, 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. Toyota and Honda are leading the way in hydrogen fuel cell cars. In support of Japan’s push to lead the world as a “Hydrogen Society,” these advancements are planned to be showcased during the 2020 Tokyo Olympics.
Hydrogen also potentially offers a solution to balance the power grid, a challenge with which Beijing has had to contend. A weakness of electricity generated by renewable energy is that it tends to come in surges, with big windstorms or a long spell of sunny days. Other issues include the cost of large-scale batteries and the fast rate at which their energy depletes. Instead of wasting the excess electricity available during these intermittent surges, it could be used to split water into hydrogen, which can be stored in great quantities for long periods. That said, hydrogen does have its own challenges, as it is less efficient given the energy required to both create and store it.
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 (Display 4). In fact China is already dominating in every area of new energies and had the most EVs in 2017 – 40% of the global stock period.7
Investor demand and implications
As these political, social and economic tipping points bring disruptive changes in the energy and auto sectors across different regions, the question becomes, "How should investors respond?" Enough are asking that question to drive markets to a fourth tipping point: investor demand. Within the last 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 direct headwinds, the impact on other sectors should not be ignored. The insurance industry, which is facing greater risks of loss from floods and hurricanes, is also subject to potential legal risks. For example, if future regulations deem oil companies to be liable for their contributions to climate change, there is an argument that this is a general liability matter, for which oil companies already have insurance against damaging lawsuits and penalties.
Climate change related issues can increase political uncertainty and have implications across a portfolio’s broad asset allocation. Investors should consider this factor during the asset allocation process. For instance, the ‘gilets jeunes’ movement contributed to the already heightened political uncertainty in Europe in 2018.
Within sectors, we believe, it is worth 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.8 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 but, within those sectors, tilting our portfolio holdings towards, higher scoring, more ESG-friendly companies.
Climate change: Not just a long-term problem
The current U.S. President withdrew the U.S. from the Paris Climate Agreement and has at times denied the threat of climate change. Therefore, the U.S. government’s response to climate change, as with that of many other governments, has been insufficient.
However, across the rest of the world there are some who are beginning to participate in the green race in a way that echoes a former U.S. president, John F. Kennedy’s, exhortation of urgency for American leadership in a different race. In a speech that marked a tipping point in the Apollo space programme, JFK rallied the nation: “We choose to go to the moon. . . because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win.”
Many are starting to realise that the need to tackle climate change is an issue that can no longer be postponed. We have reached a number of tipping points already: political, social, economic and investment. There is no need to wait a century or a decade to see the effects. The consequences are unfolding right now across the planet. Investors should be taking advantage of the opportunities presented by these disruptions, while protecting their portfolios from the adverse consequences.
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