janvier 31, 2022
Decarbonisation: The Inevitable Policy Response
janvier 31, 2022
Decarbonisation: The Inevitable Policy Response
janvier 31, 2022
In the second paper of our decarbonisation series, we focus on what the UN Principles for Responsible Investing (UN PRI) refer to as the ‘inevitable policy response’ to global warming and ask: why does this matter for investors?
AT A GLANCE
Stronger government decarbonisation policies are critical to reaching net zero by 2050. Technology alone is not enough.
Rapid decarbonisation does not have to be a material net negative to the world economy or living standards, although there are likely to be pockets of disruption.
There is increasing regulatory momentum, with rapid global adoption of net zero targets and carbon tariffs, and investors should be preparing for the implications now.
High-quality, low-carbon portfolios are well positioned for the for the carbon transition given their low sensitivity to carbon taxes and green technological disruption.
The challenges are immense…
Although climate change concerns have surged, fuelled in part by the pandemic, the immediacy and severity of the threat to global ecosystems and economies is not broadly understood. The world is supposed to decarbonise by 2050 in order to keep global warming at 1.5 °C as laid out in the Paris Climate Agreement – but global greenhouse gas (GHG) emissions have not yet begun to structurally decline.
On their own, new low-carbon technologies are not enough, given the enormous fossil fuel system we have built. Using BloombergNEF data, we estimate that, based on historic trends, it would take 50 to 80 years to decarbonise global electricity generation and even longer to electrify the total energy system – Display 1.
Source: BloombergNEF, New Energy Outlook 2021
…but not insurmountable
The key debate is whether governments can accelerate decarbonisation through radical policy mechanisms. Already, regulation has proven to be effective. European Union (EU) policies driving tougher environmental standards have helped to significantly reduce emissions over the past 15 years, even as global CO2 levels have risen – Display 2.
Elsewhere, momentum is positive, with countries accounting for roughly 90% of global emissions having now set net-zero targets (as at 23 December 2021)1 – including a recent announcement from India at the UN Climate Change Conference, COP26. We expect these will start to trickle down into real economic policies over time.
The pathway to success involves governments creating climate change policies with increased impact and scope, as well as greater global coordination. This does not have to be a significant net cost to the economy or a structural negative for living standards. Carbon taxes can be redistributed through green dividends or zero-sum emission trading schemes, and the building out of green infrastructure can serve as a net fiscal stimulus and a net job creator. Inevitably, certain sectors will be disrupted (e.g. coal production and power generation, oil industries, aviation etc.), but others are likely to benefit (e.g. renewable energy, electric vehicles, greener utilities etc.).
GOVERNMENT POLICY TOOLS
In our view, policymaking can and must play a crucial role in global decarbonisation. We advocate a combination of measures: both the ‘sticks’ to penalise and the ‘carrots’ to encourage.
Source: Crippa, M., Guizzardi, D., Muntean, M., Schaaf, E., Solazzo, E., Monforti-Ferrario, F., Olivier, J.G.J., Vignati, E., Fossil CO2 emissions of all world countries - 2020 Report, EUR 30358 EN, Publications Office of the European Union, Luxembourg, 2020, ISBN 978-92-76-21515-8, doi:10.2760/143674, JRC121460. Material available under Public License, as modified by Morgan Stanley Investment Management. All content © European Union, 2020
Raising carbon prices and taxes is the most common and obvious policy tool, given higher carbon prices will encourage both companies and consumers to switch to low-carbon alternatives faster. There are over 50 different country-level carbon pricing schemes in operation, however these cover only 20% of global emissions, and the consensus is that prices have not been high enough. The EU Emissions Trading Scheme (ETS) is the most established scheme, essentially operating on a “cap and trade” principle whereby dirtier companies buy credits in the market from cleaner companies to meet the cap on emissions. It is currently being expanded with more sectors and activities bring brought into scope. Several other countries are also considering carbon price schemes.
Carbon border tariffs or “green border” taxes level the playing field for domestic producers of globally traded commodities such as steel, aluminium and cement. In these cases, a domestic carbon tax can lead to “carbon leakage” if buyers avoid paying the tax by importing commodities more cheaply from countries with no carbon taxes. The EU Carbon Border Adjustment Mechanism (CBAM), the first of its kind, will be phased in from 2023 to 2026.
Coal phaseout is critical to limiting climate change, given coal is the most carbon intensive fossil fuel and coal-fired power generation is the largest single source of all global CO2 emissions. However, this is easier for richer countries with ageing coal plants, growing renewables generation and relatively flat electricity demand. Although most EU countries have already mandated the phaseout of coal power generation, large coal consumers, e.g. India, China and Indonesia, while trying to contain coal, are still building coal plants to meet growing energy demand.
Reducing fuel subsidies could be impactful. Global fuel subsidies were an estimated $180 billion in 20202, including consumer fuel subsidies in emerging markets. Many governments are reluctant to cut subsidies given their political sensitivity. However, if this changes, and they come up with a way to reduce subsidies or decouple them from fossil fuel use, this would have roughly the same effect as introducing a carbon tax system.
Bans on Internal Combustion Engine (ICE) vehicles and electric vehicle (EV) targets are increasingly popular among green minded governments, and have already been announced in several countries – Display 3. In July 2021, the EU proposed a 100% reduction in new fleet emissions by 2035, effectively a comprehensive ban on ICE vehicles. This is a strong incentive for car companies to shift their sales rapidly to EVs. Some of the largest car markets also have EV targets for car manufacturers, e.g. the EU has progressive targets, and China has a manufacturer quota system whereby EVs must have at least a 25% share in light vehicle sales by 2025.
Green dividends are a mechanism to make carbon taxes more palatable by redistributing them to every voter as a “green dividend”. Consumers who switch to greener alternatives – for example, green electricity tariffs or buying electric vehicles (EVs) – become financial beneficiaries if the dividend they receive is greater than the carbon tax they pay. Such a scheme has been operating successfully in British Columbia for a number of years now.
Source: IEA (2021), Global EV Outlook 2021. All rights reserved; as modified by Morgan Stanley Investment Management.
Green infrastructure stimulus provides government support for the massive increase in infrastructure investment that decarbonisation requires. Obvious targets include electricity grids, energy storage, EV charging points, rail networks and energy-efficient buildings. The EU Green Deal has pledged €1 trillion to help reach net zero by 2050, but estimates are the total climate and energy investment gap is €2.6trn over the next ten years, suggesting more investment will need to be generated.
THE INVESTMENT IMPLICATIONS
Though the exact implications for companies and investors may be hard to quantify, it is clear that carbon is rapidly becoming a key consideration in company analysis.
Carbon pricing should reduce long-term demand in carbon-heavy industries such as coal and oil. Tougher carbon policies are also likely to upset the relative competitive landscape within some carbon-heavy sectors, as companies who have invested into cleaner technologies are likely to take market share at the expense of those who have not (e.g. in auto manufacturing).
Furthermore, companies offering decarbonisation solutions and low-carbon alternatives in any sector may benefit from accelerating policy support at the expense of carbon laggards. And, as consumers become more aware of the impact of climate change, carbon will likely become a key driver of individuals’ purchase decisions, meaning consumer brands with superior carbon profiles would be relative winners.
Bottom Line: Reducing Carbon Uncertainty
One way to reduce “carbon uncertainty” in a portfolio is to focus on companies that are high-quality compounders. These companies are typically naturally carbon-light, benefit from pricing power and resilient demand, and face lower carbon disruption risks than most other companies. For instance, the estimated impact of a $100 tax per tonne of CO2e on the earnings before interest and taxes (EBIT) of companies held in our global portfolios is less than -1.5%, versus the MSCI World Index at up to -14% (for Scope 1 and 2 emissions) – Display 4. Therefore, we believe their compounding ability should be preserved even in an environment of rapidly tightening carbon policies.
Source: Morgan Stanley Investment Management, FactSet, Trucost. Data as at 30 September 2021 for Strategy Representative Accounts.
Policy making can and must play a crucial role in global decarbonisation. To be effective, it must be more coordinated and the price of carbon necessarily higher. We advocate a combination of both stick and carrot measures.
While indications are the individual will be no worse off from more robust regulation, for corporates, there will be winners and losers and asset owners must have a process in place to help mitigate climate change risk in their portfolios. A low carbon, high quality portfolio is one way to help position investors for what’s to come.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. 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 strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy’s assets were invested in a wider variety of companies. In general, equity 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- and mid-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. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. 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.