Climate strategy at scale – emerging risks and opportunities for 2020

Not only are natural disasters and catastrophic events becoming more frequent, risks are realising more rapidly than expected as we get closer to reaching climate tipping points. With less “white” ice in the arctic to reflect the sun’s rays back into space combined and higher levels of greenhouse gases, ice will continue to melt faster and the temperature will rise more rapidly.

Such a tipping point may be impossible to reverse. Rising sea levels and new weather patterns mean increasing unpredictable climate events will have major financial ramifications for every area including coastal cities, agriculture and the insurance industry.

With a current 3.5°C global warming trajectory, coupled with the ambition of the Paris Agreement to limit global warming to 1.5°C by reaching net zero emissions by 2050, a huge investment gap must be filled in the next 30 years with estimates of an extra $175 billion to $290 billion needed every year to meet the climate neutral goal. Private capital will need to be mobilised.

Nearly half of all carbon emissions are from industry and agriculture and are thus embedded in goods and other products. This makes fossil fuels very challenging to replace. At 14%, transport accounts for a relatively small proportion of carbon emissions, while electricity generation and home heating make up around a quarter each.

Over 80% of the world’s energy needs are provided by coal, oil and gas. And yet, as an example, the share price of German energy provider Eon fell by three quarters from a peak in 2007, with its income from fossil fuels down by more than a third since 2008.

While factions in the private sector are working to decarbonise the economy, there is also a proliferation of regulatory-level risks in the transition to a low-carbon economy. In Europe, new forms of regulation include climate-related disclosure such as the Taskforce on Climate-related Financial Disclosure, the EU Action Plan – the Taxonomy – alongside numerous global platforms seeking to establish common approaches such as the Network for Greening the Financial System, the Principles of Responsible Investment, Principles for Sustainable Banking, Climate Resilience Principles and the Net-Zero Asset Owner Alliance.

“The big money is not investing yet. The pension funds and the institutional investors are saying it’s better to do nothing than do something wrong,” noted Markus Bodenmeier, chief financial officer of AQAL AG.

For capital markets to tackle climate change, there is an urgent need to advance from disclosure to integrating climate change in strategies, establish common approaches and harmonisation. There is also a need to implement forward-looking scenario analysis and targets, a reflection of results in strategy, incentives and investment decisions under a short-to-medium timeframe.

Investors require steps towards more granular, consistent over time reliable data that is transparent. Disclosure on carbon footprint is improving but at a slow pace and data gaps still exist. Qualitative information remains important despite the necessity of artificial intelligence to trawl through the vast amount of quantitative data.

“We are now working with pension funds and insurance companies, and are establishing a similar system to that used by refrigerators of ‘ABC’ in terms of green and red energy labels. This should be the same for investment, so it must be clear that if you are investing on a red label, you are a bad guy.

“Nobody understands the measurements as they are different,” Bodenmeier added.

The EU takes the lead in establishing common approaches

From a regulatory perspective, the EU is currently setting the benchmark for creating a conducive investment for climate strategy at scale, with China set to implement its own framework next year.

The EU Action Plan consists of 10 actions aimed to push the finance sector to incorporate Environmental Social and Governance (ESG) factors into its decision making processes. Here are some of the action plans:

Action 1: Implement The Taxonomy, an EU classification system for environmentally sustainable economic activities.

Action 4: Propose that investment advisors will be obliged to ask their retail clients whether they have any preference for ESG aspects when they approach investment advisors. Draft proposals were published in January 2019 and are scheduled to be adopted before year-end.

Action 5: Involves developing climate benchmarks and ESG disclosures for benchmarks.

Action 6: Explores how credit rating agencies can explicitly integrate sustainability into their ratings and market research to create a much needed ecosystem for sustainable finance.

Action 7: Enhance transparency to end-investors on how financial market participants consider sustainability.  

Action 8: Explore the possibility of incorporating sustainability into prudential requirements for banks and insurance companies.

Action 9: The Non-Financial Reporting Directive obliges large listed companies to disclose not only how they are facing the risks of ESG, climate change, and environmental degradation but also how they are contributing to or affecting the climate change and the environment.

“Voluntary standards won’t work. We need regulation. We are looking both at 2050-compliant investments to ensure confidence and certainty for genuine long-term investments that will address climate change. We are also looking at a whole range of transition investments that will work now,” explained Sean Kidney, chief executive officer of the Climate Bonds Initiative and member of the Technical Expert Group, which made the recommendations for the EU Taxonomy.

The EU Taxonomy – The starting Point

The EU Taxonomy was created to provide the rules for disclosure, in order for every major investor in Europe to disclose its carbon risk and also its sustainable investments on a level-playing field. It covers 67 sectors and is a part of a multi-policy plan. As a form of “comply or explain” regulatory proposal, the Taxonomy will require any issuer of financial products that claims to make a contribution to environmental sustainability to make a disclosure on how the investment activities make that contribution.

“Natural gas is not included. It doesn’t fit the Paris Agreement anymore. So these vast investments that we are making around the world in gas, thinking that they are transition investments – are not. On the other hand, manufacturing investments in steel, aluminium or cement that lead to reductions in Co2 are included in the taxonomy,” revealed Kidney.

Although it is not an investment requirement, all investment funds, regardless of the stated purpose will need to make an ESG-based risk disclosure and a statement of how they affect ESG outcomes in accordance with the EU Action Plan.

“Rating agencies don’t get it. Credit ratings are historical and only look five years forward so it’s not very useful for a long-term horizon. What we are trying to say from an environmental perspective is that this is your investment grade universe; within that, start looking at the credit universe,” said Kidney.

“The first thing you need to know if you are a committed family office is: is it Paris Agreement -Consistent[? Which is currently a mess. The new taxonomy will make that simpler for everyone. It supports within that framework pioneers and the bigger masses, or the thundering herds with regulation, to drive the herds in a certain direction,” further added Kidney.

The International Platform on Sustainable Finance was launched in 2019 with China and India as members to deepen international coordination on approaches for mobilising private investors to identify and seize environmentally sustainable standards globally through harmonisation of taxonomies, standards and disclosure.

With no national standard on ESG disclosure yet in China, the self-reported data is relatively poor in quality and lacks transparency, although the two local stock markets have compiled guidelines for voluntary ESG disclosures in 2018. Chinese financial regulators are currently working on a framework for mandatory ESG disclosure requiring all domestically-listed companies to release ESG reports based on new requirements beginning in 2020.

Moving from data collection and disclosure to action

There is an increasing number of low-carbon mutual funds and exchange-traded funds for climate-conscious investors to choose from, while demand for green bonds is outstripping supply as financial institutions develop their capability to issue green bonds with the right supporting infrastructure in place to manage and monitor these assets.

As of November 2019, total green bond issuance stood at $223 billion with total green bond issuance from China reaching $42.8 billion for the year 2018, the second highest in the world and representing a 12% increase year-on-year.

The three largest corporate bonds issued to date in 2019 have been a $2.69 billion by Noor Energy 1, a special purpose vehicle project set up by ACWA Power, a Saudi Arabian power generation and water desalination facility developer and owner. ACWA Power has assets primarily across the Middle East and North Africa regions, and is in collaboration with the Silk Road Fund (China) and the Dubai Electricity and Water Authority – a $1.7 billion bond from Eon –  and Bank of Jiangsu for $1.49 billion issuance. The largest sovereign green bond issued in 2019 is from the Netherlands, which delivered a $6.7 billion issuance, according to Climate Bonds Initiative.

China is making vast strides for a green economy, with five provinces launching green finance pilot zones in 2017. Local governments have established green development funds and ESG indexes are gaining traction on stock exchanges in mainland China and Hong Kong. 

In September 2019, the Chinese Ministry of Ecology and Environment released a trial Plan for a National Emissions Trading Scheme (ETS) which will allocate emission allowances starting with the power sector. With two allocation schemes, with different benchmarks, the allowances will be calculated and allocated to entities using the same baselines.

According to The International Carbon Action Partnership, entities will receive allowances at 70% of their 2018 output multiplied by the corresponding benchmark factor for the first phase. Allocation will be adjusted later reflecting the actual generation in 2019. The national ETS is expected to cover some 1,700 companies accounting for more than three billion tons of carbon dioxide equivalent (tCO2e) per year in its initial phase and then gradually expand to other key emitting sectors, including petrochemical, chemical, building materials, steel, nonferrous metals, paper and domestic aviation.

The implementation of the ETS and a rising carbon price in China will mean significant risks for carbon-intensive companies, as well investment portfolios. The 2018 China Carbon Pricing Survey conducted by International Carbon Forum and the China Carbon Forum, reported that the price of carbon in China is expected to rise from its current average of RMB 38 (US$5.50) per ton.

The ETS will be an important regulatory instrument to bring about a transition to a low-carbon economy, which China has committed to meeting its target of peak carbon emissions by 2030. In 2017, China emitted about 10.5 billion tons of Co2 – roughly 30% of the world's total according to data from Global Carbon Budget.

Plato Yip, CEO of the Treelion Foundation and the vice chairman of Elion International Investment Limited said that Elion Investment has been able to sell quite a large number of carbon credits to institutions through business-to-business channels, although the frequency is low due a lack of standardisation.

“There are different systems: the EU, Chicago, and the London system. But if you can have a digitalised method such as a token, which can be easily recognised and set up by independent authorities, then we can use blockchain technology which is very transparent at the end of the pipeline process to encourage more people to recognise the value of these ecological assets.

“In terms of (business-to-consumer) B2C, individual investors will be able to understand that this token actually carries a value, which can even increase, and then we can aggregate the problem,” explained Yip.

The new ETS is taking shape while coal production in China is still increasing – albeit at its slowest rate since 2004, while the rest of the world’s combined coal production is decreasing.  According to a report by Global Energy Monitor, from January 2018 to June 2019, countries outside of China decreased their total net coal power capacity by 8.1 GW, while China increased its net coal fleet by 42.9 GW and added a net 150 GW over the last five years.

The report concludes that China’s proposal to continue increasing its coal power capacity through 2035 is not compatible with the steep and rapid reductions needed in coal power generation to limit the rise in global average temperature to well below 2°C. While on the other side of the Pacific, despite the US administration’s pull out of the Paris Agreement, coal consumed by the electric power sector is projected to fall below 500 million short tons in 2020 for the first time since 1978, according to the Energy Information Administration – a decline of 27% since 2016.