With the increasingly urgent need for climate action, governments globally are moving decisively to accelerate the transition to a low carbon economy, which will be necessary if we are to limit temperature increases to 1.5C or less above pre-industrialized levels and therefore mitigate some of the worst risks of global warming. With this significant global energy shift underway, there are some clear ways for investors to incorporate carbon transition investment implications into their portfolios.
There are two distinct potential low carbon transition models to bear in mind. It could be a more “sticks-based” transition, with governments mandating and enforcing sustainable behaviour and private businesses bearing the bulk of the cost of the transition. If governments shift the cost of limiting temperature increases onto the private sector, such as imposing carbon taxes or regulation, that could reduce 2030 GDP by around 1%.
On the other hand, it could be a more “carrots-based” transition, with governments incentivizing green behaviour through subsidies and other forms of fiscal stimulus. If governments decide to provide debt-financed green stimulus to build low carbon infrastructure or increase public expenditure on green R&D, there would be enough fiscal tailwinds to offset any medium-term costs of the transition. An expansionary transition such as this could increase the level of global GDP by 2030 by around 1%.
Of course, it will likely be some combination of these two approaches with a hybrid model in which some of the transition cost is borne by public-private partnerships. Whichever form the low carbon transition takes, what is certainly clear at the moment is that simply reducing the energy intensity of GDP (the “fewer fossils” approach) will not be enough to avoid significant increases in temperatures. It will be essential to also generate energy in less carbon-intensive ways (the “more green” approach).
Investors need to start looking now at the carbon transition readiness of their portfolios in order to capture investment opportunities as well as manage risks. Importantly, we see three dimensions of assessing carbon transition readiness in terms of portfolio exposure: geography, inflation/interest rate implications, and company-level impact.
First, there will be significant variations geographically in the low carbon transition. Countries with highly carbon-intensive domestic economies will find the transition more painful than those with less carbon intensity. Countries that are currently large net exporters of fossil fuels, or countries that are home to large energy companies, will also experience a more difficult transition.
In our view, Russia, India, South Africa, Australia and Canada will likely be the hardest hit. Among those, Australia and Canada have the fiscal headroom to raise debt to alleviate the short-term pain, while others may not. Conversely, the euro area, Sweden, Switzerland and Japan look much more transition-ready. They are less reliant on fossil fuels, have the willingness to embrace the transition to a low carbon economy, and are in many cases already leaders in green technologies.
A second dimension of assessing carbon transition readiness involves forecasting the equilibrium interest rate implications. In our view, if the private sector bore the bulk of the cost of the transition, this would result in a small drag on medium-term economic growth and a correspondingly modest reduction in equilibrium real interest rates. On the other hand, if governments launched substantial green stimulus, taking on the cost of transition, it would provide a tailwind to growth that would boost rates at the margin. In either scenario, we see only modest equilibrium rate moves of just around 10 basis points up or down.
Interestingly, central banks acting on climate change could prove to be another important determinant of future interest rates. The European Central Bank and Bank of England may reorient their quantitative easing (QE) programmes toward greener assets. This could include purchasing corporate debt issued by companies that are deemed more sustainable and/or buying designated green bonds, a fast-growing market currently estimated at around US$850 billion. While we would not expect green QE programs to affect the aggregate level of interest rates, they could introduce a wedge between the yields of green assets and their non-green counterparts.
A third carbon transition aspect would be to look at companies and how that factors into overall equity market long-term performance. This, of course, will vary significantly by sector. Sectors that stand to gain include renewable energy and green infrastructure. The sectors likely to be hit the hardest include energy, consumer cyclicals (especially autos), materials and some utilities. Companies in these sectors will suffer from demand destruction as the goods they sell become less sought-after and carbon costs are become ongoing burden.
That said, even for sectors squarely in focus for the carbon transition like oil companies, there will be meaningful dispersion between companies that are embracing a decarbonization strategy and those that are lagging. For example, markets were initially slow to price in differences in oil companies mobilizing transition strategies and those that were not, but that is changing quickly. This underscores the importance of security selection and taking an active approach.
By moving early in assessing carbon transition readiness in their portfolios, investors can avoid or mitigate climate policy risks as well as capture investment opportunities across asset classes and markets – before they are fully priced in.
Jennifer Wu is global head of sustainable investing at J.P. Morgan Asset Management