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Achieving net zero: the investment challenges ahead
Policy changes on decarbonization will have a huge impact on cash flows and valuations
13 May 2021 | Kerry Craig and Marcella Chow

With nearly 60 countries representing more than half of the world’s greenhouse gas emissions having signed decarbonization commitments, promising to reach net zero in the next few decades, the real challenge will be actually achieving what is set out in the targets.

This implementation phase ahead will have significant implications for investors, creating return opportunities as well as potentially costly disruptions, underscoring the importance of getting a handle on what decarbonization means for portfolios.

Each country is on a different path closely related to its own stage of economic development. But we do know that major breakthroughs in climate technology to overcome the current hurdles will require the right policy mix by governments to foster these advancements, as well as companies that are focused on delivering on their own environmental goals.

This has already created rallies in certain sectors of equity and commodity markets and cries of bubbles. However, the long-run challenge of decarbonization will also generate lasting investment ideas.

Policy risk is of course the juggernaut, because of the outsized influence of regulatory changes on decarbonization, but policy change can also open the door to investment opportunities.

Governments can use both “carrots” and “sticks” when it comes to greener corporate actions, either by mandating climate change mitigation, or incentivizing it. Infrastructure spending, research and development (R&D), subsidies, and tax incentives (carrots), along with regulation and enforcement (sticks), all have roles to play.

The mix will probably look like some combination of the following: government-led public infrastructure investment in renewable energy to make transportation greener; R&D spending to improve existing technology and reduce economic barriers, like developing biofuels or researching direct air capture technology to remove carbon dioxide; subsidies, tax credits and other incentives such as loans and guarantees to accelerate change and reduce costs, like making it worthwhile for consumers to swap internal combustion vehicles for electric vehicles or upgrade appliances; thoughtful regulations like tougher fuel, energy and appliance standards that can push companies and consumers to reduce their carbon footprints, as well as more stringent codes for buildings and future construction, with respect to insulation, material usage, heating and cooling systems, and lighting.

Policy tools will need to be combined with carbon pricing strategies to maximize their effect. The price of carbon can be set through taxes or emissions trading schemes (ETS), both of which incentivize carbon producers to reduce their carbon intensity. Although many countries don’t have such schemes set up yet, this will without question be one of the most efficient and cost-effective means of reducing emissions.

Where does this leave the investment opportunities at a company and sector level? One thing is clear – following a decade of dominance for consumer-facing technology companies, those that can achieve climate-based technology solutions will be the biggest beneficiaries of new environmental initiatives.

The industries undergoing the greatest changes include autos, energy, infrastructure, transport, real estate and renewables.

Cars account for over a third of transportation-related emissions, which explains the intense focus on vehicle emission reductions and the adoption of electric vehicles, leading to one of the biggest transformations in the industry’s history, especially in China. Companies that end up on top will be those with dedicated EV platforms and higher levels of vertical integration of the battery electric vehicle (BEV) powertrain, including investments in the battery cell and its supply chain.

When it comes to renewables, these companies will likely continue to enjoy solid premiums given both their scarcity and their ESG credentials, but there are less expensive ways to access this theme, like renewable equipment producers and grid suppliers, or companies that provide the technology used in carbon capture, storage, production and transportation.

Another opportunity: some traditional energy and power generation companies are active in renewables investments or have aggressive plans to decarbonize and yet are still trading at low valuations. A good example is a coal and hydro power producer in Japan, which announced a plan to cut CO2 emissions by 40% by 2030 and to be carbon neutral by 2050. Another example are oil companies that are becoming energy companies, such as one oil refiner that will have over 30% of its profits coming from offshore wind by 2030. These are often the companies that are working alongside asset managers who are urging faster progress on decarbonization.

The transition to a net-zero-emissions world will have an enormous but uneven impact across economic sectors. Regardless of the industry or geography under consideration, a thorough understanding of how the wave of policy changes ahead will impact cash flows and valuations will be essential for investors to remain informed and to adjust portfolios accordingly.

Kerry Craig and Marcella Chow are global market strategists at J.P. Morgan Asset Management.