COP26 is right around the corner. The scientific consensus has become increasingly clear: in order to avoid the worst impacts of climate change, society must act urgently to decarbonize the global economy and to transition the energy and transportation sectors from fossil fuels to clean energy.
At FFI, we believe that this transition will happen, regardless of policy action because technology has, and will, continue to make the economics of green preferable to the economics of brown. But science tells us that it is not the inevitability of the transition that matters. It is the speed of the transition that is critical for reaching net zero by 2050, and for cutting emissions roughly in half by 2030. As such, a coordinated set of global policies that support decarbonization can certainly accelerate the transition that until now has been driven mostly by technology.
Thus far, countries have been slow to act. International agreements of the last three decades, such as the UN Framework Convention on Climate Change of 1992, the Kyoto Protocol of 1997, the Copenhagen accord of 2009, and the Paris Climate Agreement of 2015, have arguably done little overall, and have only begun to scratch the surface of what is required to assure a net-zero carbon environment by 2050. Moreover, many of these agreements have had signatories exit over the years. It may be that in order to achieve further gains, nations will be forced to rely on governmental policy and regulation to incentivize and promote these newer transition strategies, with regulators playing a central role in promoting businesses to focus on environmental issues through policy and spending priorities.
A few days ago, the International Energy Agency, long thought to be a mouthpiece for the fossil-fuel industry, released their annual World Energy Outlook for 2021. The outlook stated unequivocally that the world must increase its adoption of clean energy to reach net-zero objectives. Fatih Birol, the IEA Executive Director, said:
“The world’s hugely encouraging clean energy momentum is running up against the stubborn incumbency of fossil fuels in our energy systems….. Governments need to resolve this at COP26 by giving a clear and unmistakable [sic.] signal that they are committed to rapidly scaling up the clean and resilient technologies of the future.”
The transition to clean energy has been hampered in part because of a lack of an explicit cost of emitting carbon, which has provided little financial incentive for companies to decarbonize. Furthermore, international policy is hampered by countries relying on others to act, which undermines the ability of individual nations to implement climate policies in their home countries. Going forward, climate policy must address these weaknesses. Necessary to any energy transition strategy is developing and enforcing universal carbon pricing, governmental support for new low-carbon technologies, and developed structure of international climate agreements.
So what should investors expect from COP26?
Many are framing COP26 as our “last chance” to develop policies that will put the world on course to limit warming to 1.5 degrees Celsius above pre-industrial levels. While referring to COP26 as a “last chance” may be extreme, nevertheless, we believe that the outcome of COP26 will likely set or stall the direction of national decarbonization policy implementations.
It is clear to us that to speed up the transition, global policy actions (through Nationally Determined Contributions (NDCs) must be ramped up. Science tells us that we need to achieve a 50% reduction in emissions by 2030 (compared to 2020). Getting to collective NDCs that align with net zero, and to the monetary commitments from developed nations to developing nations, will be politically challenging. Nevertheless, we expect that the pressure for nations to act, driven in part by the visible physical impacts of climate change (wildfires, floods, droughts, and storms) will force countries make their NDCs more ambitious.
Once updated commitments are made, the key question for investors to ask will be “how will those countries meet decarbonization goals?”. That’s where things get tricky. The two most talked-about mechanisms to reduce GHG emissions are carbon pricing and command-and-control regulations. Climate-aligned investors for the most part seek clarity on policy. While COP26 will not, for example, produce a global mechanism to price carbon, there are other finance-related elements in play that might move us in that direction. One topic that will be discussed is corporate reporting frameworks and disclosure. Disclosures are important because investors need clarity on each company’s exposure to the energy transition. In order for a price on carbon to be useful, companies must disclose their Scope 1, 2, and 3 emissions, and that information needs to be reliable and comparable. We would expect that one outcome of COP26 would be an explicit endorsement of the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD).
There is currently much discussion among financial regulators, including the SEC, regarding climate-risk disclosures. There are several groups including SASB, PCAF and others that are crafting guidance on what such measurement and disclosure requirements should contain. This disclosure will ultimately do two things: 1) provide clarity to investors, allowing for a more informed assessment of the readiness to transition; and 2) raise awareness of the sheer magnitude of the systemic financial risks, if in fact we don’t dramatically accelerate the process of decarbonization.
We do expect that outcomes from COP26 will have long-term implications regarding the speed of the energy transition, but we do not expect that those outcomes will immediately have an impact on markets or security prices. For that, investors need clarity on national policies. Climate-aligned investors and advocacy groups are asking central banks of developed nations to set stricter capital requirements for carbon-intensive loans and requiring banks to improve climate-related disclosures. In the US, for example, the infrastructure bill and the $3.5T reconciliation bill contain massive amounts of potential spending on the necessary infrastructure (think transmission cables) to incorporate renewables into the grid. Policy clarity is just as important to markets as the policies themselves.
In summary, we are hopeful about the outcomes of COP26, in that we will see some momentum in the form of more ambitious commitments and the funding for developing countries. Society’s ability to avoid the worst impacts of climate change rests on the interplay between science, policy-making, and business. The science is clear, and the investor community is stepping up in the form of net-zero portfolio commitments. What net zero exactly means is still evolving, but it is evident that two main elements of a net-zero investment strategy are to decarbonize portfolios and invest in climate solutions. Early investors in the energy transition theme have participated based on technological advances that have made clean energy competitive with fossil fuels. We believe that national policies that align with science will be enacted, and that those policies will enable wide spread adoption of clean energy. Such policies will act to provide clarity for investors, possibly exponentially increasing the number of net-zero portfolio commitments and accelerate the necessary movement of capital toward climate solutions and away from climate polluters.