By Jean-Marc Champagne for WWF.
Following the marathon two-week climate negotiations in Paris by representatives from governments around the world, a bold new global agreement was struck which begins the challenging task of cutting global greenhouse gas emissions. The key elements of the Paris agreement – keeping the global temperature rise well below 2 °C and having a long-term goal of net zero emissions – will undoubtedly have positive impacts for our planet. They will also have major impacts on companies that are heavily reliant on fossil fuels such as coal, oil and gas. The institutional investor community now needs to seek understanding on how these impacts will affect financial markets.
The world’s markets did not initially react to the positive news out of Paris. However, it will be unwise for markets to continue to brush off the implications of the negotiations. There are a number of risks associated with climate change mitigation policies and two risks to discuss: risks to companies and risks to investors.
The companies most exposed to climate change-related policy risks are those which rely on fossil fuels – coal, oil and gas. The reality is that if the world is going to keep warming to below 2 °C, then 80 per cent of known fossil fuel reserves will need to stay in the ground. Many of those reserves currently reside as assets on the balance sheets of companies, but have yet to be discounted. When this discount is realized, these reserves could become “stranded” or assets that are worth much less or even zero due to unanticipated write-downs.
Broadly, companies that directly or indirectly rely on carbon, such as coal miners, mining equipment makers, oil rig manufacturers, cement producers, ship builders, steel producers and utilities will all see increased risk exposure and the income statements of these companies may well be negatively impacted due to the increasing cost of carbon and as governments ensure compliance to new policies.
Next, consider investors and their portfolios. Risks will mostly be related to the magnitude and timing of new policies. If new policies are expected, then most investors will have time to prepare for their impact, but if some are caught off guard then potential losses could ensue. For example, China is committed to introducing a full carbon market for the whole country by 2017. Major details, such as the size of their emissions cap and the derived carbon price, are not yet available; there is no carbon price certainty as of now. But what we do know is that a price is coming.
A recent Mercer study indicated that many boards and investment committees have little familiarity with climate-related risks, indicating that the investment sector is ill-prepared, which will leave many investors improperly positioned. This raises some questions: are portfolios heavily exposed to fossil fuels properly valued? What impact will poor positioning have on markets? How quickly can investors adapt? What options are there for hedging against uncertainty? Investors need to begin asking these questions now.
Some investors are acting diligently. For example, just a few weeks ago German insurer, Allianz made an announcement ahead of the Paris talks that it would cut investments in companies using coal and boost investments in companies using sustainable energy. In the wake of the Paris negotiations, we will probably see further hits to fossil fuel companies as similar decisions are made by other investors. Asset managers and financial institutions that seek to build their knowledge and awareness, and move first will be best-prepared to counter emerging risks. Managers that take a wait-and-see approach will see real dangers lurk in their portfolios as risks mount and become harder to mitigate.
As with the continuing need to address climate change itself, more action and urgency on risk is clearly necessary in the investment community and the initial step to solutions is to first realize the problems.
Jean-Marc Champagne is the Climate Finance Advisor of WWF-Hong Kong and advises institutional investors on the financial risks related to climate change.