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Investors need to take transition risk seriously

Last week, Blackrock CEO Larry Fink wrote a letter to CEOs calling for them to “serve a social purpose”. A key phrase reads:

“Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”

He explicitly tied financial performance to meeting sustainability objectives:

“Your company’s strategy must articulate a path to achieve financial performance. To sustain that performance, however, you must also understand the societal impact of your business as well as the ways that broad, structural trends – from slow wage growth to rising automation to climate change – affect your potential for growth.”

When the man who oversees $6trn in assets says sustainability matters, the theme cannot really be regarded as a purely ethical activity.

I was in Zürich last week for the 2nd FINEXUS conference on Financial Networks and Sustainability, attended by leading practitioners, policy makers and academics. The purpose of the conference was to assess how sustainability criteria can be better integrated into the policies of central banks and development banks, the lending decisions of retail banks, and the portfolio decisions of asset managers.

If the forecasts for climate change are right, we are currently on course for irreversible environmental damage. We all know what this means: coastal flooding, water shortages, and lower crop yields; not to mention the effects on our oceans and for biodiversity. As the impacts of climate change will be concentrated in the Global South, we can expect huge intercontinental migrations that make the 2015 Syrian refugee crisis look like the tip of an iceberg.

The 2015 Paris Agreement commits countries to take action to limit the amount of global warming to 1.5C by 2100.

As Stanislas Dupre – member of the High Level Expert Group on the EU’s sustainable finance taskforce – explained at the event, the investment industry is funding a path that leads to warming of 4-6 degrees on the basis of its current choices, financing infrastructure that locks in emissions for decades to come.

Putting these two facts together means that investment managers who do not take sustainability seriously are likely to find themselves on the wrong side of transition risk in the coming decade. This is because commitments to the Paris Agreement make it highly likely that governments will regulate their economies to discourage and penalise carbon-intensive activities. It has almost nothing to do with the moral case for unilateral action and everything to do with the future tax, regulatory and legal changes made by governments which have committed to going green.

Asset managers who hold securities tied to carbon-intensive firms may therefore face significant losses. Huge amounts of capital need to be mobilised into green investments, and states committed to the Paris Agreement will take steps to facilitate this process. The ultimate risk that firms and investors face during the transition is being left holding stranded assets that have lost their value by either regulatory or technical changes.

There are other kinds of transition risk – such as the risk of a bubble in green assets – but the one that is immediately relevant for industry is the risk of stranded assets. This could plausibly arise in a number of ways:

  • An announcement on a global (or national/regional) price for carbon
  • New technological breakthroughs in the low-carbon sector
  • The achievement of a price parity between renewables and fossil fuels
  • Changes in legislation reflecting the legality of GHG emissions
  • The forced nationalisation of selected assets
  • An increase in pressure from shareholders, employees and activists to limit GHG
  • Commitments to reduce implicit subsidies of fossil fuels (which are very large)
  • An increase in accuracy in the monitoring and measurement of emissions for attribution to firms
  • An increase in social awareness of the risk of GHG emissions

Any of these factors could affect the long-term return from carbon assets in portfolios.

The conference also hosted panels that discussed the need for stress-testing for climate and transition risk. This would be an activity that would help asset managers, central banks and development banks understand the possible consequences of the renewable energy transition.

This is a new area of research that could inform the policy of central banks in the future, especially when it comes to QE. If it is understood that carbon assets present a threat to financial stability as the effects of climate change on the economy take hold, central banks could make the case to favour ‘green’ assets (such as green bonds and companies that have low carbon intensity) when engaging in asset purchases.

A future Basel IV agreement could see rules that impose stricter capital requirements on banks that lend significantly to carbon-intensive activities. These policies could therefore reduce the cost of capital and increase its availability for green companies.

Other policies could have a similar effect. Mafalda Duerte from the World Bank’s Climate Investment Funds explained how state development banks could further raise the NPV of green activity by issuing green bonds that pay for subsidies and ‘credit enhancements’ to green firms.

Further, tax benefits could be offered to issuers of and investors in green assets, again with the aim of lowering the cost of capital as well as increasing the depth and liquidity of green asset markets.

These policies and others create transition risk for firms and investors, and they need to be assessed and quantified.

There is no immediate threat to existing portfolios but the message from the conference was that the status-quo will be costly in one way or another, and quite soon. Companies that invest for the long-term need to consider the issue of sustainability. There are opportunities as well as risks, and there will be returns for being on top of both.


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