Reality check for investors on Paris Agreement readiness

Lord Nicholas Stern
Lord Nicholas Stern

There is a gap between what politicians have signed up to in Paris and what markets and fossil fuel companies are assuming, the London School of Economics and Political Science’s Nicholas Stern and Dimitri Zenghelis have warned.

They say the news “should alarm policymakers and central bankers”.

The warning comes in a submission to the Task Force on Climate-Related Financial Disclosures. Chaired by former New York City mayor Michael Bloomberg, the taskforce was set up in December 2015 by the Financial Stability Board at the behest of G20 Finance Ministers and Central Bank Governors to “develop voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurer and other stakeholders”.

Dimitri Zenghelis

Dimitri Zenghelis

Stern and Zenghelis point to a significant gap between the current stock market valuations of carbon-intensive companies and their estimated value should the commitments made in the Paris Agreement on climate change be acted upon.

They argue in The importance of looking forward to manage risks that companies should not only publish the “carbon exposure” of their past activities, but carry out “stress tests” for the risks associated with climate change in their future business, including those from new policies to reduce greenhouse gas emissions. Investors need to know this information and the strategies for addressing those risks, they say.

“It is becoming increasingly risky for companies to pin all business strategies on the assumption that extensive decarbonisation will not happen,” they argue. “Business models reliant on the assumption that governments were not serious in Paris are looking increasingly vulnerable.”

The overall risk is that unless the transition is orderly then financial markets may be unlikely to cope. History does not provide confidence.

The New York-based taskforce is currently focussing on the financial impact of climate change on reporting companies’ businesses, as the starting point for the development of recommendations for voluntary disclosures within mainstream financial reports.

It has identified the following risks and opportunities:

risks

 

Of these risks, the submission highlights not just the physical changes due to new climate and weather patterns but “non-physical risks” such as new policies and laws, technological advancements, changing consumer preferences and risks to a company’s reputation.

“Resilience requires the presence of forward-risk management and hedging strategies,” Stern and Zenghelis say. “In addition to answering the question, ‘What is your most likely scenario?’ investors will seek to ask ,’What will you do in alternative scenarios such as a net-zero emissions world?’ The answer to this puts market players in a better position to assess market capitalisation.”

For example, what if there is a breakthrough in battery storage technologies within the next 20 years? This could lead to the widespread use of electric vehicles and resolve problems with intermittent generation of renewable electricity.

One way that a tipping point emerges from one status quo to another is by falling technology costs as new technologies are developed and benefit from learning and experience, and as engineers learn how to cheaply install, connect and repair technology. The potential for this is higher for many new technologies than for long established incumbents. This has already happened with solar photovoltaic and onshore wind technologies.

Tipping is also influenced by the perceived payoff to action to decarbonise by any single player as a function of what others are expected to do. Once enough players shift – for example in markets such as China, the US and the EU – the rest will quickly follow. Technology and finance costs are expected to fall while markets are expected to grow.

This, say Stern and Zenghelis, is why such risks are often termed “transition risks” – where paths become self-reinforcing the more players tread them. If this type of change occurs, its pace could be rapid. So investors will rightly demand that firms have made appropriate contingency plans.

“Put another way, it is becoming increasingly risky for companies to pin all business strategies on the assumption that extensive decarbonisation will not happen, for example, on the basis of (mostly backward-looking) lack of political will.”

The submission concludes: “Climate risks and climate policies are likely to have a profound impact on firms in the global economy in the years to come. The commitments expressed by almost every country in the world in the recent Paris Agreement cannot be safely dismissed.”

The submission is published by ESRC Centre for Climate Change Economics and Policy and the Grantham Research Institute on Climate Change and the Environment.

The taskforce is due to publish its final report by the end of the year.

David Thorpe is the author of:

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