Understanding Climate Risk at the Asset Level
The future financial and social consequences of climate change are becoming increasingly apparent to companies, investors and policy makers. Strong action to reduce emissions and limit climate change may avoid the worst physical impacts of climate change but presents significant market, technology and regulatory transition risks for market participants. Conversely, failure to adequately reduce greenhouse gas emissions may limit transition risks but will result in increasing climate change and associated physical risks.
This paper explores the interplay between regulatory transitional risks and physical risks under alternative climate change scenarios, and how this may impact the performance of companies across sectors and geographies.
What is carbon pricing? Carbon pricing is an increasingly popular mechanism that harnesses market forces to address climate change by creating financial incentives for companies and countries to lower their emissions — either by switching to more efficient processes or cleaner fuels. Carbon pricing can take the form of a carbon tax or fee, or a cap-and-trade system that depends on government allotments or permits. As awareness and support increases around these new instruments, analyses show that carbon pricing could lead to significant costs for companies.Read More About Carbon Pricing
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- Since the release of the Intergovernmental Panel on Climate Change report in October 2018, there has been growing investor interest in 1.5οC scenario-aligned portfolios.
- In May 2018, the EU announced its action plan for sustainable finance, which included proposals to create two new carbon transition benchmarks: the EU Climate Transition (CTB) and Paris-aligned Benchmarks (PAB). The EU appointed a technical expert group (TEG) to report on the minimum standards for new benchmarks.
- On Sept. 30, 2019, the TEG released its final report on benchmarks and benchmark ESG disclosures. The report provides information regarding the preparation of the delegated acts by the European Commission, which will be published in draft form before the end of the year. What is the likely effect of the TEG’s proposals on indices?
ESG & Infrastructure
Global infrastructure spending has remained resilient in an environment of financial instability, underpinned mainly by interest from private sector investors. Private investors seeking long-term, stable returns are keen to fund infrastructure projects ranging from energy, to transport, to water infrastructure. These investors are providing support to governments facing a growing infrastructure funding gap. Yet, the sector is now awakening to the threats and opportunities that sustainability brings to realizing this long-term source of finance.
Long-term climate risks are unlikely to leave any sector untouched as governments worldwide seek to maintain warming below 1.5 degrees Celsius under the 2015 Paris Agreement. This may force infrastructure projects to address energy use concerns, particularly as urban infrastructure consumes approximately two-thirds of global energy.
- S&P Global Ratings has considered how pursuing a circular economy strategy could be compatible with the low-carbon transition and may also lead to significant benefits for infrastructure developers and investors. This may in turn encourage infrastructure projects to design for the future (including decommissioning considerations), adopt low-carbon materials, and achieve flexible designs to withstand the physical risks of climate change.
- We recognize the merits of the circular economy as businesses seek to align their sustainability strategies with wider social goals articulated by the United Nations Sustainable Development Goals (SDGs). In our view, sustainable infrastructure and circular economy initiatives could directly support the private sector's pursuit towards the SDGs.
- In our view, circular engagement in infrastructure is already occurring, with reported early signs of success. We believe circular engagement in infrastructure is continuously proving itself to be a credible strategy for lower capital and operational costs, with the added benefits of reducing environmental impact via resource-cutting. We expect to see further engagement for major projects.
Sink or Swim
Since S&P Global Ratings' most recent review on the matter in December 2018, the need for climate change adaptation projects hasn't abated. Indeed, more people are noticing. We believe the recent surge in damage from extreme climate events has significantly increased the attention of public authorities on the need for investment in this area.
According to the reinsurer Swiss Re, 2017-2018 insured losses from natural catastrophes, including climate related events, were $219 billion, the highest 24-month figure on record. In total, economic losses from natural catastrophes totaled $497 billion, with a further $40 billion during the first half of 2019. This implies uninsured losses from natural catastrophes of approximately $280 billion in 2017 and 2018 alone.
What is energy transition? Energy transition refers to the global energy sector’s shift from fossil-based systems of energy production and consumption — including oil, natural gas and coal — to renewable energy sources like wind and solar, as well as lithium-ion batteries. The increasing penetration of renewable energy into the energy supply mix, the onset of electrification and improvements in energy storage are all key drivers of the energy transition. Regulation and commitment to decarbonization has been mixed, but the energy transition will continue to increase in importance as investors prioritize environmental, social and governance (ESG) factors.Read More About Energy Transition
In recent years, governments have become increasingly aware of the perils of greenhouse gases and have aimed to penalize the source of pollution while looking to incentivize low-carbon technologies. In addition, investors are now considering an organization’s future financial position to discount potential write-downs of assets and the effect on revenues, costs, cash flows, and capital expenditure associated with adhering to policy changes that factor in climate risks.
The global market for environmental, social, and governance (ESG) exchange-traded funds (ETFs) alone is expected to expand from USD 25 billion to more than USD 400 billion within a decade. In Japan, sustainable investments grew fourfold between 2016 and 2018.
- In our recently published research paper, Integrating Low Carbon and Factor Strategies in Asia, we studied the performance of carbon-efficient and carbon-inefficient portfolios with sector-neutral and unconstrained approaches in seven Asian markets—Australia, China, Hong Kong, India, Japan, South Korea, and Taiwan.
- In the paper, we concluded that carbon-efficient portfolios resulted in a significant reduction to weighted average carbon intensity scores without sacrificing returns across Asian markets over long time horizons.
- We also observed that the carbon-efficient portfolios outperformed their respective carbon-inefficient portfolios across the seven markets on absolute and risk-adjusted bases over the entire studied period.
S&P Global Ratings believes that investment in sustainable land use is critical in mitigating climate change and bridging the gap between the need for increased agricultural production and a concern for the environment. However, unlike the transition to clean energy — which has to date been a focus of the $744 billion green bond market — sustainable land use is still a comparatively nascent green bond financing objective.
- Though land use, which includes categories such as forest land, cropland, grassland and wetlands, currently only has a small presence in the green bond market, demand for sustainably produced agricultural and forestry commodities is set to increase.
- As the green bond market continues to develop, we believe it is vital that the focus on transaction transparency and impact assessment — which distinguishes green bonds from conventional bonds — remains robust to encourage further market scaling.
- We used our Green Evaluation analytical approach, newly expanded to include land use projects, to gauge the potential environmental contribution of two green bonds issued by Fibria Celulose S.A. and Klabin S.A., targeting sustainable land use in Brazil. The results show that green bond issuers and purchasers could view land use projects as making a positive environmental contribution.
More than 190 nations will meet for the next two weeks in Madrid to put the finishing touch to implementing the Paris Agreement, and in so doing will bring a new generation carbon market to life.
COP25, the 25th Conference of the Parties to the UN Framework Convention on Climate Change, should complete the task of implementing the 2015 Paris treaty that sets the course of climate action for the period after 2020, when the Kyoto Protocol expires.
The meeting comes at a time when climate change has never been higher up the political agenda in many countries, boosted both by youth-led popular protests and by reports from UN agencies warning on the growing concentration of carbon dioxide in the atmosphere.
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Of the eight major economies that account for 67% of the world's greenhouse gas emissions, only Europe is gearing up to extend its Paris Agreement commitment after the European Parliament announced a climate emergency Thursday.
Incoming European Commission President Ursula von der Leyen is set to call for EU member states to cut carbon emissions by at least 50% below 1990 levels by 2030, up from a current 40% reduction target.
But ahead of the COP25 climate talks in Madrid starting Monday, climate scientists say around 75% of current national plans are inadequate to put the globe on a path that meets the Paris Agreement's aim of limiting global warming to 1.5 to 2 degrees Celsius.