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S&P Global's featured article in honor of Climate Week 2020.
Published: September 1, 2020
The energy transition to a low carbon economy will be especially challenging since many industries and economies have become reliant upon cheap, expendable energy sources to power their growth.
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Our vision of the coming climate disaster is limited by political, practical, and professional horizons—which limit foresight to, at best, a decade. The tragedy of this limited horizon is that our planning cycles are out of sync with the systemic risks of global climate change.
When Mark Carney, the economist and former Governor of the Bank of England, evoked the metaphor of the horizon to describe the market’s relationship with long term threats like climate change in a 2015 speech at Lloyd’s of London, he focused on three risks for financial stability from climate change: Physical Risk, as threatened assets and liabilities; Liability Risk, as compensation sought from those perceived as responsible for climate change; and Transition Risk, as costs associated with transitioning towards a low-carbon economy. The apparent horizon is now five years further along than it was when Mr. Carney gave his speech. If nothing else, the event of irreversible climate change is five years closer and may now be visible within the apparent horizon.
Nonetheless, there is also evidence of businesses, investors, politicians, and technocratic authorities’ longer-term visions. The horizon appears clearer, if not closer, because we are developing the social and political will to address the challenges of climate change.
There are three potential reasons why climate risk may have entered the horizon of our planning cycles:
While climate change is increasingly visible within our planning horizon, this is not itself a reason for optimism. A shifting horizon on climate risk may reflect an acceptance of the inevitability of changes in global temperature in excess of the 2-degree Celsius target proposed under the Paris Accords, rather than a commitment to forestall that change.
Investors focused on the carbon intensity of financial assets are necessarily aware of and preparing for transition risks, whereas investors focused on physical asset risk related to climate change are necessarily aware of and preparing for the possibility of inaction. To be clear, responsible investors must take both physical and transition risks into account, but the weighting of these two approaches will indicate the relative market force of optimism versus pessimism on climate.
Looking at the methodologies of both the Climate Bonds Initiative and the EU Green Bond Standard, it is not clear how much green or climate bonds are focused on transition versus physical risk. A green bond focused on mitigation is inherently pessimistic regarding a transition to a low carbon economy—since it plans for the worst. The EU Green Bond Standards allow for climate change mitigation as one of their six environmental objectives. The Climate Bonds Initiative does allow for “flood, sea and drought defenses including pumping stations, levees, gates.” However, there is no current data on whether most green bonds focus on transition or mitigation.
Most market observers believe that the current pricing of rare earth metals is not reflective of the needs of an energy transition necessary to limit to a 2-degree temperature change. The World Bank estimates that production of neodymium, a key element for permanent magnets found in wind turbines and electric vehicles, will have to increase by 50% to meet demand from just wind turbine expansion, yet neodymium still trades well below its long-term average.
The structure of green bonds and the pricing of rare earth metals are just two snapshots of the apparent horizon. Neither are definitive. They simply provide different views on whether or not the horizon is representative of tragedy or opportunity.