Floods, the Shell verdict, EU climate plans: climate change is coming to you and is increasingly becoming a factor in investment decisions. How do you deal with it? Quantification is difficult, but that makes the opportunity for fundamental investors all the greater.
That is what Willem Schramade, founder of Sustainable Finance Factory, author of the book Sustainable Capitalism and columnist of Fondsnieuws, Investment Officer Luxembourg’s sister publication, wrote in this contribution. Schramade is one of Fondsnieuws knowledge experts, who will give a presentation at the 14th edition of the Fondsevent next Monday.
He has analysed the challenges of the climate transition on the basis of seven parameters.
1. Climate change is a much bigger problem than Covid-19.
Covid temporarily halted the economy. But climate change is an even bigger phenomenon: it causes severe damage over a long period of time, it can make countries unliveable and trigger migration flows, with all the disruption that implies. Mitigation (slowing down change) and adaptation (protection) are both necessary and require major investments. This offers opportunities and risks for many companies and countries.
2. Transitions are mainly a social challenge
Besides being a technical challenge, climate change is above all a societal challenge that brings with it a great deal of disruption - whether or not you tackle it. People have to change their behaviour and there are costs involved that are not automatically shared fairly. An example. When French President Macron announced a tax increase on petrol and diesel, it hit the lower middle class hard and the yellow jacket protests broke out. This could have been avoided if he had compensated them with lower income tax, for example. That is politics, you will say. What does this have to do with investment? Everything, because we are in an era of transition in which these kinds of choices are the order of the day. Technology, consumer behaviour and regulation are in flux.
3. The long term is fast approaching
These developments are happening faster than people think. See the demise of coal-fired power stations. See the Shell verdict. The car industry is a good example of the interplay between regulations, consumer behaviour and technology. The ever stricter emission requirements force manufacturers to make their cars ever cleaner. Some of their suppliers are leading the way with innovative energy- and emission-saving solutions. The rise of Tesla has accelerated that process: electric cars have proved attractive and the cost of batteries has fallen sharply. Petrol and diesel cars are likely to be banned by 2035 but may have been priced out of the market well before then.
4. Opportunities too
The emphasis is usually on the risks of transitions, but they also offer opportunities. One person’s problem is often solved by another person’s invention. New innovative parties emerge. Established parties struggle and try to adapt. Some go under, others reinvent themselves and become more successful than ever.
5. Non-linear & asymmetric
It is too simple to measure the exposure to climate transition risk purely by the CO2 emissions of a company. A company in a heavy polluting industry such as aluminium may actually benefit from a high CO2 price. This is because many effects are non-linear and asymmetric. Asymmetric in the sense that the same change does not affect everyone in the same way. And non-linear because small changes can have large effects, also in a different direction than one would think.
Take these fictitious mining companies, whose cost curves are shown now and after a CO2 tax. As expected, the CO2 tax leads to higher costs and presumably to lower demand - unless the CO2 tax makes this material more attractive, as is the case for aluminium versus steel, for example. At the same time, the higher costs increase the price and the profitability changes in various ways: those with the highest emissions lose out and those with the lowest emissions gain.
In short, there are also “dirty” companies that gain from a CO2 price - as long as they are relatively clean. Conversely, clean companies can also lose out if they are put at a competitive disadvantage.
6. Understand the mechanisms
Given the above, it is important to understand the second order effects. So not just “higher CO2 price=higher costs”, but also: by what mechanisms does change take place? How does it affect supply and demand? What about product substitution? How do cost curves shift and what does that mean for value chains? In other words: what does it do to competitive positions? Who wins and who loses?
7. Data: man + machine
There is rightly a lot of attention for data, but data also has limitations. They are often unreliable and incomplete. But above all: data does not know what is important. Data does not see context and has no intuition. In most applications, a human being is needed to make the final decision. Even in the still reasonably manageable game of chess, man+machine is better than machine-only or man-only. So don’t see data as an end point but as a means for decision making.
Conclusion
More and more asset managers are disclosing the CO2 footprint of their portfolios and offering products with the green label. This development is positive for the amount of information on sustainability and a step forward towards better pricing. But it is still only a small piece of the big puzzle. There is still no efficient market for investments that win in transitions. And that offers opportunities for the investor who does his homework.
Willem Schramade is the founder and owner of Sustainable Finance Factory. He is author of the book Sustainable Capitalism and connected as a researcher to Erasmus University.