Bursting the Carbon Bubble

By Rachel Weller

What are the risks and opportunities facing business and investors in a carbon-constrained future?

This was the question addressed by Carbon Tracker’s founder, Mark Campanale, energy strategist Kingsmill Bond and a range of senior businesses leaders from sectors spanning finance to consumer goods to real estate at a recent Sancroft event.

Here are the five take-aways from that discussion which also looked at the extent to which markets are effectively pricing in the fundamental changes to the way businesses and economies work as they deal with climate risk.

1. Financial Markets are still Mispricing Climate Risk. Today, the capital markets are out of step with the risk presented by climate change. In particular, oil and gas firms continue to forecast growing demand on the assumption that government policy won’t change that much from where it is now. Worryingly, many investors are also working on these business as usual assumptions.

However, it is clear that the shift away from fossil fuels will be driven by price, not just by policymakers and the science that tells us that we urgently need to decarbonise the economy. Electricity is already eating into oil and gas demand, with the electrification of core economic activities such as transport and  Carbon Tracker estimates that the economy is already reaching peak demand for fossil fuels and conventional cars.

2. When investors start to properly price in the risk of fossil fuels and the opportunities of renewables we will see a greater mobilisation of capital towards greener technologies. The evidence suggests that this shift is happening at an accelerating rate with mature technologies such as solar and wind becoming cheaper and experiencing much higher growth rates. To survive we need to embrace disruption

The transition away from fossil fuels will trigger a wave of disruption which will profoundly change society and the economy. From cars to carbon-intensive concrete, nearly every sector will be impacted.

History shows that in times of rapid disruption, change is driven by the disruptors, not incumbents. The resistance of incumbent industries, particularly the oil and gas and automotive industries is evidence of this today.

Investors, leaders and managers need to think more deeply about the risks and opportunities that the transition to a carbon-constrained future presents.

Those vulnerable, in particular those reliant on fossil fuels, need to disrupt their industries before others do.

Decarbonising our economy will require imaginative solution and businesses, public and private, large and small, need to think seriously about reinvention – not circumvention.

3. We need better data. For markets to better incorporate climate risks – and to function more efficiently – investors need access to better data. They also must ensure they are using data already at their disposal.

We have seen momentum build behind the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations which have a strong focus on the risks and opportunities related to the transition to a lower-carbon economy. Many investors support and are expecting companies to align their reporting with these recommendations.

While TCFD asks for stress-testing of business models and scenario-based analysis, the quality of this disclosure will be only as good as the scenarios and stress-tests that companies choose to use. This can vary widely, even within one industry. For instance, oil and gas companies such as ExxonMobil and Chevron still report against scenarios that assume that demand for oil and gas will remain the dominant paradigm. By contrast, the Spanish energy company Repsol has voluntarily written down $5bn of asset value after revising its long-term view of the value of its oil and gas assets in a decarbonised future.

This lack of a level playing field points to a failure among the major auditing firms to apply their professional judgement in a consistent, uniform manner, according to robust financial accounting principles – something which has to change if we are to get data we can trust.

4. Debt finance needs greater scrutiny. We heard that more needs to be done to constrain the international supply of capital for fossil fuels. With the increasing integration of ESG and scrutiny regarding the risk of stranded assets in the public and private equity markets, the pool of capital available to the sector is narrowing. However, there is less visibility of the extent of scrutiny which is applied to the debt markets.

More needs to be done to understand current practice – how aligned for example are investors’ equity and debt ESG practices – and to what extent are the challenges of short-termism being overcome?

5. Focus on ESG provides evidence of change. We ended our discussion on a note of cautious optimism, reflecting on the surge in interest in ESG investing, especially among the world’s largest institutional investors.

While there is appropriate scepticism about whether investors such as BlackRock can credibly claim to be the good guys – especially in light of the gap between their public statements and voting record on climate change – there is genuine interest in doing more rigorous analysis.

Most of the major institutional investors have invested in dedicated, in-house ESG teams, with investors such as BlackRock and Standard Life Aberdeen boasting upwards of 30 to 50 ESG specialists globally. These individuals are acting as a welcome countervailing force against business as usual.

We will continue to convene opportunities for businesses to learn and connect about the most pressing sustainability challenges and opportunities, even in the age of social distancing. To register your interest in forthcoming interactive webinars please email events@sancroft.com

Sancroft has a wealth of experiencing in advising clients on ESG integration and reporting. Please do get in contact with rachel.weller@sancroft.com to talk about this further.