Companies that can get ahead of impending climate-change initiatives and work with governments to achieve their goals may benefit from first-mover advantage.
This November sees the UK play host to COP26 – the 26th Conference of Parties – where global leaders from almost 200 nations will come together and discuss climate objectives and, more importantly, revisit the commitments made as part of the 2015 Paris Agreement. The parties are likely to agree that efforts will need to be meaningfully increased to ensure that achieving net zero by 2050 is within reach. In the coming years, investors can expect a raft of policy changes, with governments increasingly targeting public spending on infrastructure. Corporates are likely to face higher costs as a result of broader adoption of carbon pricing systems, but may find that capital markets reward them for focusing future investment spending on climate-related projects. Companies that can get ahead of the impending change and work with governments to achieve their goals may benefit from first-mover advantage. We discuss the technology and policy developments required to reach net zero in more detail in our paper, “Achieving net zero: The path to a carbon neutral world.”
More ambition required on the path to net zero
The main aims of the Paris Agreement were to keep global temperatures from warming above 1.5 degrees Celsius and effectively reach net zero greenhouse gas emissions by 2050. Countries were asked to submit their own emission reduction targets in the form of NDCs (Nationally Determined Contributions) and review them every five years. Importantly, COP26 is the first meeting of global leaders since the end of the first fiveyear period. We now know that the proposals set out in 2015 are not sufficient to meet the target of restricting global warming to 1.5 degrees.
Just over 110 parties – accounting for around half of global emissions – have submitted new NDCs, but the United Nations (UN) has judged that these proposals still fall well short of the degree of change required to meet the 1.5 degree target. The UN estimates that current national plans will lead global emissions in 2030 to be around 16% above 2010 levels. In order to be consistent with the 1.5 degree target, 2030 emissions need to be below 2010 levels by 45%. With progress wide of the mark, the current proposals and potential improvements are expected to form a significant part of discussions at COP26.
The US, UK and European Union are all among those to have submitted new plans to reach net zero by 2050. The US has pledged to cut net carbon emissions in half by 2030 (relative to emissions in 2005), while the EU plans to reduce its emissions by 55% by 2030, relative to 1990. The UK has one of the most ambitious plans, aiming to cut emissions by 68% by 2030 (relative to emissions in 1990), but is responsible for less than 1% of total global greenhouse gas emissions. In fact, these three developed nations make up just 25% of global carbon emissions, which only makes clearer the need for global coordination.
Herein lies the challenge at this conference. A significant number of countries have still not submitted an update of their emission reduction targets. COP26 can only be deemed a success if all countries – including those with the highest emissions – decide to increase ambitions when they update their targets for the next decade. China has not updated its NDC but has stated its intention to reach peak carbon emissions by 2030 and net zero by 2060 – a pledge that does not go far enough for a country that is responsible for the largest amount of global carbon emissions. Undoubtedly, China will argue that the onus should be placed on developed countries, which initiated the industrial revolution, have a longer history of emissions and have the financial means to cut down on them (Exhibit 1). With China’s attendance at COP26 still in doubt, the potential for climate disputes to catalyse geopolitical tensions is increasingly clear.
Exhibit 1: US and China CO2 emissions over time
Billion tonnes
The metrics used to measure emissions make a huge difference: on a per capita basis, the US has a greater level of emissions than China (Exhibit 2). It is also worth noting that around 14% of China’s carbon emissions are attributable to goods that are exported and consumed abroad, which underlines the major role that recipients of China’s exports have to play in helping China to reduce its emissions. Another key expectation from COP26 will be for developed countries to make good on their promise to deliver at least USD 100 billion in finance per year to support developing countries in their climate goals. OECD data suggests that around USD 80 billion was mobilised in 2018. Commitments to increase this support will perhaps encourage some of the important developing nations to step up their carbon-reduction initiatives.
Exhibit 2: Global CO2 emissions per capita
Tonnes, 2019
Source: Global Carbon Project, Our World in Data, United Nations, J.P. Morgan Asset Management. CO2 emissions are from the burning of fossil fuels for energy and cement production. Emission impact from land use change (such as deforestation) is not included. Data as of 30 September 2021.
Considerations for investors
Investors should be prepared for climate-related headlines in the coming weeks, as COP26 acts as a catalyst for governments and corporates to make new, more ambitious commitments. We expect this to impact financial markets in multiple ways.
Green bond issuance set to grow
Green infrastructure spending will be a major focus for governments that are under pressure to demonstrate their climate credentials to an increasingly green electorate. There are already several examples. The Biden administration’s USD 2.3 trillion American Jobs Plan includes multiple spending measures aimed at clean energy technology and the transition to electric vehicles. It is a similar story across the Atlantic, with the UK government’s Ten Point Plan for a Green Industrial Revolution aiming to generate 250,000 green jobs. In Europe, at least 30% of spending in the EU’s EUR 750 billion recovery fund must have climate-related benefits. Yet with more than USD 13 trillion of global investment in electricity systems alone estimated to be required by 2050 if net zero targets are to be reached, the scale of the challenge is clear.
A rise in green bond issuance will be the key means by which governments will fund new climate-focused spending. The European Investment Bank became the first issuer of green bonds – for which proceeds are earmarked for environmentally friendly outcomes – back in 2007, and both governments and corporates have flocked to the sustainable bond market since, with green, social and sustainable bond issuance growing from just USD 6 billion in 2012 to over USD 700 billion last year. The popularity of the market is unsurprising given that strong demand for this debt often leads to lower borrowing costs for the issuer – a dynamic known as the green premium, or “greenium” (Exhibit 3). Despite this benefit, the US government remains a notable absentee from the green bond market. While officials have so far been reluctant to discuss this idea publicly, the emergence of a “Green Treasury” appears increasingly inevitable.
Exhibit 3a: Global sustainable, social and green bond issuance
Source: Climate Bonds Initiative, J.P. Morgan Asset Management. Data as of 30 June 2021.
Exhibit 3b: Spread between green and traditional corporate bonds
Source: Barclays Research, J.P. Morgan Asset Management. Data shown is for a Barclays Research custom universe of green and non-green investment-grade credits, matched by issuer, currency, seniority and maturity. The universe consists of 105 pairs, 73 euro-denominated and 32 dollar-denominated, and 59 financials and 46 nonfinancials. Spread difference is measured using the option-adjusted spread. Data as of 17 September 2021.
Private capital encouraged to be part of the solution
An acceleration in government spending is one piece of the puzzle, but we also expect to see further measures aimed at incentivising private capital to be part of the solution. Strengthened regulation that pressures large investors to tilt portfolios towards climate-friendly strategies is one way to achieve this outcome. Another route is for governments to co-invest alongside the private sector in public-private partnership models. This type of structure can often be used to ensure that initiatives that would be too risky for the private sector to invest in alone can still access the financing they require.
Corporate announcements to demonstrate the leaders and laggards
In the face of increasing investor scrutiny, the corporate sector is unlikely to wait for regulation to force its hand on tackling climate change. The number of companies signing up to science-based target commitments had already surpassed last year’s record by June of this year, and November’s summit will intensify pressure on corporations that are not yet on board. Those that are able to align with government goals will benefit from government spending and be rewarded with access to easier finance through capital markets. Central banks are likely to incorporate green bonds or tilt their corporate asset purchases towards companies that are making investments consistent with net zero, meaning these companies will likely benefit from relatively lower borrowing costs. Additionally, investors may find comfort in owning the bonds of these firms, particularly in more stressful market environments, in the knowledge that the central bank is likely to be a willing buyer.
In industries such as energy, logistics, airlines and farming that are typically carbon intensive, there are also reasons to be optimistic. Those that adopt policies that help reach net zero will likely gain market share and be viewed as part of the solution, rather than the problem. Whatever the industry under consideration, investors may find opportunities by identifying companies that are better prepared for the transition.
Carbon pricing likely to impact corporate profits
Reaching agreement on a global carbon pricing system will be one of the most challenging issues of the summit. While some regions, such as Europe, have already made substantial progress, firms will remain incentivised to outsource production to other regions with lower carbon costs until a global solution is reached. Without a global solution, regions that decide to go it alone also risk imposing a competitive disadvantage on the profit margins of their domestic corporations. The risk of disagreements on carbon pricing spilling over into broader international relations is clear, with Europe perhaps needing to introduce a carbon border tax if other countries decide not to adopt a carbon pricing system. Without substantial progress, the path to net zero looks worryingly steep.
Views from our investment desks
J.P. Morgan Asset Management’s research analysts assess the impact of COP26 and climate policy on their respective sectors.
Energy
David Maccarrone, Equity Research Analyst, US Equity and International Equity groups
Parts of the energy sector began on the path to net zero several years ago by embracing the goals of the Paris Agreement. But what effectively amounts to an Atlantic divide exists among European and North American companies in the level of commitment to net zero. Many European international oil companies (IOCs) seek to transform themselves into international energy companies, both in goal-setting and in action. Some of the more aggressive agendas include depleting, divesting and avoiding hydrocarbon investments in an effort to dramatically reduce Scope 1, 2 and 3 emissions, while investing heavily in the energy transition across renewable electricity, carbon capture, storage and sequestration, and hydrogen. In the US, a generally more conservative approach persists, with companies seeking to reduce greenhouse gas (GHG) intensity but tending to avoid targeting absolute emissions reductions and the Scope 3 emissions that represent approximately 85% of an oil barrel’s GHG impact.
Operating across a variety of economies that are in different stages of economic development and endowed with different resources and climates, IOCs have an opportunity to tailor solutions on the path to net zero. Many are capitalising on this opportunity. But others recognise that fossil fuels will remain a substantial component of the energy mix in almost all scenarios looking to 2050. For the foreseeable future, natural depletion rates will exceed changes in demand, requiring continued investment to support fossil fuel consumption.
By focusing on the lowest cost, lowest GHG footprint development, many exploration and production companies believe they are acting in shareholders’ best interests by avoiding investment diversification into energy transition areas dependent on emerging policies, where the economic framework is not yet clear. Instead, lower rates of reinvestment and higher returns of capital to shareholders have become the norm. In the refining sector, an acceleration of retirements and of retrofitting legacy fossil fuel assets into renewable diesel or sustainable aviation fuel facilities is one example of transformation and decarbonisation. Midstream companies evaluate opportunities to utilise existing assets and invest in carbon capture, renewable natural gas (RNG) or low-carbon hydrogen. Natural gas and liquefied natural gas (LNG) operators focus on methane and GHG emission reductions and carbonneutral LNG cargoes.
With ESG-integrated investment processes likely to become the plurality of institutional capital over time, different strategies will resonate with different investors. Capital allocation to oil and gas and energy transition investments varies tremendously, and so will the rate of change with respect to the environmental footprint.
Infrastructure
Gilly Zimmer, Global Private Infrastructure Investments Group
The energy transition to net zero has been a focus for many years within private infrastructure, given the potential and actual direct impacts to opportunities and risks within the sector. The Covid-19 crisis has accelerated this focus, and consideration of carbon pricing schemes is another potential/ actual accelerant. Facilitating the energy transition will continue to provide a wide variety of investment opportunities in the space. We expect utilities to continue to spend on green infrastructure as they shift further away from traditional fossil fuels towards renewables. In light of the intermittency of renewable energy, this is likely to be complemented by less carbon-intensive and non-intermittent natural gas generation and, to some extent, battery technologies as costs decline. We also anticipate that there will be necessary complementary investment in electricity transmission and utility electric grids, because renewables are frequently located away from urban centres.
We believe stranded asset risk will remain in focus as the energy transition moves forwards (in part assisted by any potential carbon pricing scheme), with a particular lens on more carbon-intensive fossil fuels, though the timeframe is still unclear. Valuations are a further risk for investors. The recent increase in investor interest in green infrastructure has seen pricing of renewable energy assets rise globally, particularly in more mature OECD markets. However, the supply of such investments has not grown as quickly, given the length of new development cycles, which could impact forward-looking returns. Managing essential infrastructure assets in a sustainable way by reducing their carbon footprint and considering key stakeholder requirements is critical for risk adjusted returns and can only be implemented with strong governance at the board and management team levels.
Airlines
Aamina Kurji, Equity Research Analyst, International Equity group
Prior to the pandemic-related collapse in air traffic in 2020, demand in the airline industry was growing strongly, more than doubling in the 15 years to 2019. This was driven by factors including the prevalence of low-cost carriers, making flying much more affordable, as well as a shift in consumer preference from spending on things to spending on experiences. This increase in demand is clearly at odds with the goal of reducing carbon emissions.
Some countries have introduced new measures to try to reduce demand, with Austria and France, for example, moving to ban short-haul domestic flights where there are rail alternatives taking under three and under 2.5 hours, respectively. However, such measures barely dent the surface, with much more collaboration needed among countries on international flights if air travel is to be reduced. Such efforts can be perceived as infringing on the free movement of people, though, and the ease of international travel also facilitates labour movement and tourism – a significant source of income for many countries. Reaching agreement on international measures is therefore challenging. If we are truly to see a shift, there needs to be much heavier investment in public rail infrastructure to provide viable travel alternatives.
The cost for airlines to purchase carbon allowances under the EU’s emissions trading systems has increased, with prices more than doubling vs. pre-pandemic levels. Technically, this is a cost that airlines can pass on to consumers, but until now the pricing has not been prohibitive enough to change consumer behaviour. The measure also only hits EU traffic and not flights operating outside of Europe. This again highlights the need for more harmonisation at a global level, with cooperation among countries.
Airlines that have more flexibility around their hubs will be able to more easily adjust their flight networks such that any routes that are prohibited can be substituted with others. This plays to the strength of low-cost carriers rather than the legacy airlines. Given the increasing cost burden of all these measures, airlines that have historically demonstrated their ability to manage their cost base better will likely fare better in the future too.
Emerging market corporate bonds
Reuben Weislogel, Credit Research Analyst, Emerging Market Debt
It is difficult to draw general conclusions about the carbon reduction approaches taken by emerging market corporates given the breadth of underlying diversification present in the asset class (~800 issuers in 60 countries). Currently, we find no unified approaches by country, region or sector. However, one trend that has gained significant traction in 2021 (specifically in Latin America) is the issuance of sustainability-linked bonds (SLBs). SLBs are bonds where coupon rates are tied to key performance indicators such as water usage, carbon generation and board composition. Should an issuer miss a target, the coupon rate may rise in response. SLB issuance has occurred predominately in industrial sectors such as auto parts, cement, metals, logistics and pulp & paper, but has increasingly broadened out to include sectors such as financials, retail and real estate, largely because issuers have recognised investor demand for results-oriented bonds in the absence of international cooperation around carbon reduction goals. Historically, the primary option within the capital markets for engendering changes in corporate strategy was green bonds – a structure that generally lacks accountability and negative ramifications for non-compliance. SLBs are not perfect, as they commonly lack material ramification for target failure. However, they do provide a more tangible framework for measuring results and targeting carbon reductions. These features have helped the market become more comfortable with this structure over the last year.
Few emerging market corporates are currently directly discussing or setting out strategy on more complicated issues such as the coordinated development of public infrastructure, carbon pricing and carbon border adjustments. The dispersion of jurisdictions and lack of alignment across regions mean international cooperation is not top of mind. However, the direction of travel for overall corporate strategy, and specifically for the more industrial-oriented sectors, is definitely towards disclosing more information about carbon emissions, creating targets around reducing those emissions (timeframe and percentage reductions) and often aligning capital structures around these goals via SLBs. While we are still in the early stages of this transformation, and the decisions are more local than international, the pace has accelerated over the last year, with investors increasingly supportive of outcome-linked capital market solutions.
Conclusion
Investors should be braced for a wave of new climate ambitions stemming from November’s COP26 summit. With the conference serving to shine a spotlight on the enormous challenge presented by the need to reach net zero by 2050, both the public and private sectors will be keen to stress the extent of their ambitions, with potentially market-moving implications. For investors, there are risks and opportunities across sectors. Companies that prove they can be a part of the solution will likely benefit from a lower cost of financing in the years to come, as both governments and the private sector look to tilt their spending towards green initiatives. For businesses that are poorly prepared for the climate transition – regardless of sector – life will only get tougher.
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