In brief

• Policymakers will be the driving force behind efforts to mitigate climate change given the urgency and scale of the challenge.
• The pillars of the policy mix will be investment in infrastructure and R&D, creating incentives via tax credits and subsidies and mandating change through regulation.
• In the final section, our investment analysts share their views on how the transition to net zero will impact some of the industries facing the greatest changes.

Governments can use both “carrots” and “sticks” when it comes to climate change, by mandating climate change mitigation or incentivizing it. Infrastructure spending, research and development (R&D), subsidies and tax incentives (carrots), along with regulation and enforcement (sticks), all have roles to play. Fossil fuels are cheap and widespread today in part because of incentives in past decades to increase scale and reduce costs.¹

Below are the four key components of policy that will facilitate a carbon-neutral future.

Infrastructure investment: Public infrastructure investment means committing the funding and taking on more risk than individual companies can, while quickly building scale and consistency. Government investment serves as the foundation on which the private sector can then innovate, compete and ultimately reduce costs. Formal public-private partnerships can deliver economic growth and advance the energy transition, while also generating opportunities for private investors. Real assets stand to be a notable beneficiary.

Infrastructure that supports a renewable energy supply is a high priority. Solar and wind investment and capacity continue to grow, and further investment could help meet some of the technological challenges around storage and efficiency. In the meantime, investment in national grids could connect the many isolated suppliers and expand the reach of renewables. Increasing investment to improve nuclear power, a reasonably reliable and efficient form of sustainable energy, will also help to diversify from solar and wind, which are currently less reliable and efficient.

Policymakers have a number of options to make transportation greener; for example, accelerating individual electric vehicle adoption by expanding the charging network. Local governments can electrify their fleets of fire trucks, police cars, garbage trucks and school buses.

McKinsey estimates that USD 3.7 trillion per year, or about 4.1% of GDP, is required to upgrade and maintain the world’s infrastructure, and an additional USD 1trillion is required to meet sustainable development goals.² Upgrades should be designed to withstand climate change impacts, including an increased frequency/severity of extreme weather events (such as tropical cyclones, droughts, floods and wildfires). Now is an opportune time for infrastructure spending: interest rates are low, the need is high and recovering economies can benefit from the powerful multiplier effect on economic growth and jobs (see Exhibit 1).

EXHIBIT 1:

Increase R&D: R&D spending to improve existing technology will be key to reducing economic barriers. For example, we do not yet have carbon-neutral materials to use in steel, cement or fertilizer. Electrifying airplanes or long-haul trucks is unlikely, but they could use more advanced biofuels yet to be developed. We need more research on direct air capture technology that removes carbon dioxide (CO2) already in the air. These initiatives require longer timelines and have a high probability of failure. Yet the scientific community achieved an extraordinary feat developing COVID-19 vaccines in less than a year, with the help of ample funding, global coordination and a partnership between the public sector, private industry and the academic community. This is something to replicate in solving some of the toughest problems in reaching net zero. 

Incentives: Subsidies, tax credits and other incentives, such as loans and guarantees, can help accelerate change and reduce costs. Investment in solar and wind, for example, has been greatly aided by subsidies. Incentive programs that engage consumers, such as swapping internal combustion vehicles for electric vehicles (EVs) or upgrading appliances, can speed up transitions already underway. They can also help smooth out more challenging transitions over time. For example, subsidies or tax breaks to create electric vehicle manufacturing plants in areas where a local economy has depended on coal mining could provide new jobs and growth that eventually surpass the economic importance of coal.

Regulation: Thoughtful regulation can also help reduce economic barriers and catalyze real change. Tougher fuel, energy and appliance standards can push companies and consumers to reduce their carbon footprints, as can more stringent codes for buildings and future construction, with respect to insulation, material usage, heating and cooling systems and lighting. If regulatory items are phased in over the course of a decade, companies and consumers will have ample time to comply with new standards. In some cases, regulation can actually be helpful in creating demand. For example, concerns about nuclear safety and waste have been a significant barrier to increasing nuclear generation capacity in recent years. R&D spending and infrastructure investments can help improve nuclear reactors, but regulation may be key to overcoming safety and environmental concerns.

To maximize the effectiveness of these policy tools, they should be combined with a carbon pricing strategy. The price of carbon can be set through taxes or emissions trading schemes (ETS), both of which incentivize carbon producers to reduce their carbon intensity. Europe has been a pioneer in this field, launching its ETS platform in 2005. Although many countries still do not have such schemes at a national or even local level, carbon pricing is regarded as one of the most efficient and cost-effective means of reducing emissions. While carbon prices have been rising in many ETS alongside their emissions coverage, the average price still falls far short of the levels seen as necessary to limit global warming (see Exhibit 2). A sudden adjustment to much higher carbon prices would have a dramatic effect on inflation, but we see a gradual rise as more likely over time.

Carbon prices are rising but are still well below levels estimated to limit emissions
EXHIBIT 2: CARBON PRICING

Source: (Left) World Bank, J.P. Morgan Asset Management. ETS is emissions trading system. (Right) International Carbon Action Partnership, J.P. Morgan Asset Management. China ETS price is based on the average of Beijing, Chongqing, Guangdong, Hubei, Shanghai, Shenzhen and Tianjin ETS prices. CO2 equivalent tonnes standardise emissions to allow for comparison between gases. One equivalent tonne has the same warming effect as one tonne of CO2 over 100 years. Past performance is not a reliable indicator of current and future results. Forecasts, projections and other forward looking statements are based upon current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecast, projections or other forward statements, actual events, results or performance may differ materially from those reflected or contemplated.
Data as of 31 March 2021.

Investment implications

The transition to a net-zero emissions world will have an enormous but uneven impact across economic sectors. In this section, we ask a group of J.P. Morgan Asset Management’s research analysts for their views on how the transition to net zero will impact some of the industries that will undergo the greatest changes—autos, energy, infrastructure, transport, real estate and renewables.

AUTOS: MARK MAO, GREATER CHINA RESEARCH ANALYST

Cars and light commercial vehicles account for over a third of transportation-related emissions, which explains the intense focus on vehicle emissions reductions and the adoption of EVs, leading to one of the biggest transformations in the industry’s history. Nowhere is this more evident than in China, which is the world’s largest market for EVs.

China’s quickly evolving EV sector presents many interesting renewable energy investment opportunities. China’s EV sector is underpinned by strong structural growth potential as it sits at the intersection of two powerful forces of demand and supply. A growing cohort of younger and increasingly affluent consumers are placing a greater weight on the environmental consequences of their purchasing decisions. Meanwhile, the government’s commitment to decarbonization has led to sustainable subsidies and policies that are driving innovation and investment.

For investors, the challenge as well as the opportunity is to research the highest-conviction companies up and down the supply chain. The long-term winners will likely include those with dedicated EV platforms and higher levels of vertical integration of the battery electric vehicle powertrain, including investments in the battery cell and its supply chain.

The transformation will require significant investment spending (capex and R&D) at a time when margins from traditional vehicles are in decline and EV profitability is still a challenge for most companies. Battery costs are a key issue, with cost parity versus combustion engines unlikely to be reached until later this decade. Carmakers that postpone changes are likely to face significant operational headwinds as well as investor apathy. 

ENERGY: VIVIAN TAO, GREATER CHINA UTILITIES ANALYST

China has set the goal to reach a CO2 emissions peak by 2030 and reach carbon neutrality by 2060. Under this ambitious target, the National Energy Administration wants to increase the share of renewable power capacity to over 50% by 2025 (up from 42% in 2020) and lift the proportion of primary energy sourced from non-fossil fuels to 25% by 2030 (from 16% in 2020). Given the restriction of building hydro power plants, this implies that China will need to quickly accelerate capacity in solar and wind in the coming decades.

China is already the world’s single largest solar manufacturer, accounting for more than 90% of polysilicon and wafer production and more than 75% of cell and module production globally. Any acceleration of solar installation in China, as well as in other nations, will likely lead to further advancement in production efficiency. This could reduce the levelized cost of electricity, improving the economics of installing solar power more widely.

Given China’s heavy reliance on coal-fired independent power producers and the low base for solar and wind power, natural gas will become an important interim replacement for fossil fuel. We expect that natural gas consumption will maintain stable growth in city gas, transportation and power generation. The recent industry focus on regulating returns will enable leading players to consolidate a number of smaller and less efficient market participants and improve their scale of returns. Investors need to understand not only where each company sits in this evolving industry landscape, but also the comparative advantage of each player.

INFRASTRUCTURE: NICK MOLLER, GLOBAL 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 as many governments pledged commitments to environmentally friendly stimulus.

Facilitating the energy transition will continue to provide a wide variety of investment opportunities. We expect utilities will be spending further on green infrastructure as they continue to shift away from traditional fossil fuels toward renewables. Yet, in light of the intermittency of renewables, 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 investments in electricity transmission and utility electric grids, because renewables are frequently located away from urban centers.

We believe “stranded asset” risk will remain in focus as the energy transition moves forward, 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 significant increase in investor interest in green infrastructure has boosted the stock prices for certain publicly listed infrastructure assets/companies. 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 in a sustainable way, with a focus on governance, is critical for risk-adjusted returns.

TRANSPORT: ANURAG AGARWAL, GLOBAL TRANSPORT GROUP

The transportation sector is perceived as poorly aligned to conventional environmental standards, and further investment in clean technology solutions is needed. The goal of reducing emissions through engine technology improvements remains the industry’s primary focus. The development of carbon-reducing propulsion methods, such as liquefied natural gas (LNG), hydrogen, ammonia and various low-emissions synthetic fuels, is underway across land-based aviation and maritime transportation sectors.

Regulation plays a key role in shaping the industry; for example, the International Maritime Organization (IMO) has adopted standards for preventing pollution and harmful emissions. The IMO’s long-term goal is to reduce shipping emissions by 50% compared to 2008 levels by 2050. Similarly, the International Civil Aviation Organization will mandate reduction in CO2 intensity from new aircraft starting in 2028.

As the global energy mix continues to diversify from fossil fuels to different types of renewables, so will the transportation industry. However, the use of “transition fuels,” such as LNG, will be required in this process, and demand for LNG is projected to increase by approximately 30% by 2030 (compared to 2015). The growing adoption of LNG creates an opportunity, and it’s estimated that upwards of 100 additional vessels will be required to meet demand.                

Transportation assets that are more environmentally friendly can sometimes be more profitable. Fuel is often the largest operating cost for asset owners, and lowering the cost of fuel can often result in meaningful savings for those leasing the assets. Eco-friendly assets can, therefore, command a premium. In this regard, profitability and growth prospects will become inextricably linked to sustainable operations. 

REAL ESTATE: DIANNA RUSSO, REAL ESTATE AMERICAS GROUP

Reducing your reliance on carbon, making your systems more efficient and reducing power usage wherever possible lowers your property’s operating expenses and, therefore, enhances performance and returns. Equally important, carbon reductions can increase the property’s attractiveness to today’s most desirable tenants, providing a competitive edge that may allow increases in the rental rate.

The logical conclusion of the arms race of tenant appeal is net zero. However, to achieve the required reductions, property owners need to get comfortable with potentially large capital expenditures. For example, if an owner chooses to replace equipment that is not at the end of its useful life in order to achieve reduction goals, increased costs result, though often policymakers will offer incentives to induce upgrades. While some equipment upgrades pay for themselves with efficiencies, most will not.

On the other hand, there is also a growing cost to carbon. Fines and penalties based on usage or emissions represent a real cost for property owners in markets where there are heavy regulations. Legislated reductions in carbon emissions and usage are increasingly common. The sustainability ratings of assets by various industry groups also drive owners to look more carefully at usage. Tenants have standards and look to work or live in assets that match their overall corporate/personal goals.

Many property owners have turned to Renewable Energy Credits (RECs) to offset the remaining usage when working toward a net-zero commitment. RECs are created when a plant generates one megawatt hour of energy from a renewable source, such as wind or solar. Unfortunately, there are not enough new renewable energy sources being constructed to produce enough RECs to meet the demand, thus the price of these RECs has increased significantly.

One attractive way of lowering a property’s carbon footprint is to install solar panels and use the energy produced onsite to power the property—though as in other areas, reliable battery storage is needed to make this option more efficient. Renting the rooftop or parking lot to a solar provider is another option that instead adds the renewable energy to the power grid and provides an added income stream to the asset.

When you are a fiduciary to your clients, you need to weigh all the risks against all the benefits. The industry is evolving, and rapidly. To net zero or not to net zero? In the end, the need to remain competitive will drive the answer. 

BASIC MATERIALS AND INDUSTRIALS: POLINA DIYACHKINA, EQUITY RESEARCH ANALYST, EMERGING MARKETS AND ASIA PACIFIC EQUITY GROUP

Pure renewable energy plays tend to be scarce, and the most obvious names can often be expensive. Yet while renewable companies will likely continue to enjoy solid premiums given both their scarcity and their ESG credentials, we believe there are many other ways to invest in this theme. These businesses range from renewable equipment producers and grid suppliers to companies that possess technologies used in carbon capture, storage, production and transportation. Other opportunities include companies involved in the use of hydrogen, such as some engineering companies and fuel cell producers, as well as companies that possess technologies to decarbonize heavy industries, such as ammonia for coal plants and hydrogen for steel and cement producers.

Some traditional energy and power generation companies are active in renewables investments or have aggressive plans to decarbonize and are still trading at low valuations. A good example is a coal and hydro power producer in Japan, which announced a plan to cut CO2 emissions by 40% by 2030 and to be carbon neutral by 2050. Another example is an oil refiner that will have over 30% of its profits coming from offshore wind by 2030. Provided that companies are making clear improvements, we believe that engaging in ESG and decarbonization discussions with these companies results in a better outcome for both society and shareholders than simply selling out of investment positions.

Conclusion

Policymakers will be the key driver of change, by providing both carrots-based incentives, to encourage investment and R&D, and sticks-based measures, such as carbon pricing schemes. Our research analysts see both opportunities and risks in their sectors. For some, we expect the strong to only get stronger, while in other areas, major technological breakthroughs are required. Following a decade of dominance for consumer-facing technology companies, companies that can achieve climate-based technology solutions look set to be the biggest beneficiaries of new environmental initiatives ahead. Regardless of the industry under consideration, a thorough understanding of how the wave of policy changes ahead will impact cash flows and valuations should be an essential part of any investment decision today. 

¹LTCMA: “Weighing the investment implications of climate change,” Jennifer Wu et al, 2020.
²McKinsey: “Bridging infrastructure gaps: Has the world made progress?” 2017.

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