Special Report
Highlights As an introduction to a series of BCA Special Reports on the investment consequences of climate change, we review the science around the subject and suggest a framework for analyzing its implications. The scientific consensus is that global warming is a reality and most likely human-induced. However, the uncertainty around the magnitude of the impact of climate change is large. The consequences of climate change are delayed, uncertain and global. But, for investors, the prudent course of action is to accept the scientific consensus – and the impact it will have on policymakers – and hedge or invest appropriately. Feature Chart 1Climate Change Global Perception Bank of England Governor Mark Carney has called climate change “the tragedy of the horizon.” It is now perceived as a major threat across the globe (Chart 1). As such, it is essential to assess its macro and market consequences. In this introduction to our Climate Change Special Series, we review the existing literature and suggest a framework to assess the market relevance of this phenomenon. Going forward, we will produce a series of market-driven reports designed to help investors both mitigate the risk to their portfolios and identify opportunities arising from climate change. We intend to cover topics such as green financing, energy, and the geopolitical aspect of climate change, just to cite a few. These reports will incorporate both quantitative and qualitative analysis to generate actionable investment recommendations. What Is Climate Change? Climate science is not new. The initial understanding of the effect of heat-trapping gases on global temperature dates back to Joseph Fourier’s early 1800s study of planetary temperature. Subsequent research showed the importance of the greenhouse effect, a phenomenon whereby greenhouse gas molecules (e.g. CO2, CH4, N2O) absorb infrared radiation emitted from Earth before reemitting it in all directions, including back to the Earth’s surface, thus making it harder for this energy to leave the planet. This excess of energy stored in the planet, above its normal energy balance, causes temperature increases. The distribution of environmental damages caused by global warming will not be uniform around the world. The rate of warming and other climate changes will differ across regions due to climate processes and feedbacks linked to local conditions.1 Regardless, up to 14% of the global population will experience above 2°C (3.6°F) warming – a level seen by scientists as a trigger for permanent damages and changes – even if the increase in global mean surface temperature (GMST) were limited to 2°C (3.6°F) by 2100 (CarbonBrief, 2018). The consequences of climate change are delayed, uncertain and global. Even under the maximum policy effort scenario, studies assign 60% odds to an increase greater than 2°C (3.6°F) (Nordhaus, 2018). The longer policymakers, companies and investors delay tackling this issue, the less likely the world will stay below the 2°C threshold and the more rapid and abrupt the transition to a low-carbon economy will eventually be. A sudden transition will be more disruptive to the economy and damaging to investors. Defining The Issue: The Earth’s Atmosphere As A Global Common The Earth’s atmosphere - specifically its function as a sink for CO2 and other greenhouse gases (GHG) - falls within the problem of the global commons.2 It is a natural resource requiring global cooperation for its sustainable use and provision. Problematically, the consequences of climate change are delayed, uncertain and global. Delayed because the burden of climate change policies mainly falls on current generations, whereas the benefits of lower climate damage accrue to future generations, leading every generation to think it can survive the issue and let the next generations handle it. Uncertain because the list of harms from climate change lengthens with the advance in climate-science studies. We learn more and more about the extent to which human activities are at fault and the extent of the damage that will befall the planet. Global because it does not matter whether the emissions take place in China, Europe, or the U.S. since GHG mix immediately once in the atmosphere. In that sense, it is a collective-action problem in which every country’s interest is to shift the abatement costs onto its neighbor. The global aspect is crucial. The optimal emission level of one country does not follow the global social optimal. Hence, every country has an incentive to emit as much GHG as possible now, before any consequences occur (Combes, 2016). What We Know So Far: Historical Data Both climate-alarmist and climate-denier groups have captured the public debate.This polarization clouds the underlying facts about current trends and the difference between what is unlikely, likely, or very likely to happen. The resulting lack of consensus will lead to over- or under-adaptation by the various economic agents, depending on their interests. FACT 1: GLOBAL WARMING IS A REALITY Anthropogenic Greenhouse Gas Emissions - Emissions of carbon dioxide (CO2), methane (CH4), and nitrous oxide (N2O) have risen steadily since the industrial revolution and at a brisk pace relative to the previous 12,000 years (Chart 2). Chart 2GHG Global Emissions Global Mean Surface Temperature - It rose by an estimated 1°C (1.8°F) from 1901 to 2016. According to NASA data, the 10 warmest years recorded in the past 139 years all occurred after 2005 (Chart 3). Chart 3Global Land And Ocean Temperature Global Mean Sea level - It has risen by an estimated 20.3cm (8 inches) since 1900 due to the expansion of waters and meltwater from shrinking ice sheets. Almost half of this rise happened in the last 25 years (Chart 4). Glacier and Ice Sheet - The melting of ice sheets will reduce the earth’s reflectivity, accelerating the warming process (Chart 5). The record low of sea ice extent in the Arctic and Antarctic was observed in 2012 and 2017, respectively. Chart 4Global Mean Sea Level Chart 5Glacier And Ice Sheet Precipitation - Historical changes in precipitation are much more volatile and region-specific than temperature and sea level changes. Moreover, there is a lack of data covering the period before 1951, which leads to low confidence in estimates of precipitation for this period and medium confidence post-1951. Annual average precipitation for global land areas increased slightly over the period 1901–2008, and the magnitude of observed changes varies across different datasets (Hartmann, 2013). Extreme Weather Events - These are defined, in a meteorological sense, as events at the “edges of the complete range of weather experienced in the past.” The frequency and severity of extreme weather events has been linked to global warming (Table 1) (Scott, 2016). Table 1Extreme Weather Events (1950 - Present) FACT 2: CLIMATE CHANGE IS HUMAN-INDUCED The Intergovernmental Panel on Climate Change (IPCC) – considered the world’s most authoritative scientific body on climate change – concluded in 2013 that the probability that global warming was human-induced was at least 95% (Table 2). Table 2Evolution Of The Assessments Of Human Influence On Climate Change Chart 6Global Warming & Global GHG Emissions Since the late nineteenth century, GHG emissions – mainly CO2 – and global land and ocean mean temperature have shared a common steep upward trend (Chart 6). A recent study by Mann et al. estimates that in the absence of GHG emissions, the odds that 13 out of the 15 warmest years ever measured would all have happened in the current century are extremely small.3 More recently, a report by the National Academies of Sciences, Engineering, and Medicine (NASEM) concluded that “[I]n many cases, it is now possible to make and defend quantitative statements about the extent to which human-induced climate change has influenced either the magnitude or the probability of occurrence of specific types of events or event classes.” According to most recent peer-reviewed studies, at least 97% of actively publishing climate scientists now accept human-caused climate warming (Cook, 2016). While science is not a matter of popular vote, this level of consensus among experts suggests that for investors the most prudent course of action is to accept the scientific consensus and hedge or invest appropriately. Projections & Assumptions Chart 7Global Emissions Projections Climate economics deals with conditional projections based on unknown probability distributions, implying a high level of uncertainty. The level of confidence around the nearer segments of the projections is relatively elevated. Conversely, at the far end of the projected period, by 2100 for most studies, the uncertainty increases drastically. According to the United Nations Environment Programs’ 2018 Emissions Gap report, the 2°C (3.6°F) target drafted in the Paris Agreement in 2015 would require global emissions to be capped at 40 gigatons of CO2 equivalent by 2030. Throughout our Climate Change Special Series, we will rely on the following assumptions based on the IPCC Fifth Assessment Report (AR5) and the summary estimates from around 150 academic papers, the majority of which were published in 2018 (CarbonBrief, 2018). Anthropogenic Greenhouse Gas Emissions - Global emissions rose in 2017 and are now ~14 GtCO2e above the required level by 2030. Current pledges are insufficient to meet the Paris Agreement’s long-term temperature goals (Chart 7). Key factors driving changes in anthropogenic GHG emissions are mainly economic and population growth. Projections of greenhouse gas emissions vary over a wide range, depending on both socio-economic development and climate policy – which are fundamentally uncertain. Climate economics deals with conditional projections based on unknown probability distributions, implying a high level of uncertainty. The majority of models indicate that scenarios meeting levels similar to RCP2.6 (a scenario that aims to keep global warming likely below 2°C (3.6°F) above pre-industrial temperatures) are characterized by substantial net negative emissions by 2100, on average 2 GtCO2e per year. Chart 8Global Mean Surface Temperature Projections Global Mean Surface Temperature - Under all assessed emission scenarios, surface temperature is projected to rise over the twenty-first century. The change over the 2016-2035 period will be very similar to 1986-2005, and will likely be in the range of 0.3°C to 0.7°C (0.5°F to 1.3°F). Beyond that, the mean temperature rise across IPCC scenarios for 2046-65 and 2081-2100 is estimated to be 1.4°C (2.5°F) and 2.2°C (4°F), respectively (Chart 8). These estimates imply that there will be more frequent hot and fewer cold temperature extremes over most land areas on daily and seasonal timescales. Global Mean Sea Level - It has been established that the likelihood sea levels will rise in more than 95% of the ocean area is very high. Under all IPCC scenarios, the rate of sea level rise will very likely exceed the observed rate during 1971-2010. About 70% of the coastlines worldwide are in fact projected to experience sea level change within +/- 20% of the global mean. Precipitation - There are likely more land regions where the number of heavy precipitation events has increased than where it has decreased. Recent detection of increasing trends in extreme precipitation and discharge in some catchments implies greater risks of flooding at regional scale (medium confidence). These changes will not be uniform, with high latitudes and the equatorial Pacific more likely to experience an increase in annual mean precipitation while many mid-latitude and subtropical dry regions are likely to experience a decrease in mean precipitation. It remains a challenge to determine long-term trends in precipitation for the global oceans. Extreme Weather Events - Projections on extreme weather events can only infer the probability distribution of such events, i.e. more or less likely to happen. With a 1°C (1.8°F) additional warming, risks from extreme weather events are high (medium confidence from IPCC). More importantly, we can say with high confidence that these risks increase progressively with further warming. Embracing Uncertainty The uncertainty around the magnitude of the impact of climate change is large. Yet, bounded uncertainty is informational. We can extract the following important, actionable conclusions: Projections for economic variables are relatively more uncertain than for geophysical variables. The link between GHG emissions and rising temperature is more certain than the level of emissions, output, and damages (Nordhaus, 2018). Therefore, the largest uncertainty comes from economic growth and the level of emissions. We do not rely on estimates of global GDP impacts. On the other hand, it is easier to build scenarios for geophysical variables and obtain investment-relevant information from these projections. Simulating the path of future emission allows us to map this onto future temperature, sea level, and extreme weather variations. Economic models suggest that the higher the uncertainty, the larger the weights on low-probability/high-impact scenarios. This implies a positive risk premium due to risk aversion and favors stricter mitigation policies as insurance to shattering outcomes. As climate models are fine-tuned and continuously point to large damage uncertainty, the desired strength of policy could increase. Win-Win or “no-regrets” investments are the most likely at first.4 The Kaya Identity provides a simple framework to project future GHG emissions to visualize the uncertainty associated with different assumptions. The identity links future emissions to observable macroeconomic variables (see the Appendix for more details): F = P * (G/P) * (E/G) *(F/E) Where F denotes global CO2 emissions from human sources, P represents global population, G equals global GDP, and E is global energy consumption. The identity provides a useful framework for policymakers. To reduce emissions, there needs to be a reduction in one or more of the identity's components. Altering demographic trends and reducing global GDP per capita are very unlikely to happen given the damaging impact it could have – both for individuals and politicians’ careers! At a global level, this leaves us with energy efficiency and carbon intensity of energy as the only key and viable options to reduce CO2 emissions. Why Does It Matter To Investors? Markets are probably still underpricing climate-related risks because the effects only materialize gradually and in the long term – exceeding most investors’ investment horizon. Investors such as pension funds, insurers, wealth managers, and endowments need to be responsive to the threat posed by climate change. They typically have multi-decade time horizons, with portfolio exposure across the global economy. Their increasing interest in Environmental, Social, and Governance (ESG) measures fits well within this context.5 It reflects a need for more transparency and more stringent investing standards. Determining which firms or sectors will either win or lose the “green race” will be of the outmost importance to investors. Businesses are still navigating the financial and operational implications of climate change. To some extent, this can already be assessed based on the readiness of firms and sectors to adapt to a green economy – looking at the number of environmental technology patent applications, for example. Markets are probably still underpricing climate-related risks. The financing needed to mitigate climate change represents yet another opportunity for investors. Green bonds and sustainability-linked debt instruments are more widespread than ever. Sustainable debt issuance reached record levels last year, with a total of $260 billion issued, according to Bloomberg New Energy Finance data. Year-to-date issuance has nearly reached $180 billion. Green bonds offer two main benefits to issuers: corporate branding that sends a strong signal to the market of their commitment to climate change, and a wider investor base. Our series of market-driven reports are intended to both identify the risks and opportunities arising from climate change in order to help investors mitigating the risk to their portfolios. They will rely on the simple framework we present below. Climate Change Framework In future reports in our Climate Change Special Series, we will summarize our findings using a comprehensive analytical framework developed by Batten (2018) to assess the impact of climate change via physical and transition risks with respect to the type of shock induced by each type of risk. Physical Risks Physical risks are the most visible and immediate source of risk to investors and the financial sector. They can be defined as those risks that arise from the interaction between climate-related events and human and natural systems, including their ability to adapt— e.g. the volatility in food prices following a drought or a flood.6 An increase in climate-induced physical risks – such as heat waves, floods and storm – will have a direct effect on insurers. If these risks are uninsured, the deterioration of the balance sheets of affected households and corporations is likely to hurt the banking system. Electrical utilities, real estate and transportation infrastructure are other physical assets at risk of capital losses. Transition Risks Chart 9Public Opinion Of Policy Options To Tackle Climate Change Transition risks can be defined as the risks of economic dislocation and financial losses associated with the transition to a lower-carbon economy. Detrimental effects manifest themselves through three possible channels: Reduced production and consumption of high carbon products, especially energy produced using fossil fuels, potentially leading to stranded assets. Improvement in the energy efficiency of existing products and processes – energy intensity. Moving to low-carbon energy production – that is reducing carbon intensity. Lower energy intensity and carbon intensity, highlighted in the Kaya Identity above, can be achieved through technological innovation. The relationship between climate change and policy or regulatory framework is manifold, as policymakers will need both to respond to the consequences of climate change and to shape future GHG emissions. The primary responsibility for strategic planning rests with governments, which have a variety of policy options at their disposal (Chart 9). Table 3 provides a useful template to link both physical and transition risks to the type of shocks they can induce, and importantly, how it can ultimately turn into financial and geopolitical risks. Table 3A Simple And Useful Template To Summarize Our Findings Climate change can impact demand (from investment, consumption or trade) or supply (labor, capital stock, technology or other inputs). For example, transition risks such as distortions from asymmetric climate policies across countries could directly impact trade or investment (FDI). This is what is commonly referred to as the pollution haven hypothesis, which states that more stringent environmental regulations induce polluting industries to relocate to countries with relatively lax environmental regulations. Ensuing reports in the Climate Change Special Series will include this template as a mean to summarize our findings. APPENDIX The Kaya Identity And Uncertainty Feedback Loop7 Diagram 1The Uncertainty Feedback Loop The Kaya Identity links observable macroeconomic and demographic variables to GHG emissions: CO2 = P * (Y / P) * (E / Y) * (CO2 / E) Where denotes P global population, Y global GDP, and E primary energy consumption. It highlights the large degree of uncertainty around the macroeconomic impact on GHG emissions – especially at the end of the forecast period when additional uncertainty emanates from the feedback loop illustrated in Diagram 1. Historical Trend In CO2 Emissions From 1990 to 2014 CO2 emissions growth was 2.1% p.a.8: Global CO2 emissions during this period were pushed higher by population growth (1.3% p.a.) and rising rates of GDP per capita (1.9% p.a.). This was partly offset by declining energy intensity (-1.3% p.a.) (Chart 10). Chart 10Kaya Identity Components: Global Level The extent of the impact of these variables on CO2 emissions is region-specific. Therefore, when the identity is expressed at an aggregate and global level, it can lead to inaccuracies in long-term scenario analysis since it does not account for dependencies across the variables and does not differentiate between high population growth in countries with low vs. high GDP per capita growth, or between high GDP per capita growth from countries with high vs. low carbon intensity energy sources. Using The Kaya Identity To Project Future GHG Emissions Population - The UN currently expect the population to grow by an average 0.4% p.a. through 2100 in its medium variant scenario. GDP per capita - The OECD projects GDP per capita will grow 2.2% p.a. between 2018 and 2060. Energy Intensity - We assume a 1.5% p.a. decline in energy intensity over the 2018-2100 period – the trend over the past decade. Carbon Intensity - In line with scenario B2 of the IPCC Special Report on Emissions Scenarios (SRES), we assume a 0.4% p.a. Combined, this leads to a 21% increase in CO2 emission by 2050, and a 63% increase by 2100. Accounting for other scenarios for each component results to a wide range of potential cumulative CO2 emissions; a median temperature between 2.6°C and 4.8°C by 2100 (Table 4). It is noteworthy that a rise in temperature above 2°C by 2100 is almost certain under all these scenarios. Table 4Scenarios Using The Kaya Identity Emission Reduction Possibilities Table 5Policy Approach Per Factor To reduce CO2 emissions, policies aimed at reducing the growth rate of one or more of the Kaya Identity’s components will be needed (Table 5). Assuming a constraint-free world, reducing average population and income growth rates to 0% from the projected 0.4% and 2.1% would reduce cumulative emission by 60% in 2100 vs. the baseline. Economic growth is the main driver of emissions growth. For instance, post-GFC, Europe’s emissions have been subdued due to poor economic growth. However, the constraints on these variables exist and are binding. These are not the area of focus to tackle climate change. Consequently, this leaves energy efficiency and carbon intensity of energy as the only viable options to reduce GHG emissions. In order to avoid breaching the 2°C target, the IPCC estimates CO2 concentration needs to be capped below 400 ppm by 2100. This can only be achieved by significant improvements to energy efficiency. Economic theory suggests that given that energy is a cost of production, energy efficiency will continue to improve. However, the required pace of reduction in energy intensity surpasses the incentive provided by the price mechanism. The externalities of an energy intensive economy are delayed and uncertain. Thus, these are not fully included in the cost-benefit analysis of investing in new technology. As a result, policies aimed at reducing the carbon intensity of global energy input will be an important source of CO2 reduction. This includes decreasing the carbon intensity of fossil fuels – e.g. switching coal to natural gas and developing carbon capture and storage technology – and reducing the share of fossil fuels in the energy mix – e.g. switching fossil fuel energy to renewables. We will expand on alternative sources of energy in a subsequent report. Importantly, the policy response should differ between regions. The drivers of emissions are heterogeneous and policies should fit the regional reality. The Kaya Identity can also be applied at the country or regional level. Chart 11The Kaya Identity Applied At The Country Level U.S. - Elevated income growth offset by increasing energy efficiency (Chart 11, panel 1). China - Robust income growth drove CO2 emissions higher (Chart 11, panel 2). Europe - Falling energy intensity and carbon intensity led to a decline in emissions (Chart 11, panel 3). References Fourier, J. (1827). Mémoire sur les Températures du Globe Terrestre et des Espaces Planétaires, Mémoires de l’Académie Royale des Sciences, 7, 569-604. ‘Global’ warming varies greatly depending where you live, published by CarbonBrief on July 2, 2018. Nordhaus, William (2018). Projections and Uncertainties about Climate Change in an Era of Minimal Climate Policies, American Economic Journal: Economic Policy, 10(3): 333-360. Edenhofer, O. et al. (2015), The Atmosphere as a Global Common, The Oxford Handbook of the Macroeconomics of Global Warming. Hardin, Garrett (1968), The Tragedy of the Commons, Science 162, no. 3859: 1243–1248. Jean-Louis Combes et al. (2016), A review of the economic theory of the commons, Revue d’économie du développement, Vol 27. Climate Science as Culture War, Stanford Social Innovation Review (Fall 2012). The Fourth National Climate Assessment: Volume 2 Impact, Risks, and Adaptation in the United States, U.S. Global Change Research Program (2018) and Climatic Research Unit temperature database Hartmann et al. (2013), Observations: Atmosphere and Surface. In: Climate Change 2013: The Physical Science Basis, Contribution of Working Group I to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change. Scott, P. (2016), How climate change affects extreme weather events, Science 352(6293):1517-1518. Mann et al. (2016), The Likelihood of Recent Record Warmth, Scientific Reports 6:19831. Fischer, E. M., and R. Knutti, Anthropogenic Contribution to Global Occurrence of Heavy-Precipitation and High-Temperature Extremes, Nature Climate Change 5 (April 27, 2015): 560. Cook et al. (2016), Consensus on Consensus: A Synthesis of Consensus Estimates on Human-Caused Global Warming, Environmental Research Letters 11, 4:048002. The impacts of climate change at 1.5C, 2C and beyond, CarbonBrief (2018). The Emissions Gap Report 2018, United Nations (2018). Batten, Sandra (2018), Climate change and the macro-economy: a critical review, Bank of England Staff Working Paper No. 706. Robert S.J. Tol (2019), Climate Economics: Economic Analysis of Climate, Climate Change and Climate Policy, Cheltenham, U.K. Edward Elgar Publishing Limited. Hugo Bélanger Senior Analyst HugoB@bcaresearch.com Jeremie Peloso Research Analyst JeremieP@bcaresearch.com Footnotes 1 For instance, Canada is estimated to be warming at twice the global rate. 2 The term “global commons” is used to define common resources or environmental issues crossing national boundaries. They have either no well-defined property right (no individual or nation has private control of their use) or lack an international enforcement mechanism to control their use (Edenhofer, 2015). The market failures associated with common pool resources (CPR) were popularized in Garret Hardin’s famous 1968 paper “Tragedy of the Commons”. 3 The likelihood is between 1 in 5,000 and 1 in 170,000 chances. 4 No-regret strategies are cost-effective under multiple climate change and policy response scenarios. Win-win actions provide beneficial externality while contributing to adaptation to various climate change scenarios. Under uncertainty, these strategies are the most likely to be implemented to begin the adaptation process rather than a riskier wait-and-see approach. Please see “Examples of ‘no-regret’, ‘low-regret’ and ‘win-win’ adaptation actions,” published by climate exchange. It is available at climatexchange.org.uk. 5 Please see Global Asset Allocation Special Report, “ESG Investing: No Harm, Some Benefit,” dated November 21, 2018, and available at gaa.bcaresearch.com 6 Please see BCA Special Reports, “Agriculture In The Age Of Climate Change,” dated October 23, 2019, and available at bca.bcaresearch.com 7 This section is largely inspired from Robert S.J. Tol (2019), Climate Economics: Economic Analysis of Climate, Climate Change and Climate Policy, Cheltenham, U.K. Edward Elgar Publishing Limited. 8 Lowercase letters denote annual growth rates of each component.
