Keeping pace with the climate transition

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Implications for investors

Although we have already seen long-term investments move away from the historical energy sector, we know that most diversified investors still have significant exposure to fossil fuels through various value chains, both in equity markets and fixed income securities. To manage the climate transition, investors should consider the following:

The need to clarify their exposure to the fossil fuel sector and the associated risks. An exercise of massive economic depreciation of carbon-heavy assets, alongside a valuation exercise of carbon-neutral assets, is looming, and this situation will present risks as well as opportunities. Investors with a solid understanding of the regulatory and economic implications of the transition to a low-carbon economy can build more resilient portfolios and take advantage of these opportunities. Portfolio analysis using forward-looking climate measures is a key part of this process. It is therefore crucial for investors to find the right analytical tools for transition forecasts and physical risk models.

The growing importance of stewardship and engagement. It is of course understood that divestment alone is not an adequate option for investors and can, at times, also dampen the benefits of efforts to allocate sustainable capital (see To engage or divest? The question at the heart of the climate impact).

The consequences of regulatory changes – better disclosure and new financial models to incorporate evolving ESG criteria. The announcement by the IFRS Foundation regarding the creation of the International Sustainability Standards Board (ISSB) is an important step in the quest for better ESG disclosure. The inclusion of carbon pricing in equity market valuations always poses modeling challenges for investors, and pricing considerations will have implications for credit valuations and analysis.

The effect of decarbonisation on corporate profits. Government tax policies to help build sustainable economies could also cause damage to corporate balance sheets through tax increases, even if those tax increases are shared with households. In addition, decarbonization is a structural inflation driver for economies, as inputs and technologies for sustainable businesses are still in their infancy. This could hit carbon intensive sectors particularly hard. On the bright side, investors could take advantage of opportunities in green technologies such as low-carbon steel and cement, carbon offset technologies, and biofuels (to name a few). Investors could also benefit from the combination of greening and digitization, with an expected acceleration of software and artificial intelligence (AI) linked to climate change.

Closing thoughts

Investors face a potentially parabolic rise in climate awareness in the coming years, and positioning in the face of this reality is cautious for portfolio management. Drivers of the growing interest in decarbonization include the results of COP26 and many positive feedback loops that will put the climate even more in the foreground. Investors will likely benefit from stricter disclosure requirements, but they will also need to effectively integrate climate risks and opportunities into financial models and deeply understand their carbon exposure.

Encouragingly, the results of our recent global ESG survey of 300 institutional investors showed that most investors plan to implement decarbonization targets within the next three years (i.e. 71% in Europe). , 70% in Asia-Pacific and 61% in North America). Investors plan to use a wide range of asset classes to express their climate goals and, unlike our previous survey,2 they cite their responsibilities to drive the economic transition and help resolve the global climate crisis as their two main reasons for pursuing climate investment strategies. These survey responses might imply that many market players understand the expected acceleration of decarbonization, but they also show investor momentum – yet another potential driver of climate-related market movement. In short, we believe that preparing for this changing landscape is key.

Originally posted by State Street Global Advisors on December 6, 2021.

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