The Paris Climate Agreement: a wake-up call for pension funds?

By Ian Simm

So Paris produced an agreement on climate change.  196 nations reached an almost universal consensus to limit temperature rise by reducing greenhouse gas emissions; channelling US$100bn a year of climate change related investment in developing countries; and a framework to review progress regularly, tightening the ratchet if necessary.  But what does this mean for long term investors?

Cynics may shrug their shoulders.  After all, it will be nearly 18 months before we know if the Agreement is ratified (although this is highly likely), and it only comes into force in 2020.  In the meantime, energy prices are at historically low levels, and sales of SUVs are booming.  In the wake of the finalisation of the Kyoto Protocol (the precursor to the Paris Agreement) in the late 1990s, clean energy businesses delivered mixed results at best.

Yet there are three reasons why Paris is a major milestone for investors:

1. The largest economic blocs have their own domestic reasons for implementing it – China is acutely vulnerable to the effects of climate change; the United States Supreme Court has ruled that CO₂ is a pollutant that must be curtailed; and the European Union sees itself as a champion of global policy to address the issue.
2. It’s ambitious, so the impact on energy markets is likely to be significant. For example, full decarbonisation of the power sector in developed countries within the next 20 years is essential if the Agreement’s goals are to be met.
3. It’s very likely to lead to long-term policy mechanisms, which are generally conducive to a favourable investment climate.

There are a number of “obvious” investment risks and opportunities.  In the absence of commercially viable carbon capture technologies, we can expect a rapid demise of coal and further growth of proven renewables such as wind and solar.  Demand for technologies facilitating energy efficiency is likely to accelerate, for example hybrid and, in time, electric vehicles.  And we should expect new infrastructure that is more resilient to extreme weather events.

Meanwhile, the risk of owning fossil fuels has risen further.  A major reduction in greenhouse gases will require an absolute drop in consumption as well as a switch from “high carbon” fuels such as coal to “low carbon” fuels such as natural gas.  Carbon taxes (or equivalent mechanisms such as “cap and trade” schemes) will reduce wholesale prices for owners of fossil fuels, further compounding the current problem of over-supply.  In contrast, retail energy prices are set to rise, which should bolster markets for energy efficiency.

Given the timeframe for implementing the Paris Agreement, investors may be tempted to sit on the side-lines and wait for developments.  Nevertheless, investment valuations often move on rumour or non-specific news.  By the time an opportunity is confirmed, the price has moved, so, by necessity, investment requires decisions with imperfect information.  Sources of rumour could arise from potential acquisitions of companies with low carbon products or services.  Non-specific news could be corporate announcements of investment programmes in clean energy.  Meanwhile, the process of ratifying and implementing the Paris Agreement is likely to produce a steady stream of news throughout the next decade, further stimulating investor interest.  Investors who deployed capital ahead of time could see the value of their holdings increase significantly.

Concretely, investors should consider four steps.

1. Model the potential impact of carbon taxation on their portfolios in order to assess the magnitude of the risks, particularly in relation to other factors such as changes to oil supply. Impax has developed a scenario analysis tool that can help here.
2. Adjust their energy portfolios, taking some money off the table in fossil fuel assets and reallocating to energy efficiency.
3. Build portfolios in specialist companies providing goods and services for which demand in a “low carbon world” is likely to be high.
4. Set up a mechanism for monitoring climate change risk on an ongoing basis.

The Paris Agreement is a wake-up call.  Climate science is incredibly complex and will probably never produce definitive predictions on how the climate is changing at a local level.  Nevertheless, political leaders have decided to act:  it is this decision that fundamentally changes the game for investors.

Ian Simm is chief executive of Impax Asset Management