Investment implications from COP26
“Paris built the arena, Glasgow started the race” - John Kerry, US climate envoy
COP26 produced many agreements and initiatives that should have an investment impact, even if overall the gap between pledges and emissions reductions required to keep warming below 1.5 degrees persists. Here we summarise the views from Fidelity experts as to what the outcomes of COP will mean for companies, sectors, and investors.
Jenn-Hui Tan, Global Head of Stewardship and Sustainable Investing
From pledges to implementation
Over 140 countries submitted new or updated Nationally Determined Contributions (NDCs) covering 70%+ of global emissions, including India and Brazil. But there is still no real enforcement mechanism against those pledges beyond naming and shaming. The focus now is on understanding how this gets translated into national level energy transitions and other key decarbonisation objectives - this is key to evaluating future corporate prospects.
Progress on carbon markets
COP26 brought encouraging work on agreeing basic technical rules for international carbon markets (Article 6) including unified standards around emissions trading, double counting and carry over of credits. This has implications for voluntary carbon markets (ICE launched the first future on carbon credits during COP) and on setting prices for carbon globally.
Balancing energy security and decarbonisation
This is the first COP to take direct aim at fossil fuels and attempt to phase-down, if not phase-out, coal - but the reality is that many developing nations, including India and China are still reliant on coal and global energy emissions will continue rising until 2025 at least. The lack of agreement regarding the mobilisation of climate finance to developing markets to or to make sure the shortfall from previous years is addressed (the “loss and damage” function) further highlights the importance of private sector capital flows and public private partnerships to deliver the financing necessary to decarbonise EM economies.
Active private sector participation and better disclosure
Climate and COP pledges are now a driving force for finance and regulation. Significant private sector activity (e.g. the GFANZ US$130trn commitment to net zero, the ISSB international disclosure standards) will help create market incentives for decarbonisation and for better mechanisms to assess and enforce progress (i.e. call out greenwashing). Country pledges have moved beyond CO2 to include methane, deforestation, financing activities overseas etc, and the capacity to review targets every year instead of every five years suggests there will also be broader scrutiny of investors and corporates with regards to their (financed) environmental footprint. There will also be a focus on the just transition, ensuring companies retrain workers for new skills as industries decarbonise.
Positive growth prospects for green technologies
We saw further support for alternatives such as nuclear, green/blue hydrogen, renewable infrastructure, carbon capture and storage as well as hard-to-abate sectors like steel and cement production (see carbon sectoral arrangement and Breakthrough Agenda detail below).
The unexpected bilateral US/China climate collaboration at the conference has the potential to mitigate wider strategic tensions (or potentially for those tensions to undermine global climate progress), and is something we will be watching carefully.
Looking beyond mitigation to adaptation
As there is a decreasing likelihood of holding warming to 1.5 degrees, there needs to be an increasing focus on physical risk assessment and adaptation efforts by countries and companies, especially those that are already dealing with the effects of temperatures rising by 1.1 degrees above industrial levels.
Salman Ahmed, Global Head of Macro and Strategic Asset Allocation
Anna Stupnytska, Global Macro Economist
Disorderly transition remains likely, despite COP pledges
As the dust settles in the wake of COP26, it is becoming clear that, despite some progress in a number of areas, the outcome of the conference keeps a wide range of warming scenarios very much alive.
Current policies put the world on track for 2.7 degree warming, with an estimated range of between 2 and 3.6 degrees, according to Climate Action Tracker. The newly updated estimates - following pledges at COP26 - suggest that even assuming full implementation of all announced measures including the new and updated Nationally Defined Contributions and net zero targets, warming would likely be limited to 1.8 degrees, with a range of 1.5 to 2.4 degrees.
A wide range of possible outcomes reflects huge uncertainty
With huge uncertainty inherent in these estimates, the range of possible macroeconomic outcomes remains exceptionally wide. Using the Network for Greening the Financial System (NGFS) scenarios framework, developed by central banks, we believe that the more likely path for the world from here is that of disorderly transition, whereby policies are delayed or diverge across countries and sectors.
This means global GDP is likely to be significantly lower relative to its prior trend, given losses from both physical and transition risks. Importantly, those losses are not backloaded towards the end of the century and do not mainly fall on emerging economies - they are most pronounced in the next two decades, with developed countries sharing the burden.
Radically different financing decisions needed to reach net zero
One of the clear messages from COP26 was the recognition of the importance of aligning incentives for public and private financial flows on national and international scales, as these would be critical to achieving a global transition to net zero.
With public finances under huge strain from the Covid pandemic, however, very different - and often tough - policy decisions are required from governments to make progress. In addition to activating carbon credit markets, carbon taxation and other mitigation instruments could prove to be a source of substantial revenue, which if used effectively can also support an equitable transition.
Such policies, however, may be politically sensitive, especially if they lead to transitory GDP losses and inflationary pressures in the medium term. This could drive further differentiation in transition prospects across countries, with those capable of radical reform likely to be more successful in the long term.
Progress on carbon markets supports inflationary outlook
Carbon pricing remains the main mechanism that can make significant reductions in CO2 emissions possible on the path to net zero. According to NGFS, the global carbon price has to rise multiple folds throughout the transition, reaching US$200 per tonne of CO2 (in 2010 USD) by 2030 and nearly US$700 by 2050 to cap the temperature increase to 1.5 degrees. Under a disorderly transition, the carbon price would need to be even higher or else increase at a much faster pace.
Whichever path is taken, this will likely result in more persistent and potentially more volatile inflation during the transition period. The COP26 step towards international carbon pricing makes this regime shift in global inflation more likely. But for the time being, given carbon pricing remains highly fragmented across countries, we expect related price pressures to be more meaningful among the first movers such as Europe.
Developed markets need to share the burden with emerging markets
COP 26 also laid bare important differences between emerging and developed market countries given different stages of the economic development cycle, differential vulnerability to climate change and different costs of adaptation, especially for countries still heavily reliant on coal in the energy stack.
No doubt, US/China cooperation is a great step forward but more credible coordination and burden sharing between advanced and emerging economies will be needed at COP27 to make net zero a reality for the planet. Here, reconciling national interests with common global aims remains a work in progress but it’s a positive development to see a spotlight being put on critical underlying issues that will need resolution sooner rather than later.
Nonetheless, as of today, a divergent net-zero trajectory seems to be taking shape, with COP26 highlighting the very different approaches being adopted by the main greenhouse gas emitters. This puts us on a potentially hazardous track towards a disorderly transition and further action is needed to avoid it.
Cornelia Furse, Portfolio Manager for the Fidelity Sustainable Water and Waste Fund
While the conference failed to deliver sufficient action to limit warming to 1.5 degrees, there were key announcements on deforestation, coal and methane that will have implications for investors.
Deforestation, methane, and coal - a start but not enough
Probably the most comprehensive announcement was on deforestation as leaders from more than 100 countries, representing 85% of the world’s forests, have promised to “halt and reverse forest loss and land degradation by 2030 while delivering sustainable development and promoting an inclusive rural transformation”. Despite some backtracking by signatories, there were also investor pledges to phase out deforestation activity from portfolios on a swifter timeline.
The deforestation declaration comes with around USD19bn of pledged finance from both public and private sources for forest-related actions such as conservation, development policies and reducing vulnerabilities in developing countries between 2021 and 2025. The UK, US, Germany, Norway and the Netherlands will provide USD1.7bn directly to indigenous peoples and local communities (IPLC) to recognise their effort in protecting forests. While very welcome, this is only a drop in the ocean when we think about the overall level of investment in decarbonisation necessary for zero carbon (total of 144tn according to Goldman).
More than 100 countries have agreed to cut methane emissions by 30% by 2030, which is below the 50% overall emissions reduction required over the next decade and does not include key emitters like China, India, and Russia. Coal represents one of the largest sources of CO2 emissions, yet this agreement is probably the weakest of the three, given that less than 40 countries have agreed to shift away from coal and the largest consumer of coal, China, is not one of them. China accounts for over 50% of global coal demand and having a clear commitment on the shift of its power generation fleet to renewables is crucial. The US, India, Australia and Japan are also absent from the list of signatories and some countries have not endorsed all four clauses.
The Breakthrough Agenda could prove a catalyst
An initiative known as the Breakthrough Agenda was launched to “accelerate the development and deployment of the clean technologies”. One of its goal is to align standards globally so that developing economies can access the new technologies and processes easily. Power, road transport, steel and hydrogen and more sustainable farming are the initial focus. A ‘First Movers Coalition’, a collaboration between the World Economic Forum, government and large companies, is being set up to purchase low carbon products and help create demand for green supply chains.
The Breakthrough Agenda could be a strong tailwind for climate solutions. However the funding being discussed is tiny compared to what is needed to significantly reduce the costs of these technologies quickly. More promising is the commitment to discuss progress every year. My hope is that as climate change accelerates further and as it becomes evident that progress is slow, global leaders will have this an opportunity to discuss stronger financial support.
While this is the right direction of travel, there are no strict targets associated with this initiative. Therefore, key contributors to emissions, like transportation - both cars and commercial vehicles, buildings, industry - steel, cement and others, aviation, etc. do not have decarbonisation targets.
Finally, the UN updated its synthesis report (aggregate of all official pledges) and found that emissions in 2030 would be 13.7% higher than 2010 levels. This is a modest improvement from the 16% increase before these new pledges and there is a long way to go to reducing emissions by 50% instead.
US and China talk about climate action
The US/China joint declaration on climate action mentions ‘concrete actions in the 2020s’. Areas of cooperation (though vague) include regulation, methane, decarbonisation, renewables, circular economy, carbon capture and storage, and illegal deforestation. It would have been better to have set targets, but cooperation between the two countries is key to achieving global net zero, and if China sets decarbonisation as its goal, then it is likely to achieve it.
Extract from the statement:
‘They [the parties] nevertheless recognize that there remains a significant gap between such efforts, including their aggregate effect, and those that need to be taken to achieve the goals of the Paris Agreement. The two sides stress the vital importance of closing that gap as soon as possible, particularly through stepped-up efforts. They declare their intention to work individually, jointly, and with other countries during this decisive decade, in accordance with different national circumstances, to strengthen and accelerate climate action and cooperation aimed at closing the gap, including accelerating the green and low-carbon transition and climate technology innovation.
The intention here is more relevant than the content of the statement. A year ago it was entirely inconceivable that the two most significant laggards in terms of climate policy at a global level, and the US and China at that, would do anything of this nature. They are making a very loud statement that they are united on this. This is vital as Europe can implement carbon pricing on as many industries as they like, but that won’t make any difference if the US is consuming Chinese materials/ products which don’t reflect the cost of carbon.
China’s emissions per unit of GDP targets are relatively ‘easy’ to set as CO2 intensity of GDP is likely to fall naturally given the faster growth in the service economy versus the old economy with the latter having significantly higher carbon intensity. What is much more difficult to do is cut the absolute tonnes of carbon emitted. Targets for this are less specific - emissions peak in 2030, which is too late.
Acting together will make a difference
The US/China partnership is also important because it could lead to closer alignment in timeline as well as a coordinated approach to decarbonisation and therefore more powerful support for some technologies. For example, everyone knows green hydrogen is crucial. But having the EU provide subsidies now, the US later and China in 10 years’ time would be far less powerful than if they all work together with a starting point of working out how much investment is needed to make green hydrogen economic, sharing the bill and doing it now. Of course, the situation might play out differently, but it is clear that Biden and parts of Xi’s government are very concerned about climate impacts.
Kris Atkinson, Portfolio Manager
- Expectations coming into COP were low - historically there are high aspirations and a low level of action. The US/China statement was a good step forward but lacked tangible detail; otherwise it was a mixed bag of results.
- The latest set of pledges included net zero commitments but will only lower global greenhouse gas emissions in 2030 by 7.5% compared to prior pledges. To get on track to 2°C, a 30% reduction is needed, whereas a 55% (25-28GtCO2e) GtCO2e) reduction is needed to get on track to 1.5°C. This highlights the challenges of finding political agreement and reinforces the need for investors to put climate risks front and centre of our analysis.
- Utilities, energy, transport, food supply chains, financed emissions and industrials are key areas for us and COP agreements will have an impact on the types of companies we invest in whether due to decarbonisation of their operations or a strategic shift to a different model.
Transportation - the clean car pledge
On Transport day on 10th November, 24 nations with 20% of the global auto market joined a climate pact to pledge that all new cars and vans will be zero-emission by 2040, or 2035 in leading markets. The nations were joined by 11 automakers who will work to ensure that the sales of all new cars and vans being zero-emission globally by 2040 and no later than 2035 in “leading” markets. When taken together with ICE phase-out targets and other national goals, two-fifths of the global auto market has targets that incentivise zero emission vehicles. However, decarbonising autos is relatively straight-forward; everyone understands the EV case and while policy support is needed to speed this up, it is not where the heavy lifting will be needed.
Aviation and shipping
Aviation and shipping are global sectors that are part of the Paris agreement but excluded from NDCs. The focus this time has been on shipping, as aviation is challenged by the post-Covid environment and technology challenges. Shipping is crucial to the global economy and will continue to grow. The whole maritime sector needs to be decarbonised end-to-end if we are to offset the growth in global trade. It is a challenge just to keep current emissions where they are.
The Clydebank declaration launched at COP seeks to establish green shipping corridors between certain countries, scaling up what is already happening. The shipping industry does not use offsets, but will connect two or more ports that both have net zero emissions. The aim is to have six green corridors by the middle of this decade and scale up from there, with hopefully many more corridors by 2030. The Clydebank declaration talks about very large projects that would facilitate the production of zero emission fuels, pulling in private financing. However, island states at the end of trade routes need to not be disadvantaged.
Ammonia and hydrogen will be the clean shipping fuels of the future, and there are plans underway to make these green corridors viable via investment in new infrastructure. This initiative is helpful to investors seeking to invest in this sector as a transition play.
Decarbonising the shipping industry helps to decarbonise every other sector as it is absolutely key to the global economy. We expect the sector to change significantly in the next few years with the majority of the 90,000 ships in service needing to be replaced with zero emissions vessels. That’s a lot of steel, which highlights the importance of the next theme.
Industrials - the carbon-sectoral agreement on steel
Two announcements pushed industrials up the agenda. Metals are key to decarbonisation and so the progress made on developing the world’s first “carbon-based sectoral arrangement” on steel and aluminium trade is encouraging.
The EU and the US announced the world’s first “carbon-based sectoral arrangement” on steel and aluminium trade by 2024. (Low carbon steel is also an area of focus for a newly launched coalition of more than 40 countries - the Breakthrough Agenda - that aims to rapidly scale up climate technologies). The bilateral arrangement appears to be a stop gap to a fuller border adjustment mechanism that would prevent carbon leakage arising as a result of the import of carbon intensive steel from jurisdictions without a carbon price.
Furthermore, the Glasgow Financial Alliance for Net Zero (GFANZ) also named steel as a “priority” sector for engagement due to its importance and the UK, Germany and Canada unveiled plans to create demand for low carbon steel, cement and concrete. Taken together with targets for greening public procurement, these initiatives should lead to a material uplift in the demand for low carbon materials.
We believe this increased focus on the steel sector will have a number of implications for markets; firstly it should facilitate the issuance of green instruments and support strategic shifts for companies in the sector; secondly it will result in relative outperformance of cleaner steel production (such as that which uses Electric Arc Furnaces). It should shift the field to favour certain steel companies, for example those which focus on steel made from scrap.
Energy - coal stole the limelight
The energy sector currently accounts for 84% of emissions from fossil fuels, of which 1/3 is coal. COP discussions were almost entirely focused on coal - 40 countries signed a pledge to halt investment in new coal, probably one of the biggest statements to date but China, India and the US were not signatories. In the US, the economic and technological argument against coal has been won, but 24 new coal fired power stations have been approved in China this year alone.
Gas was notable by its absence. It has been proclaimed by some as an easy transition fuel, and gas has taken over from coal in the US. We don’t yet know how to take coal off the system without using gas as we saw when we needed to balance the grid recently in Europe. There was much less discussion around the removal of oil, perhaps in recognition that the energy system is so complex, it is better to focus on the easy near-term win of declaring the death of coal.
Carbon capture and storage was pretty low key - it divides opinion, but it is the only near-term solution for hard-to-abate sectors. However the US administration made a strong statement that it is looking to support large scale carbon capture projects in the Gulf of Mexico. The agreement around Article 6 means there is now a global framework for a carbon offsets market which should, alongside emissions regulation (and taxation), help put a price on carbon, and make investing in CCS economic. We could see different carbon prices for different parts of the world.
On the back of the conference, utilities and strong transition stories look attractive. Recent volatility in the rates market has left some value on the table.
Just as COP got underway, the Net Zero Asset Managers initiative (NZAM) released a progress report which for the first time shows how asset managers are measuring, targeting, and implementing their net zero strategies. NZAM represents 220 firms responsible for c60% of global AUM with a commitment to net zero investment (halving of portfolio emissions by 2030 (scope 1 & 2 initially, but scope 3 soon to follow). This has potentially huge implications for the pricing of assets since it will steer investors away from high carbon sectors.
Members of GFANZ presented a new financing roadmap that shows the private sector needs to fund around 70% of the US$2.6trn of global annual decarbonisation investments required to meet net zero goals through 2025, of which half comes from corporates. GFANZ is also leading efforts to accelerate capital flows into developing regions. This demonstrates why the annual US$100bn commitment to developing countries is such a high priority (which is getting closer to reality with Japan’s latest pledge). Implications here are (hopefully) for additional support for the green bond market and financing of decarbonisation efforts.
Almost 90% of global emissions are now covered by a net zero target, but there is a lack of tangible action from the nations that matter. China, India, and Russia are missing from both the coal phase-out agreement and the Global Methane Pledge and, as highlighted by Carbon Action Tracker, current NDCs only put us on course to achieve 2.4 degrees.
The UK Met Office has warned that 1 billion people will be affected by extreme heat stress if the climate crisis raises the global temperature by just 2C. That includes heating to the point that the human body cannot cool itself by sweating and even healthy people sitting in the shade will die within six hours. Meanwhile, parts of the world are already in danger from existing climate impacts. Therefore, in the wake of some but still insufficient progress at COP26, attention is turning towards embedding physical climate risks and adaptation measures within investment decision-making.
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