The Paris Agreement resulting from COP21 was kind of a big deal. It demonstrated the shifting political resolve towards addressing climate change and moving the world towards a low carbon future. As European Commission President Jean-Claude Juncker commented at the end of the COP, “today the world gets a lifeline…This robust agreement will steer the world towards a global clean energy transition”.
The financial sector will play a key role in delivering the economy-wide financial shifts required to maintain global temperature increases below 2ᵒC. For investors, this is particularly salient. Philippe Defosses, Director of French Pension Fund ERAFP, has said that ‘… the world has a shared vision that will lead inexorably to investors moving away from fossil fuels and towards a future powered by low carbon energy.’’ The Governor of the Bank of England, Mark Carney is one of many experts from the financial sector that share this sentiment. In September 2015 Carney clearly outlined the financial instability which is likely to arise from climate change if insurers, financers and the private sector as a whole do not take bold, forward-looking action.
How will the agreement impact investments, assets, loans and (re)insurance? What opportunities will it present? Here are five things to think about:
- There is increased financial risk associated with holding investments in the fossil fuel sector.This is not only because of falling oil prices, but also because of the stranded assets associated with investing in coal, oil and gas projects which are not financially viable in a low carbon economy future scenario. According to recent research, if atmospheric carbon dioxide levels are to be maintained below 450 ppm (the 2ᵒC benchmark), the amount of known fossil fuel reserves which are ‘unburnable’ amounts to$2 trillion worth of stranded assets.
- It’s likely there will be financial impacts from Paris on energy intensive industries (utilities, manufacturing, etc). Within the Paris Agreement, each country has legally committed to reduce emissions through a combination of legislative and fiscal measures. This is likely to include higher carbon taxes, higher standards of energy efficiency and more stringent energy and carbon reporting requirements. For example, the fourth stage of the EU ETS is to be agreed this year, and the UK’s fifth carbon budget (2028-2032) is to be confirmed by the end of June 2016. Both are likely to impact energy intensive industries (and therefore their investments).
- Investors should be starting to ask ‘which industries and companies are going to win and lose as the world transfers to a low carbon economy’. This process has already started. For example, the Task Force on Climate-related Financial Disclosures (TCFD) has been set up, with Michael Bloomberg as the Chairman. The mission of TCFD is to “develop voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders”. This builds upon initiatives such as the Montreal Carbon Pledge, through which investors commit to measure and publicly disclose the carbon footprint of their investment portfolios on an annual basis. Over US$100 billion has been committed to this as part of COP21, from investors including Aviva, HSBC Global Asset Management and BNP Paribas Investment Partners.
- The (re)insurance sector is critical too. Financial liabilities associated with physical assets will increase as the frequency and magnitude of climate related events (such as flooding, temperature rise, hurricane / typhoons) change. Europe’s largest insurer, Allianz, has estimated that climate change stands to increase insured losses from extreme events in an average year by 37 per cent within just a decade. The most vulnerable classes include physical asset insurance and weather derivatives. Locations most likely to be impacted include London, New York and Shanghai. It is likely that changes will need to be made to underwriting screening as well capital adequacy to deal with unexpected events.
- But it’s not all bad news for the financial sector. Paris and a ‘low carbon’ world brings investment opportunities too. The market for green investment is growing rapidly. Investments in renewable energy are growing exponentially, and are likely to do so even more in the future. A UNEP report exploring global trends in renewable energy investment showed that there was a 17% growth in investments in 2014, amounting to a total of $270 billion. In parallel, there is increasing interest in financial vehicles to help drive the required improvements in energy efficiency. For example, The Climate Bonds Initiative is seeking to mobilise $100 billion for the green bonds market this year. The Bank of America Merrill Lynch, amongst others, has already issued several high value green bonds, which have been used to finance energy efficiency projects such as LED street lighting across Los Angeles.
The Paris Agreement will bring both risks and opportunities to the financial industry. What these mean and how they manifest themselves for individual investors will depend on the portfolio mix and investment under management. What is clear is that investors, fund managers and (re)insurers need to review and assess their existing portfolios for climate change linked financial risks, and extend their investment screening to new ‘low carbon’ opportunities.