UN-supported investor group finds large gap between stock-market winners and losers from “Inevitable Policy Response” to climate change

A collaboration between financial analysts and economists, “IPR: Forecast Policy Scenario” provides a high conviction, comprehensive and detailed picture of how the inevitable policy response to climate change will likely unfold in the real economy. It models how the global economy will be impacted by the forecasted policies . This new analysis shows how equity valuations could change dramatically as market pricing based on current stated policies responds to policy developments in train and announced by 2025 – providing a vital tool for investors.

It responds to fresh concerns that financial markets are overly reliant on business-as-usual outlooks – such as the International Energy Agency’s Stated Policy Scenario (STEPS) – that assume a limited policy response to climate change. Unlike other climate scenarios that are reverse-engineered from a pre-defined temperature goal – such as achieving well below 2°C – the Forecast Policy Scenario “works up” from a detailed, realistic and probabilistic assessment of policy and technology developments, taking into account current institutional and behavioural limitations.

Fiona Reynolds, Chief Executive of the PRI, said: “Businesses and investors default to the IEA’s STEPs as a convenient business-as-usual world. But as the realities of climate change catch up, social pressure mounts, and low carbon solutions get cheaper, it’s highly improbable that governments will be allowed to let the world sleep-walk into greater rises in temperature without being compelled into forceful action sooner. More than at any point, these triggers are aligning actors in a common direction – making some form of policy response inevitable.

“This response will lead to widespread market repricing, driving a wedge between winners and losers, within sectors and between them inside a five-year investor timeframe. These policy developments are already in train - yet our analysis suggests that only 2 percent of PRI signatories, which include the world’s largest investors, are prepared. Moreover, 93 percent of institutional investors themselves recognise the financial market is not pricing climate risk. This poses huge threats for assets and for the wider system. It’s also important to note that our forecast does not include other important risks, such as physical damage from climate change or the kind of financial contagion which often accompanies other major re-pricing events. This means that a repricing event by 2025 could be just the start of value loss from which some companies never recover. So it’s time to get real about policy risks coming down the line. And to help them capture the opportunities and avoid significant risks, investors need a realistic business outlook about how the future is most likely to unfold. This forecast will provide investors with an essential tool to inform strategic asset allocation.”

Jane Ambachtsheer, Global Head of Sustainability, BNP Paribas Asset Management, said: “The IPR results reinforce our conviction that investors should anticipate significant and potentially volatile ‘climate transition’ repricing in some parts of the economy and markets. By helping to establish investor confidence in an inevitable policy pathway, the IRP Forecast may actually enable a more orderly climate transition.”

Market level impacts disguise significant winners and losers

Overall, the analysis shows a significant risk to financial markets representing a permanent (non-cyclical) $1.6trn hit to the iShares MSCI ACWI ETF, or a 3.1% fall on current values. This includes a $2.1 trillion downside driven by demand destruction and rising carbon costs, and a $0.5 trillion upside from demand for green products and services. One in five companies are impacted by at least 10% in either direction. This may at first appear manageable.

But the financial impacts could be much greater. The impact could be 1.5 times greater if market re-pricing is delayed and occurs more suddenly in 2025 with new commitments dictated by the Paris Agreement’s ‘ratchet’ mechanism. This would wipe off a further $0.7tn and would likely result in increased volatility and fluctuations in risk premia. The impact in terms of feedback loops and contagion could present additional challenges.

Our forecast also does not include other important risks, such as physical damage from climate change or the kind of financial contagion which often accompanies other major re-pricing events.

Major winners and losers – across sectors and within them

In-depth analysis at a company and sub sector level shows that these headline market level numbers conceal the real story about which companies will win and lose in the low carbon transition.

The analysis modelled the financial impact on current valuations of companies within iShares MSCI ACWI ETF if re-pricing occurred today based on a realistic policy response to climate change occurring by 2025.

This revealed significant variations in financial upside and downside between and within sectors. It shows there can be winners even in declining sectors and losers in sectors where the overall impact is positive. The biggest impacts can be found in five key sectors: Energy, Automobiles, Utilities, Minerals and Agriculture.

Energy – faces significant downsides across the sector

The fossil fuel sector loses a third of its value, highest of any sector and the only sector which does not contain a significant share of winners

Greatest impact comes from squeezed margins driven by falling prices as a result of demand destruction

Companies engaged in coal mining could halve in value (-44 percent)

Coal profits are accordingly hardest hit (-64 percent) as thermal coal for electricity generation has reached its peak and declines rapidly by an average of 6 percent per year from 2025 to 2040 at which point it is virtually non-existent.

Oil peaks around 2027 and company profits from the fossil fuel see a -34 percent impact, driven primarily by a two-thirds decline in demand from vehicles with internal combustion engines between 2025-2050

Upstream players are hardest hit (-38 percent), relative to downstream (-29 percent) but even integrated oil & gas companies see negative impacts (-31 percent)

The ten largest companies in the integrated oil & gas exploration & production sector by market cap lose nearly a third (31 percent) of current value, or $0.5tn

Natural gas profits, which peak around 2040, fall by -29 percent

Manufacturers of solar & wind equipment buck the trend, with +169 percent increase in valuation

Automobiles – huge growth for companies poised for electrification, others left in the dust

Sales of internal combustion engine vehicles (ICE) decline rapidly, hitting zero in 2050, while EVs experience significant market growth, making up almost 70 percent of passenger vehicles by 2040.

This is driven by 2035 ICE sales bans in Western Europe and China, and 2040 sales bans in USA, Japan and other regions – and results in significant winners and losers in the sector

In value terms, the best performing 10 percent of companies experience 108 percent upside, and have on average 37 percent share of EVs

Meanwhile, the worst performing 10 percent of companies, which do not have an EV pipeline, experience 34 percent downside

Electric utilities – greatest gap between winners and losers of all sectors

By 2050, the Forecast Policy Scenario predicts 93% of power generated will come from low carbon sources, including hydro, solar, wind, biomass and nuclear

Small aggregate impacts on company valuation (-4 percent) disguise huge variations, driven by the relative emissions intensities within individual generation portfolios

The best performing 10 percent of companies (the top 7 companies) in the sector more than double their value (104 percent), thanks to an asset base that is 75% less emissions intensive than the sector average

By contrast, the worst performing 10 percent of companies (the bottom 7 companies), with an average emissions intensity more than twice sector average, see their valuations fall by two-thirds (-66 percent), due to increased carbon costs

Minerals and miners – demand surge for green products reorients mining sector valuations

As an emissions intensive sector, minerals mining experience significant cost burden associated with carbon taxes such.

But growth in deployment of low carbon energy and products (such as renewables and EVs) leads to demand creation for ‘green minerals’ such as cobalt, copper, lithium, nickel and silver (ore).

The best performing 10 percent of companies in the sector experience an average uplift of 54 percent, and on average have a 53 percent of green minerals share of sales

The worst performing 10 percent of companies, with minimal share of green minerals sales, see their value halved (-49 percent)

Agriculture - shifts in demand favour greener agricultural products, while legal, market access and consumer boycott risks threaten the value of companies associated with unsustainable practices throughout the supply chain

Agricultural companies with high exposure to sustainable biofuels and production of non-beef protein sources, for which demand is growing, experience gains of at least 10 percent of current value. Those companies heavily exposed to sectors in decline, such as cattle, lose more than -15 percent.

For heavily exposed upstream and midstream producers of critical products (like soy, beef and palm oil) in at-risk jurisdictions (like Brazil and Indonesia), the potential value loss could increase to as much as 35 to 43 percent owing to additional legal liabilities, loss of market access, and consumer pressure

For downstream food and beverage companies, emerging data about supply chain exposure to deforestation suggests that the potential value loss from these compounded risks could be up to -15 percent.

In terms of emerging investment opportunities, the analysis shows that afforestation and reforestation opportunities emerging from the IPR could create new assets worth roughly $2.8tr in discounted NPV terms. Although not yet part of the universe of listed companies, investors may want to consider ways to gain exposure to such opportunities.

Concealed risk within conglomerates

Many of the world’s largest companies are conglomerates, with activities across many sectors that may contain significant climate risk even if their primary sector for industry classification is not a high-risk sector. The report suggests equity analysts should look more closely at a company’s different business units.

Significant variations in company valuations due to where they are based

Regionally, the analysis shows that companies based in OECD countries experience a moderate drop (-2.5 percent) while those outside of the OECD experience greater demand destruction and lower demand creation, facing negative impacts twice as large (-4.3 percent). The greatest variations in valuations can be found in highly diversified markets, such as the US which sees the greatest range in impacts (-25 percent for bottom performers (10^th percentile), +1 percent for top performers).

What this means for investors

Invest: investors can incorporate an IPR into investment processes, sector analysis to inform asset allocation, including identification of potential winners and losers. The IPR results enable investors to consider how well-positioned their portfolio is and encourages further analysis by investors to feed into investment decisions.

Engage: investors need to engage companies in sectors operating under business as usual on what their assumptions are and the extent to which they have factored in an IPR; asset owners need to engage managers and all players in the investment chain on what assumptions they are working to and encourage them to incorporate IPR-like thinking.

Policy advocacy: investors need to step up in pressing governments to act now, not later, on the Paris Agreement, including adopting the key policy levers identified in IPR. Investors can draw on the IPR policy levers and analysis at a regional and sector level.

Disclose: investors need to disclose how they assess climate risks, drawing on TCFD. Investors need to disclose on how their boards undertake forward-looking climate risk assessment to test the resilience of investment strategy, as per the TCFD recommendations. IPR offers a way to engage boards and apply forward-looking climate risk assessment, enabling good practice investor disclosure.

The Inevitable Policy Response has been developed by consortium partners UN PRI, Energy Transition Advisors, Vivid Economics, Carbon Tracker Initiative, 2-Degrees Investing Initiative, and Grantham Institute on Climate Change and the Environment. The project has been commissioned by the PRI with support from The Finance Hub, the Gordon and Betty Moore Foundation, KR Foundation, and ClimateWorks Foundation.

For more information, please contact Phil Drew, Amelia Pan, James Hallam, Ruairidh MacIntosh and Joseph Doyle at Brunswick on +44 (0) 20 7404 5959 / [email protected].