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COP26: expectations of a turning point
The scale of the transition to a decarbonised global economy is enormous, writes State Street’s Richard Lacaille, but world leaders should look at the 19th and early 20th century roll out of railway systems for inspiration in transforming the energy system, he says.

As we turn our attention to the United Nation’s COP26 climate summit in Scotland, it is encouraging to see the goals of the Irish Road to COP26 programme are aligned with those of this critical international meeting.

The aim of increasing transparency of climate risk and a net-zero vision for Ireland by 2050 by encouraging broader adoption of the Taskforce on Climate related Financial Disclosures (TCFD) recommendations by Irish companies has put the country in a position to partner international efforts towards successful de-carbonization.
Richard Lacaille
Richard Lacaille

While significant challenges remain, what investors need to do in the coming years and decades is becoming clearer.

We know that the scale of the transition in terms of capital expenditure and technological development is enormous. However, there is precedent in the 19th and early 20th century roll out of railway systems, which eventually represented 63 percent of US stock market value (Elroy Dimson, Paul Marsh and Mike Staunton, Global Investment Returns Yearbook, Credit Suisse, 2021) granted the railway development in anticipation of the economic growth that would follow. World leaders could follow a similar path today to transform the energy system.

Divestment from fossil fuel producers might play a legitimate role in managing portfolio level risk, assuming that equity and credit markers have yet to adequately price the changes underway. However, a portfolio level ‘net zero’ is not sufficient in generating the capital needed to effect a successful de-carbonization. More emphasis must be placed on what we will invest in, rather than what we will disinvest from.

The uncomfortable fact about fossil fuels is that, if demand persists, listed, unlisted or state-owned enterprises will meet that demand. Eliminating the demand is the only way to guarantee emission reduction. Fiscal re-balancing by developed and emerging economies plays an increasingly important role, and political will should not be sapped by high profile public rebellions. Instead they serve as a reminder to make sure there is a just transition that does not create regressive taxes as a by-product of de-carbonization.

Developed economies have made significant progress towards carbon neutrality, and it is relatively easy to envision a sharp reduction in absolute emissions over the coming decades. Emerging economies have a significantly tougher job; rising populations together with the need to increase living standards, imply strong nominal GDP growth in economies that are at the most energy-intensive stages of their development. Newer energy generation systems, and de-commissioning the existing stock of assets may be prohibitively expensive.

Seeking to grant developing economies access to low-cost energy needs to be balanced against free trade agreements. Emissions reduction in one region or country might drive some heavy carbon industries offshore. This so-called carbon leakage problem could be dealt with by introducing carbon border taxes. These will be sensitive, but critical to negotiations, and may expose fault lines we have around the world.

It is therefore vital that the assistance promised by mature economies in 2009 at the UN climate summit in Copenhagen of USD 100 billion a year to emerging economies to help fund the transition to a low carbon world is not only delivered, but enhanced in ways that bring in additional private capital.

The Sustainable Markets Initiative, the Investor Leadership Network and others have identified both the problem, and partial solutions. Conceptually, it is simple: standardise elements in the initial stages of large-scale project development, partition the risks in ways that use the multi-lateral development banks (MDBs) more effectively, and you will see more private capital in both bonds and equity supporting emerging economies. Continue as we are and the steady increase will be well below what is required.

Technology investment will be one of the most fruitful areas of the transition. We are already beginning to see, through the prism of the pandemic, how rapid both the rate of innovation and more importantly the uptake of new technology can be. At the most trivial level, Zoom and similar systems had existed for years before the pandemic, but their near universal use by private individuals as well as businesses proves the potential for rapid adoption.

For example, the Energy Transition Commission predicts that globally, we are likely to need electrical capacity of 100 TWh by 2050. On the one hand, this is a single point of failure as the world has a total dependency on electricity generation. However, in technological terms, an extremely small increase in generation, storage or distribution efficiency has staggering economic value. Based on 2020 non-household electricity costs of 12.5 eurocents per kWh, 100 TWh would cost EUR 12.5 billion. Annualise this number and you get to some large numbers.

In the long term, our likely dependence on electricity will create a new generation of hard science-based technology innovations that could be the next big driver of returns for portfolio investors. And in much the same way as railroads, we may expect a turning point for investors where climate risk becomes opportunity.