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Will the Global Stocktake move the ‘E’ in ESG?

Image: Markus Distelrath

Background

Today we live in a literal perfect storm where the macro forces of E (climate), S (living standards/inflation) and G (governance via political ideology) are duking it out in the fighting pits.

And when I refer to G, I’m not talking about board governance, rather I’m talking about the more important governance of sovereign states, wealth funds and geo-political interests.

Well, so far, the S and G appear to be winning against the E which continues to get punched in the face.

Why? A profound green lobby led underinvestment in all forms of fossil energy, plus the slow move to renewables and a big lag between the two has manifested in more demand for under-supplied fuels like oil, coal, and gas - and higher prices. Simple.

Since Russia invaded Ukraine, many governments have been busy recalibrating their energy/food security and critical minerals supply chains due to the worsening geo-political landscape. That has required sovereigns to fall back on fossil fuels.

And in doing this, the E has suffered. Even the President of COP28 recently went public with the following:

‘The world is losing the race to secure the goals of the Paris Agreement and the world is struggling to keep 1.5 within reach. Collectively, we must admit that we are not delivering the results we need in the time we need them’. Sultan Al Jaber, President COP25 and head of Abu Dhabi National Oil Company

But is this about to change? Will the first Global Stocktake that will occur at COP28 in November re-prioritise the E from an investment perspective?

Here are some different perspectives on the usual ESG narrative, and whether the Global Stocktake might be enough to move the environment above the competing agendas of stable prices/living standards, energy security and geopolitics.

The Global Stocktake (a ‘course correction’ moment)?

As a quick refresher, the Global Stocktake is the accountability ‘stick’ in the Paris Agreement that will be triggered for the first time at COP28 in Dubai in November 2023, and every 5 years thereafter.

Its function is to assess the collective progress of nation states in the journey to net zero, identify gaps and collaboratively work on solution pathways to get to net zero. You can access that and other information here.

So, what are the key aspects of this ‘recalibration’ tool?

  • Purpose: The primary purpose of the Global Stocktake is to evaluate the collective progress of nations in achieving the goals set out in the Paris Agreement. These goals include limiting global temperature rise to well below 2°C above pre-industrial levels and pursuing efforts to limit it to 1.5°C, as well as increasing adaptation measures and aligning financial flows with low greenhouse gas emissions and climate-resilient development.

  • Periodic assessment: The Global Stocktake is to occur every five years, starting in 2023, as stipulated by the Paris Agreement. This periodic assessment allows countries to review and adjust their climate strategies and commitments.

  • Data collection: Participating countries are required to submit detailed reports on their efforts and achievements related to emissions reductions, adaptation measures, and financial support provided or received. This data forms the basis for the stocktake.

  • Technical assessment: After data collection, a rigorous technical assessment takes place to evaluate the data's accuracy and the overall progress toward climate goals. Experts review the information submitted by countries.

  • High-level discussion: Following the technical assessment, country representatives engage in high-level discussions. These discussions provide an opportunity to share insights, highlight successes and challenges, and determine future actions.

  • Accountability and transparency: The Global Stocktake serves as an accountability mechanism, ensuring that countries are held responsible for their commitments. It promotes transparency by providing a platform for sharing information and learning from each other's experiences.

  • Challenges: Challenges associated with the Global Stocktake include ensuring the reliability of data submitted by countries, addressing disparities in the capacity of nations to provide detailed reports, and the non-binding nature of the Paris Agreement's commitments, which can make enforcement challenging.

Okay, so this stocktake is far from a panacea, and at best it’s a rubber stick with enough play in it to bury some inconvenient details relating to environmental commitments that are in any event, non-binding.

In saying that, here are a few scenarios (of many) that might play out.

Three potential scenarios (out of many)

As always, what we as investors and business owners want to know is how investment markets and governments (via policy response) will respond to events in 6, 12 and 18 months from now, so that we can position our businesses and investment portfolios now, to take advantage then.

Below I’ve ideated three simple scenarios of what might come out of COP28 and the Global Stocktake in November.

I’m not saying they’re exhaustive and I would point out that market responses can be complex and influenced by many factors, including government policies, public sentiment, and technological advancements. Also, there are scenarios I don’t contemplate due to time and space, as well as the unpredictable forces of creative destruction that will impact these and other scenarios, but I think they are good enough to stimulate some thought.

They are:

  • Scenario 1: The world is far from achieving the net zero goal, and achievement is highly unlikely.

  • Scenario 2: Achievement is possible subject to sufficient funding.

  • Scenario 3: No amount of money can achieve the 1.5°C goal due to time constraints.

Scenario 1 (Uncertainty): The world is far from achieving the goals, and achievement is highly unlikely

In this scenario, the stocktake and COP28 in general reveals that the world is significantly off track from achieving the climate goals set in the Paris Agreement and investment markets are likely to respond with a sense of uncertainty and concern. Key points of response include:

  • Market uncertainty: Investors and businesses dislike uncertainty, and the market is likely to react negatively to the lack of progress. This could lead to increased market volatility and fluctuations in stock prices, particularly for companies heavily reliant on fossil fuels.

  • Risk perception: Climate change poses long-term risks to various sectors of the economy. If it becomes clear that the world is not making sufficient progress, investors may perceive climate-related risks as more immediate and accelerate carbon-intensive industry divestments.

  • Renewable Energy opportunities: Conversely, renewable energy and clean technology sectors may still attract investment as they represent solutions (good or bad/right or wrong) to climate challenges.

  • Pressure on high emission industries: Industries with high greenhouse gas emissions, such as coal and oil, could face increased regulatory pressure and reputational risks, which might negatively impact their stock performance.

Scenario 2 (Optimism): Achievement is possible, yet conditional on sufficient funding

If the stocktake comes up trumps (albeit, unlikely) and COP28 generally indicates that the climate goals are achievable within the timeframe with adequate funding, the market is likely to respond with a mix of optimism and investment opportunities:

  • Investment optimism: The market could respond positively, with investors seeing opportunities in sectors related to renewable energy, energy efficiency, and green technologies. Companies aligned with these goals may experience increased demand and higher valuations.

  • Transition investments: Investment in carbon reduction and transition technologies, may attract substantial funding as it becomes clearer that the world is committed to achieving the climate targets.

  • Carbon pricing: The potential for stronger policies and carbon pricing mechanisms could impact the valuation of companies based on their emissions and encourage efforts to reduce carbon footprints. This could also make carbon response programs/assets more valuable. However, value will be a function of whether ‘free credits’ are oversupplied into markets as they were under the EU ETS in 2013.  

  • BRICS currency: The requirement for financing including in countries like Africa which are almost unbankable via traditional methods, might provide part of the explanation for why Brazil, Russia, India, China and South Africa will welcome the oil producing middle east into the bloc from January 2024, two short months following COP28. Although a BRICS currency has many hurdles to overcome the inclusion of these countries is timely because as demand for transitional fossil fuels continues to increase, denominating oil in a BRICS currency avoids currency devaluation. A BRICS currency remains to be seen.

Scenario 3 (Futility): No amount of money can achieve the 1.5°C goal due to time constraints

If the stocktake is a bust, and COP28 reveals that the 1.5°C goal is unattainable regardless of funding due to time constraints, the market is likely to respond with a sense of urgency and potential shifts in investment strategies:

  • Climate related investments: Investors may start to focus on adapting to the changing climate and mitigating risks associated with higher global temperatures, such as investments in resilient infrastructure, agriculture technology, and water management.

  • Carbon offsetting: Companies could explore carbon offsetting strategies more aggressively, which may create even newer markets for carbon credits and offset projects. Carbon offsets/assets may become more valuable.

  • Transition challenges: Sectors heavily reliant on fossil fuels may experience increased pressure to accelerate their transition plans. Some investors may accelerate their divestment from these industries, anticipating future regulatory changes and stranded assets. This could also lead to mass privatisation of high carbon business, particularly in coal and oil as institutional fund managers and governments withdraw support. This scenario has the potential to create a sub-class of dirty industries, which while desperately needed, take on a ‘big tobacco’ flavour while uranium once again becomes a wonder mineral.

  • Innovation focus: The market may prioritise investments in innovative climate solutions, such as advanced energy storage, sustainable transportation, and climate-resilient technologies as well as uranium fed micro-reactors.

Which scenario will win?

Will it be uncertainty, optimism or futility?

There’s no way to tell, but we know from various discussions in the lead up to COP28 and the actions of OPEC that the world is well behind targets and losing the battle.

As a consequence, scenarios 1 and 3 look more likely than scenario 2 at this time.

Wood Mackenzie recently published its energy outlook, and its position probably fits somewhere between scenarios 1 and 3 given it believes there will be many more decades required to get to net zero, and that won’t be at 1.5°C.

It also placed a US$72.9 trillion price tag ($2.7 trillion in real dollars over 27 years to 2050) on it, which is lower than the COP26 estimates of $100 to $130 trillion made by Mark Carney and Janet Yellen in November 2021, and Bank of America’s $150 trillion estimate three weeks earlier (here’s a refresher).

Here’s Wood Mackenzie’s current Base Case outlook:

In this scenario, Europe and the UK come close to reaching their climate goals but don’t quite get there in 2050. Globally, net zero arrives around 2070. The world fails to meet the Paris Agreement goals. This scenario corresponds to approximately 2.5˚C global warming by 2100. Wood Mackenzie. Energy Transition Outlook, 2023

One of the key problems to achieving these goals is that while there is some focus on decarbonisation, many industry executives and companies are prioritising global energy security and emphasising oil and gas production due to geopolitical concerns.

And because of that, and no matter which scenario we get, there are some common themes present:

  • Major dollars at a higher cost will be required to: (a) accelerate decarbonisation; (b) finance the steady requirement for oil, coal and natural gas supply during the green transitional period; and (c) restart old/build new nuclear reactors in many countries.

  • Whichever way funding is directed, almost all governments operate with deficits (or beyond their legislated debt limits) and will be required to borrow at potentially higher interest rates to support the transition. Spending will support higher rates for longer (to make government issuance attractive) and a higher USD for longer, which means the U.S. will continue to export inflation, commodity prices will likely rise again, and calls for a BRICS currency will get louder.

  • Geo-politics is now a massive macro factor and equally applicable to all three scenarios, and this may lead to some relaxation of fossil fuel bans/supply blockages and/or a better disposition towards nuclear power to ensure energy security. We are already seeing this reflected in the U3O8 price.

  • Governments are still fighting elections based on climate change and may find it difficult to approve new drilling, pipelines and spending levels given the effect fiscal spending will have on inflation, i.e., the S. Politically, this means an under supply of energy. Economically, this means higher energy mineral prices.

  • As there is still a long way to go under all of the scenarios, carbon emission allowances and carbon credits are likely to become more popular, but whether their value goes up will depend on whether carbon allowances are oversupplied like they were under the EU ETS in 2013.

At this time and after analysing these scenarios, it’s difficult to see the Global Stocktake making a material difference to the E. Rather, there are mounting social and geopolitical reasons for there to be more investment aimed at fossil fuels and nuclear energy, regardless of whether the Global Stocktake results in uncertainty, optimism, futility, or all of the above.

Investment markets

Under all scenarios the current predicament appears to provide a tailwind for:

  • Fossil fuel prices as well as producers, refiners, and support services particularly those with low debt/capex requirements.

  • Selective Renewable Energy projects that demonstrate high return metrics due to an increasing cost of capital.

  • Uranium prices as old reactors restart, and new reactors are constructed.

  • Battery mineral prices as well as producers/explorers.

  • Carbon asset demand and potentially prices, subject to scheme issuance.

  • Innovation in Agtech and Watertech.

  • BRICS development banking and China’s soft power aspirations along the new silk road.

However, given current monetary policy settings and geopolitics are acting as a sort of thermal wind for fossil fuels, the above tailwinds are likely to be supported for longer, and may ‘crowd out’ investment in more environmentally beneficial technologies unless and until monetary policy is relaxed.

The answer to today’s question?

No, I don’t think the Global Stocktake outcome (which is likely to cause uncertainty) will be enough to prioritise the environment above the competing agendas of stable prices/living standards, energy security and geopolitics; from an investment perspective.

Rather, the Stocktake will most likely accelerate conversations about the transition being longer and more expensive than expected, and hence create a thermal for fossil fuel and uranium prices to consolidate/ride higher for longer.

See you on those thermals.

Mike