Managing the net zero transition

Capital at risk. The value of investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Summary

The transition to decarbonize the world is happening. Whether it achieves its goal of net zero carbon emissions by 2050 is far from certain. What is clear: Ignoring the transition is no longer an option. Understanding how the journey will unfold in years to come has never been more important for companies and investors alike.

Climate risk is investment risk – and will be determined by how the transition to a net zero economy unfolds. On top of physical climate risks, companies and asset owners must now grapple with the transition. Economies will be reshaped as carbon emissions are cut. The transition will involve a massive reallocation of resources. Supply and demand will shift, with mismatches along the way. Value will be created and destroyed across companies.

The transition is happening, and companies and investors need to have a view on how it’s evolving. Companies must decide how to revamp their business models, where to invest and what operations to phase out. Asset owners must decide where to put capital to work, and how to use their shareholder votes to try to guard their long-term economic interests.

Companies and investors are faced with great uncertainty. The transition is underway, but its future speed and shape are deeply uncertain. The outcome will be determined by an intricate interplay of evolving societal preferences, company strategies, capital allocation, new technologies and government policies.

The energy sector faces the starkest and most acute challenge. Its transition has so far been lopsided, with extra investment in renewables failing to keep pace with reduced capex in fossil fuels. This mismatch has contributed to energy price spikes in the economic restart, giving a glimpse of what a disorderly transition could look like. The outlook for renewables is bright, and we see a need for lower-carbon fossil fuels to meet global energy demands during the transition.

The transition’s value creation and destruction is being priced. We expected two years ago that a tectonic shift toward sustainability would trigger a great repricing of assets across the board. This is why we incorporated climate change in our return and risk assumptions. We now have evidence of this repricing, and believe most of it is yet to come.

The path of transition will shape the macro environment. A gradual, orderly transition, supported by private capital and public aid for emerging markets, should allow for a relatively smooth reallocation of resources and moderate price increases. A sudden, disorderly transition raises the risk of supply-demand mismatches, inflation spikes and growth disruptions.

The popular notion that tackling climate change comes at a net economic cost is wrong, in our view. Will the transition hurt growth? Will it trigger more inflation? Compared with the past, yes. But the rear-view mirror is irrelevant for what’s ahead, we believe. Climate change is real. An orderly transition should boost growth and mitigate inflation versus no climate action or an eventual rush to decarbonize, in our view.

Our bottom line: Companies and investors cannot ignore the transition. It’s similar to how they had no choice but to deal with China’s economic rise and the tech revolution. All companies and investors must navigate the way economies are being re-wired by taking a view on how the transition will shape their operations or investments. Some may choose to drive the transition via thematic or impact investments or invent the net zero world by funding new technologies.

¹ This research is for institutional, professional clients and only for end-investors in the U.S., Canada, Hong Kong, Singapore and Australia.

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