Climate Crunch

Climate Crunch: A closer look at the transition risks of net zero

Although most investors would agree that building a net zero economy is no longer an option, but a necessity, the transition could cause considerable disruption over the next five to seven years. These are the findings of a new report conducted on behalf of Pictet Asset Management by the Institute of International Finance.

The study – Climate Crunch: A closer look at the transition risks of net zero – identifies three specific transition risks that investors will need to attend to.

Chief among them is a surge in government debt: growing debt burdens are likely to have a negative ef­fect on the credit profiles of the many countries that are financially stretched in the wake of the COVID-19 pandemic, the report says.

Assuming governments continue to fund half of all the climate spending required globally, net zero investment alone could potentially add over USD50 trillion to govern­ments’ debt piles by 2030, and over USD215 trillion by 2050. This would account for over one-third of the pro­jected increase in government debt through 2050.

The second transition risk confronting investors is economic disruption. The laws and regulations designed to penalise carbon emitters – such as carbon taxes and the EU’s border adjustment tax – will inevitably add to the cost of doing business. Currently, carbon taxes are applied to less than 25 per cent of human carbon emissions. Extending their reach would likely increase input costs for almost every industry.

While companies may absorb some of that transition expense, much of it will inevitably be passed onto households in the form of higher prices for goods and services, the report says.

This could weigh on consumption and, ultimately, GDP growth. The IIF projects that real GDP could be some 1 to 4 per cent lower by 2030 under this scenario than would otherwise be the case. 

To begin with, investors should recognise that building a sustainable economy will inevitably involve continued investment in many of today’s carbon-intensive sectors.
— Evgenia Molotova, Senior investment manager , Pictet AM, responsible for the Positive Change investment strategy

A third side-effect of the net zero transition is financial market instability. Capital projects, particularly those directed in part by governments and state institutions, are always vulnerable to mismanagement. And the greater the amounts being invested, the greater the potential waste and damage. All of which means that the potential for capital misallocation - the emergence of asset bubbles on the one hand and unjustifiably cheap assets on the other - grows considerably. 

Evgenia Molotova, Pictet AM senior investment manager for the Positive Change investment strategy said: “None of this is to downplay the importance of the world’s commitment to net zero. It is vital to the world’s future prosperity. Yet the journey to a net zero economy is complex and fraught with risks. Investors face significant challenges – particularly in the initial phase of the energy transition – that could disrupt economic activity and financial mar­kets. Overlooking these threats could be costly. 

Investors with sus­tainability goals need to take a more pragmatic ap­proach. 

To begin with, they should recognise that build­ing a sustainable economy will inevitably involve contin­ued investment in many of today’s carbon-intensive sec­tors.”

Sonja Gibbs, IIF’s managing director and head of sustainable finance, said: “The world’s net zero ambition is vital, but will come at a high cost, meaning new challenges and risks for the financial sector. A successful net zero transition will require a radical change in production, consumption, investment, and trade practices, with the corporate sector playing a significant role in supporting this transformation. By understanding these challenges and risks, investors can play an essential and proactive role in encouraging and accelerating the transition to a sustainable future."

About the Institute of International Finance

The IIF is the global association of the financial industry, with more than 400 members from more than 65 countries. Its mission is to support the financial industry in the prudent management of risks; to develop sound industry practices; and to advocate for regulatory, financial and economic policies that are in the broad interests of its members and foster global financial stability and sustainable economic growth. IIF members include commercial and investment banks, asset managers, insurance companies, sovereign wealth funds, hedge funds, central banks and development banks.

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