Green or brown? Why the colour of the recovery matters to investors
Green or brown? Why the colour of the recovery matters to investors
Carbon dioxide emissions dropped substantially as global economic activity collapsed as a result of the Covid-19 pandemic.
The International Energy Agency (IEA) estimates that annual global CO2 emissions are expected to fall by around 2.5 gigatonnes (Gt) to just under 31 Gt, around 8% lower than in 2019. This would be the lowest level since 2010.
Total primary energy demand is expected to contract globally by around 6% this year, amounting to a shock around seven-times larger than occurred during the 2008-09 financial crisis.
However, emissions tend to move hand-in-hand with macroeconomic activity and so they are expected to bounce back as the recovery gathers momentum. After all, a brown recovery, in which we would continue to rely on fossil fuel for energy, is what’s happened after previous crises: but what if this time is different?
This could be the time for a green recovery
The pandemic may have significantly changed the outlook for the oil market. A great deal of demand for oil comes from the transportation sector and has been hit dramatically by lockdown measures which brought cars, trucks, trains and airplanes to a standstill.
Comments from the airline industry indicate that travel demand will likely remain depressed until there is a vaccine or treatment for the coronavirus.
At the same time, long-term structural pressure on the oil industry is likely to stay even when the pandemic eases. Amid concerns about the climate crisis and tighter regulation from governments to control emissions, the oil industry was already under pressure before the coronavirus outbreak.
After delivering strong returns at the beginning of the new millennium, the fossil fuel industry started to underperform the S&P 500 in 2014 on the back of plummeting oil prices (chart 1).
This trend is likely to continue given the ongoing downward pressure on oil prices from subdued travel demand and a potential shift to cleaner sources of energy such as renewables.
How energy companies are responding to the oil price shock
In recent months we have witnessed several write-off announcements from oil companies, suggesting that oil and gas worth billions of dollars may be left in the ground as a result of lower energy prices. But pressure to decrease carbon intensity and efforts to cut emissions are also playing a role. If this is the case, then even if oil prices recover so that extracting reserves becomes profitable, a large chunk of these assets could be left in the ground.
According to the Transition Pathway Initiative (TPI), a global asset-owner led initiative which assesses companies' preparedness for the transition to a low carbon economy, less than three years ago no European company had set targets to reduce the carbon intensity of the energy it supplied.
Today, all companies assessed by the TPI have set such targets. In addition, five major companies (BP, Eni, Repsol, Shell and Total) have recently updated their long-term climate ambitions. Repsol and Total are now aligned with the Paris Pledges scenario, and Shell now plans to cut its emissions intensity by 65% by 2050.
As in any challenging transition there will be winners and losers. As pressure on companies to address climate change is only likely to escalate, financial markets should begin to factor in the economic risks of the transition to a low-carbon economy.
In particular, any attempt to limit global carbon emissions is going to mean we have to reduce the quantity of fossil fuels we burn. Yet present valuations of energy companies, for example, implicitly assume that their energy reserves have future market value. If this changes, there will be consequences for equity markets.
As highlighted in our work on climate change and 30-year market returns, almost 60% of oil and gas reserves, and over 80% of current coal reserves should remain unused in order to limit the increase in global temperature to 2 degrees Celsius as established in the Paris Agreement. This may result in stranded assets, defined by the IEA as “those investments which have already been made but which, at some time prior to the end of their economic life, are no longer able to earn an economic return”.
Stranded assets is a key risk for markets
While oil companies have already written off a substantial amount of fossil fuel reserves in the face of the Covid-induced collapse in energy demand, our analysis highlights that a lot remains in the ground. Risks of a stranded assets scenario have not been priced in. We use MSCI data on companies’ potential emissions to find that the stock markets of countries such as the US, Russia, China and India could see a reduction in returns, should climate policies be implemented in a low carbon transition (chart 2).
As shown by our Climate Progress Dashboard, despite new emissions pledges, we are still far from meeting the Paris target. The pandemic could bring forward the peak of fossil fuel demand and discourage exploration. Structural changes are needed to accelerate the transition to a low-carbon economy. Only fiscal and regulatory policy can boost a de-carbonisation of the energy sector through reduced reliance on fossil fuels, increased energy efficiency, and increased use of renewables.
According to fDi Markets data, in the first quarter of the year while investment in the oil and gas industry declined dramatically, investment into renewable energy boomed, registering the strongest quarter in a decade. Even more importantly from a financial investor perspective, the renewable energy sector significantly outperformed the fossil fuel industry since the start of the pandemic (chart 3).
A green recovery could be stronger than a brown one
Finally, a green recovery, while being beneficial for the environment and reducing pollution, might prove to be stronger than a recovery in which the bounce back in activity is accompanied by a rise in emissions.
Recent research highlights that investment in clean energy creates three jobs for each job lost in the fossil fuel sector, and for each $1 million shift from fossil fuels to clean energy, an average of five additional jobs are created. It is important to highlight that this research focussed on the short-term employment effects of reducing fossil fuel production while boosting clean energy production. Therefore, as green energy is a relatively young industry, the decarbonisation of the energy sector is likely to involve significant increases in manufacturing and installation of renewable and efficiency technologies, providing a much needed support to employment at a time where governments try to reboot their economies.
- Outlook 2023, China: will a loosening of zero-Covid provide a spark?
- Podcast: What the energy grid of the future might look like
- Economic and Strategy Viewpoint - Q4 2022
- China’s latest Covid crisis, war in Ukraine: observations for investors
- Outlook 2023, US multi-sector fixed income: yields up risk down
- Seek expert help: how investors are responding to rising inflation
The views and opinions contained herein are those of the Authors, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested.
Schroders has expressed its own views in this document and these may change (to be used if the 1st statement above is not being used).
Issued by Schroder Investment Management (Europe) S.A., 5, rue Höhenhof, L-1736 Senningerberg, Luxembourg. Registered No. B 37.799. For your security, communications may be taped or monitored
The forecasts stated in the document are the result of statistical modelling, based on a number of assumptions. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today’s date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters change.