Welcome to the first of Schroders' Green Macro Newsletters. Each quarter this newsletter will provide a roundup of critical news relating to the economics of climate change and the energy transition; links to Schroders' latest research as well as key reports from other organisations; and a look-ahead to upcoming key dates and events.

This quarter we focus on recent climate regulation and its impact on the investment and the economic outlook. We are seeing important steps in climate mitigation, and the response to climate change is set to accelerate on the back of increasing physical risks.

In the news

Climate mitigation is beneficial to the economy

The latest climate scenario analysis from the Network for Greening the Financial System (NGFS), a group of 116 central banks and supervisors seeking to enhance the role of the financial system to manage climate risks, highlights that the potential benefits from tackling global warming are set to offset the climate mitigation costs.

An orderly transition to net zero will largely reduce the physical risks of climate change and their impact on the global economy. Global GDP is estimated to be 7% higher in an orderly transition than under current policies, where physical risks are set to increase on the back of insufficient mitigation efforts.

Our view: An orderly transition to net zero requires a strong increase in carbon prices which would cause a rise in energy prices, hitting demand in the economy.

Recycling carbon revenues into government investment and lowering employment taxes will help limit the impact on the economy. Most importantly, the economy would see greater benefits by reducing emissions and avoiding the economic damages of global warming. The analysis also shows one important challenge in addressing climate change. The positive impacts of climate action are going to be tangible only in the medium to long term, while the impact of higher carbon prices would be quite visible through a rise in inflation. This creates a potential conflict with politicians’ agendas, who usually tend to focus on policies with immediate benefits that voters can see.

Net-Zero Industry Act: Council and Parliament strike a deal to boost EU’s green industry

In February the European Council and the European Parliament reached a provisional deal on the Net-Zero Industry Act (NZIA), a key regulation aimed at expanding clean energy technologies in Europe.

The NZIA is one of the three key legislative initiatives of the Green Deal Industrial Plan to support a rapid transition to climate neutrality. The NZIA wants to simplify permit-granting procedures and supporting strategic projects, setting a time limit of 18 months for delivering a permit for large net-zero technology manufacturing projects, and 12 months for smaller projects. The final list of technologies includes solar panels, wind turbines, fuel cells, electrolysers, batteries, and grid technologies.

The regulation also wants to enhance the skills of the European workforce in these technologies and promote the development of net-zero acceleration ‘valleys’, regional clusters of companies involved in a certain technology that will boost reindustrialisation while increasing the attractiveness of the EU.

Our view:  The IEA finds that delays resulting from complex authorisation procedures are one of the main challenges for renewable expansion, as they slow project pipeline growth. The EU NZIA is an important step in addressing this challenge as it is set to ease conditions for investing in green technologies in the continent, while providing more certainty to green energy investors. It shows Europe’s strong commitment to supporting the clean energy transition. It also represents an important reaction to the US Inflation Reduction Act (IRA), as the EU addresses the potential loss of competitiveness to the US and the risk of energy-intensive industries relocating overseas. The return of industrial policy in the EU is likely to boost competitiveness and productivity in the region, while strengthening its path towards net zero.

US economic growth and emissions diverged in 2023

According to a preliminary report recently released by the research provider Rhodium Group, US GDP growth continued to rise in 2023, while greenhouse gas (GHG) emissions shrank.

After two years of emissions growth, they estimate that emissions were down 1.9% y/y in 2023, while the economy expanded by more than 2% y/y. This is the largest decline in emissions since 2016, not counting the drop driven by the covid pandemic in 2020. The drop in emissions was driven by an 8% decline in emissions in the power sector, as coal production hit a new record low.

Our view: Breaking the link between economic growth and emissions is crucial to achieving climate targets without hurting the economy.

The drop in emissions is a step in the right direction for the US, but the country is still far from meeting its Paris target. US emissions are now down 17% from 2005 levels, while the US targets a 50-52% reduction by 2030. According to Rhodium Group's estimates, US emissions must now drop 6.9% annually between 2024 and 2030 for the US to meet its 2030 target, a big acceleration from the 2023 drop. The study also reveals that coal production dropped thanks to cheaper gas prices compared to coal since 2022 favouring a coal-to-gas switching in the electricity sector.

A reversal of gas prices in the medium term could undermine emission reductions. Renewable development made a positive contribution to the reduction in emissions, but faster clean energy expansion is needed to permanently break the relationship between economic growth and emissions. While the IRA is promoting green investment, it takes time for the clean energy additions to come online, as there are still some market challenges that need addressing. Supply chain constraints, grid constraints and connection queue backlogs are responsible for important project delays for renewable technologies. Overcoming these barriers will require stronger policy efforts and more climate regulation.

The US IRA is working for EVs

Recent research from the Clean Investment Monitor, a joint project of Rhodium Group and MIT’s Center for Energy and Environmental Policy Research, found sales of electric vehicles (EVs) in 2023 came in near the top end of the range of projected sales for the year, thanks to the green subsidies of the IRA.

Around 1.4 million EVs were sold in the US in 2023, registering an increase of more than 40% compared to sales in 2022. These sales account for 9.2% of total light-duty vehicle sales last year, up from 6.8% in 2022 and 2.2% in 2020 as shown in the chart below. Actual sales dramatically exceeded projections from a few years ago. In 2020, for example, the Energy Information Administration’s forecast for 2023 EVs sales was for just 500 thousand.

Our view: The data provides clear evidence that the IRA tax incentives are working and speeding up the penetration of clean technology, at least for the transportation sector. EV deployment is on a path that is consistent with the IRA’s 40% emissions reduction objective. This evidence should offer some reassurance to clean tech investors, as it comes against a number of headlines that were pointing to slowing momentum for electric vehicles. While the EV market in the US is expanding, China is still the largest market for electric cars. In 2023, electric car sales in China reached over 8 million, representing almost 60% of global sales.

China is set to keep dominating clean energy manufacturing production

According to the Renewables 2023 report of the International Energy Agency (IEA), the global amount of renewable energy capacity expanded by 50% in 2023, recording its fastest growth in the last 20 years.

Renewable energy capacity reached almost 510 gigawatts (GW), half of what is needed to meet the global goal of tripling of total capacity to 11,000 GW agreed at COP28. While the rise in renewable energy capacity hit an all-time high in Europe, the US and Brazil, China saw the largest growth as the country commissioned as much solar PV in 2023 as the entire world did in 2022.The IEA forecasts that China will meet its 1 200 GW of cumulative solar PV and wind capacity target by 2030 this year, six years ahead of schedule. China’s renewable energy capacity over the next five years is set to grow by more than 200% compared to the previous five, accounting for almost 60% of global new renewable capacity by 2028.

Our view: China is set to continue to play a key role in the global energy transition. While developed countries, like the EU and the US are showing a renewed focus on industrial policy to boost domestic clean energy manufacturing, China is expected to retain its global leadership in the sector. More policy efforts from the EU and the US are required to attract new green energy capital. Intensifying Chinese competition for clean energy technologies could put manufacturers at risk in developed economies, where cost pressures are higher.

European tariffs on Chinese exports of EVs are looming

The EU accounts for almost 40% of Chinese exports of EVs and the region represents their top destination. Chinese EV exports to the region rose 37% y/y in 2023 to $13bn.

The European Commission has launched an anti-subsidy investigation into the imports of EVs to determine whether EV value chains benefit from illegal subsidisation from the Chinese government. The bloc looks set to apply retroactive tariffs to protect European EV makers from unfair competition. 

Our view: The Chinese EV market share in the European bloc has grown dramatically over the most recent years, leading to higher concerns from European states and domestic carmakers, as Chinese companies, helped by state subsidies, could sell their vehicles at artificially lower prices in the EU. Raising tariffs could be seen as a protectionist move from the Chinese government and could mean higher geopolitical risk between the two countries. It is also important to note that so far, the US has successfully shielded itself from Chinese competition in the EV market as the US places a 27.5% tariff on Chinese-made car. 

Our economic sustainability publications

Long-run asset class performance: 30-year return forecasts (2024–53) – January 2024 
 

• Our central case is the Delayed Transition scenario, where there is a disorderly transition to net-zero with carbon pricing only starting to rise from 2030. 

• In 2024, we are expecting higher returns across most asset classes in real and nominal terms, particularly among the fixed income markets. 

• The impacts of climate change on asset returns are uneven with winners and losers in different geographies. Despite the substantial downgrades in emerging market returns from the incorporation of climate change, they are still expected to deliver higher returns than most of the developed markets. 

The heat is on: how investors are underestimating physical risks of climate change

• The scale and pace of change required to stave off the worst impacts of global warming will be more disruptive and costly than expected.

• Climate scientists have long warned that we must limit global warming to 1.5°C to avoid triggering climate tipping points and stave off the worst impacts of climate change. Data from 2023 shows it was the warmest year on record, and by a considerable margin.

External economic sustainability research

Is the Paris Agreement Working? A Stocktake of Global Climate Mitigation, IMF – November 2023 

• Several countries are making good progress on climate mitigation, but the world is still not on the path to reach net zero. Current National Determined Contributions (NDCs) would cut emissions by about 11%, which is much lower than the 50% reduction in emissions required to meet the 1.5°C target.  

• In particular, today’s carbon prices are too low. The global average carbon price is only $5 per ton, significantly below the carbon price of $85 that is needed to limit global warming to 2°C. 

• Investment is also not progressing quickly enough. To achieve net zero by 2050, public and private investment in climate mitigation would need to increase from $0.9 trillion in 2020 to $5 trillion annually by 2030. 

• Policymakers face difficult trade-offs when addressing climate change as policy action could send debt to unsustainable levels, while the lack of mitigation policies will lead to large costs for the economy on the back of higher physical risks. Carbon pricing is an important and necessary tool in climate action, as it generates revenues while discouraging emissions, helping reduce these policy trade-offs. 

• Relying on spending measures, such as increasing public investment and subsidies for renewable energy to reduce emissions will become increasingly costly, with the IMF estimating public debt to rise by 45% to 50% of GDP by mid-century.  

European Electricity Review 2024 – EMBER 

• Recent data show the EU accelerated its move away from fossil fuels in 2023, with coal and gas dropping to new low levels. That caused emissions in the power sector to decline by a record 19% y/y. After peaking in 2007 power sector emissions have now dropped 46% since then. 

• Coal generation fell by 26% y/y in 2023, and now accounts for just 12% of the EU electricity mix. The structural decline of coal is expected to continue as 20% of the remaining coal fleet in the EU will shut down in 2024 and 2025. Gas generation fell by 15%, dropping for the fourth year in a row and recording its largest decline since 1990. 

• In the meantime, the share of electricity of renewables increased to a record 44%, with wind and solar being the main drivers of the rise. They generated a record 27% of electricity in 2023 and reached their largest ever annual capacity additions. More importantly, wind produced more electricity than gas for the first time as shown in the chart below. Renewables need to grow faster if the EU wants to achieve its 2030 target of 72% as proposed in the REPowerEU plan. 

• Lastly, while supply chain constraints and higher interest rates are putting price pressure on the renewable energy sector, data shows that the levelized costs of electricity for coal and gas is higher than wind and solar, with new build wind and solar projects remaining cheaper than new build coal and gas in the EU, as fossil fuel prices are still higher than pre-energy crisis levels. 

What’s coming up

EU Parliament is up for elections – prospects for stronger climate action are not good 

EU citizens are set to elect a new parliament in June. A recent study commissioned by the European Council on Foreign Relations think tank highlights that the upcoming election could deliver more seats for populist, right-wing parties, while centre-left and green parties are set to lose votes. This major shift could represent a major challenge for EU’s commitment to reaching net zero as would be harder to get backing for climate change policies. Far-right lawmakers have been sceptical of climate policies and could limit the EU’s actions to speed up the green energy transition, undermining the EU’s Green Deal framework, increasing uncertainty among clean energy investors.