Guy Cameron, CIO of Cameron Hume, says more pessimism in the bond markets might be a positive sign investors understand the scale of the climate change challenge.
Climate change has long been a divisive topic. Although we are now much closer to achieving consensus on the existence of climate change and the impact it will have on our planet, what needs to happen to address it is still the subject of great debate. This is a debate that will take centre stage at this year’s COP26 in Glasgow.
One side of the argument will be championed by the US Special Presidential Envoy Climate, John Kerry. He declares himself an optimist and believes human creativity and our self-interest will guide us to a successful transition to net-zero.
While it may be comforting to listen to optimists, optimism will not save us from the impact of climate change. We must be positive; we must take positive steps to reduce greenhouse gas (GHG) emissions in order to cap the rise in temperatures. This means managing a successful transition to net-zero emissions and for that to happen the nature of economic activity will need to change. The result of this will see winners and losers. Some countries and companies that will be economic losers may be encouraged to make changes for the greater good.
Positive pursuit of opportunity
John Kerry is right, however, when he says that a successful transition to net-zero depends on human creativity and self-interest. This is why climate change is an investment issue. On one side there are opportunities, on the other threats, but there also consequences in between, for the mainstream. Everyone is affected. The companies that will be the most successful are likely to be those whose management is positively pursuing opportunities, and managing the threats to their operations. In contrast, those companies whose management is simply ‘optimistic’ that human ingenuity will provide a solution, will be left behind.
Of all businesses, the oil majors are those most exposed to the risks posed by climate change. Some may prosper by transitioning away from oil and gas to embrace new energy production methods, but not every, and probably not even the average, oil major will do this successfully.
Yet, the bond market is optimistic. It does not distinguish between the oil majors and other companies in less-exposed sectors, with the same credit rating. If the bond market was pessimistic about the implications of a successful transition to net-zero, then the oil majors’ borrowing costs would be higher than other companies’ with same credit rating. In reality, our research shows that the difference is negligible.
The bond market also doesn’t distinguish between the oil majors that are taking positive steps to adapt, and the ‘optimists’ who hope that technological ingenuity will provide an answer. Surely we should distinguish between those seeking positively to diversify the source of their energy production, from those that instead apply their ingenuity to developing niche opportunities in lubricants for wind turbines?
Niche opportunities and individual projects will play a part, but as the Taskforce of Climate Related Financial Disclosures (TCFD) declared: “the large scale, long term nature of the problem makes it uniquely challenging”.
The main event
For investors, climate change is a mainstream investment issue affecting companies’ entire activities from upstream supply chains to downstream customers. Climate change is not a peripheral issue addressable by individual projects or products.
For John Kerry’s optimism to be realised, the composition of global activity will have to change. Companies will finance these changes by using retained earnings, equity capital and bond issuance. As always, investors will play their part if they distinguish between those who walk the walk rather than just talk the talk. Bond investors should be the first to step forward.
Some oil majors will thrive by successfully changing their businesses, some will stumble in the attempt, and the optimists may get lucky. Today the bond market does not distinguish between oil majors and less vulnerable companies. Nor does it distinguish between oil majors on the basis of their transition strategy or their competency to execute it. At Cameron Hume we don’t believe the risks and opportunities represented by those taking positive steps are identical those of the optimists who simply hope they will not have to.
The oil majors example is a special case of the issues played out across the whole market. Investors are attracted by exciting stories about transformational technologies that are just out of reach. As for the rest, the bond market tells the story. The livelihoods and prospects of generations of people will depend on achieving a successful, minimally disruptive transition to net-zero. Hope is rarely a sound basis for success and in tackling climate change we need to succeed. John Kerry can keep his optimism, but at COP26 we need to agree to be positive.