Disorderly outcomes cannot be ruled out, but scenario analysis models can help investors to measure risk.
As EU carbon prices spiked to a record high in February, investors may have been prompted to consider how carbon risk could impact their portfolios going forward.
Reuters reported that benchmark prices for European Union carbon permits rose above 40 euros per tonne, the highest price in the carbon market’s 16-year history.
While the spike was likely driven by a mixture of short-term bets and cold weather, EU carbon prices are also being boosted by the bloc’s plans to tackle climate change.
In this feature, ESG Investor looks at why investors may see a rapidly increasing carbon price in the future and how they can use scenario analysis to prepare for such risks. Next week, we’ll explore which strategies can help them to manage these exposures.
Will politicians ratchet up the carbon price?
A rising carbon price incentivises high-carbon emitting companies to decarbonise while stimulating clean technology.
But carbon prices have for a long time meandered around levels that have been deemed as insufficient to spur the low-carbon transition.
A group of economists convened by the Carbon Pricing Leadership Coalition estimated that carbon prices of at least US$40–80/tCO2 by 2020 and US$50–100/tCO2 by 2030 are required to cost-effectively reduce emissions in line with the temperature goals of the Paris Agreement, as noted in a 2020 World Bank Group report.
As of today, less than 5% of greenhouse gas emissions covered are within this range, with about half of covered emissions pricing at less than US$10/tCO2e, according to the report.
Carbon pricing initiatives have many forms, including carbon taxes, emissions trading systems (ETSs) and carbon crediting mechanisms.
The European Commission is expected to present a proposal for an EU carbon border adjustment mechanism (CBAM) in 2021 as part of its Green Deal to reduce the risk of carbon leakage.
A recently tabled EU Parliament resolution has suggested that, to prevent carbon leakage, effective carbon pricing under the CBAM should spell the end of free allowances under the EU ETS – as soon as possible but no later than 2023.
This would give carbon pricing a further boost in the EU.
In the US, after the election of President Joe Biden, allies have been crafting a proposal for a potential carbon tax, to help pay for an expected US$2 trillion infrastructure plan.
An inevitable future carbon push?
Richard Mattison, CEO of S&P Global’s Trucost, explains that the firm analysed the impact of a smooth carbon pricing scenario on the S&P Global 1200 by 2025.
“We found that the carbon price risks, the additional costs that [firms] would have to pay under carbon pricing or carbon tax regimes across the world, would be as much as US$284 billion, which is around 13% of their aggregate earnings,” he notes.
Mattison points however to the difficulty of forecasting the impact of a rise in carbon price precisely, as he expects that different levers will be deployed by jurisdictions.
Keeping global warming below 2 degrees would require that “the bulk of the transition has to take place within the next 10 years or so”, say Willemijn Verdegaal and Lisa Eichler, Co-Heads for Climate & ESG Solutions at Ortec Finance, a Dutch technology and solutions provider for risk and return management.
“It is unlikely that such a transition will happen without significant disruption,” they believe.
Delayed policy action could lead to a more abrupt and sudden rise in the price of carbon.
Nick Stansbury, Head of Climate Solutions at Legal & General Investment Management, tells ESG Investor the world is probably on track for 2.5-3.5 degree global warming by the end of the 21st century.
“We are still on a pathway to failure at the moment. The longer we remain on that pathway, the greater the probability that we [see] a disorderly rather than an orderly 2-degree scenario,” Stansbury says.
Yet, he explains that a four-degree world is also unlikely, as there would be an “inevitable” policy response to avoid this outcome.
The Network for Greening the Financial System (NGFS), a group of central banks and supervisors, has built a set of reference scenarios on how to conduct scenario analysis.
Its orderly scenarios assume an emission price that is introduced immediately to limit the rise in temperatures to well-below 2 degrees by the end of the century. Most of its disorderly scenarios assume that such an emission price will be introduced after 2030, according to the NGFS 2020 Guide to Climate Scenario Analysis.
In case of a delayed policy response, the carbon price could see a sudden and sharp increase by US$100 per tonne globally, De Nederlandsche Bank (DNB) found in a separate transition risk stress test in 2018.
Stansbury comments: “It is in our interest as investors to do everything we can to advocate for support, to increase the likelihood of an orderly rather than a disorderly transition to a decarbonised world.”
Measuring risks with scenario analysis
Risk averse investors can apply scenario analysis to prepare themselves for transition risks.
Steven Sowden, Senior Investment Consultant at Mercer, cautions however that the relevance of climate scenarios depends on how much of the carbon price is already priced in.
A 2018 report by the Society of Actuaries, the global professional organisation for actuaries, showed that carbon risk has not yet been fully priced in by the stock markets in either Europe or North America. The report drew on analysis of a sample of 30 stocks from emission-intensive sectors.
But UNEP FI has pointed to broader difficulties in modelling scenarios.
“The forward-looking nature of climate risk assessments imply a myriad of assumptions, baselines, inputs and modelling choices that result in a great diversity of methodologies and tools available to financial institutions,” a 2021 report titled ‘The Climate Risk Landscape’ writes.
Paul Smith, Consultant for climate change at UNEP FI and the author of the report, explains to ESG Investor: “Investors should be able to understand the assumptions inherent in the scenarios used and in the analytical tool, so a methodology’s transparency is crucial to the user being able to understand and deploy the outputs in full knowledge.”
He also says that a forward-looking methodology to assess carbon risk in investment portfolios should include “an assessment of expected emissions and/or carbon lock-in that takes into account carbon budgets for a given scenario”, which not all methodologies currently do.
“With increasing granularity, costs will increase and data may be increasingly poor or unreliable, for example when looking at supply chains (scope 3 emissions) and adaptive capacity of investee companies,” he adds.
Smith recommends thus methodologies that combine top-down macroeconomic analysis with bottom-up approaches.
In terms of metrics, a survey by UNEP FI has shown that the most common output metrics are climate-related value-at-risk and expected value, even though forward-looking carbon-adjustments are increasingly being incorporated into other key risk metrics, Smith says.
Despite the challenges that climate scenario tools face today, UNEP FI states in another 2021 report that scenario analysis is “an essential tool for financial institutions in the assessment of climate risks and opportunities as well as the effective management and support of the low-carbon transition”.