Bold Climate Policy Is Coming. Investors, Take Note

A group of global investors foresees bold policy action on climate by the mid-2020s. What will such action, dubbed the Inevitable Policy Response, mean for capital markets and economies?

Principles for Responsible Investment, a London-based organization focused on socially responsible investment, has introduced a dramatic vision of a global response to climate change. PRI, which is supported by the United Nations and a consortium of global investors, believes that by the middle of the next decade national governments will be compelled to take major policy actions to address climate change.

The shift, which PRI calls the Inevitable Policy Response, will fundamentally reorient the global economy and drive investment away from industries that are dependent on fossil fuels, and toward less carbon intensive activities. The policy shift will come quickly, disrupting financial markets, and overriding the assumption that industry and economies will have time to gradually adapt to the pricing of climate risks.

Nathan Fabian, chief responsible investment officer with PRI, discusses the drivers, timing and economic impacts of an expected shift in climate policy.

Andy Stone: Good day and welcome to the Energy Policy Now podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone.

Recently, a global organization of institutional investors known as Principles for Responsible Investment, or PRI, introduced a dramatic vision of a global response to climate change. PRI, which is supported by the United Nations, believes that by the middle of the next decade, national governments will be compelled to take major policy actions to address climate change. The shift, which PRI calls the inevitable policy response, will fundamentally reorient the global economy and drive investment away from industries that are dependent on fossil fuels and toward less carbon intensive activities. The policy shift will come quickly, disrupting financial markets and overriding the assumption that industries and economies will have time to gradually adapt to the pricing of climate risks.

On the line to talk about this rapid policy and economic shift is Nathan Fabian, Chief Responsible Investment Officer with PRI. Nathan’s work focuses on sustainable financial markets and the expected economic impacts of an inevitable policy response. Nathan, welcome to the podcast.

Nathan Fabian: Thanks. Good to be with you.

Stone: So Principles for Responsible Investment, which is based in London, focuses on socially responsible investment. Could you tell us about the organization and its aims, particularly as they relate to climate?

Fabian: Thanks, Andy, the Principles for Responsible Investment is an investor association, which means it’s a group of investment organizations working together on responsible investment. And this organization has been running for around, almost 12 years now. And climate change is identified by our signatories as being the number one ESG risk and return issue that they are concerned about and that they want us to support them on in regards to their investment activities. So our job, one of our main jobs, is to help investors understand how climate change might affect their investments in future.

Stone: So who are PRI’s members?

Fabian: So they are the large pension funds, fund managers, some sovereign wealth funds, and family foundation investors around the world. There are over 2000 signatories to PRI. And the amount of assets that they manage is now over 80 trillion U.S. dollars. So this is most of the private savings in the global market, through these organizations, and our signatories to the PRI. So the organization was started by the UN. But we’re lucky, in a way, that we have the independence to operate as an investment industry group, but with UN support for our mission. And so although the UN endorses the activities, it’s really the investment organizations that are driving it.

Stone: And before we go any further, I want to ask you, what is your role at PRI?

Fabian: So I’m the Chief Responsible Investment Officer. And what that means is that I, with my team, assist investors to understand how they can invest responsibly on ESG issues. And that, in practice, means that we provide guidance, and tools, and collaborative platforms and research to help our signatories bring ESG information into their investment practices. And that means around investment allocations, around their active ownership, or their stewardship of companies. And we also work to bring these ESG issues into financial policies and regulations by governments. And that main thing means things like specifying ESG issues in pension regulation, in disclosure rules for companies and for investors, and in market mechanisms that often run through lists and share markets, for example, like stewardship codes. So our role is to prepare information and then provide this to our investors to help them do this integration in their investment activities. 

Stone: And just to clarify, ESG stands for environmental, social, and governance. Those are the issues that you’re concerned with?

Fabian: Yeah, that’s right. ESG stands for environmental, social and governance issues. And that last one mostly means corporate governance. So the ways in which risk and strategy are managed inside corporations, but this also flows through into the way that investors govern their own risks, and often around ESG issues.

Stone: PRI has put forth the concept of inevitable policy response which describes the point in time, which you believe is not far in the future, when governments will implement climate policies that are much stronger than we see today. Can you tell us about the basic idea of the policy response and the macroeconomic shift that you’d see taking place?

Fabian: The basic idea is that higher levels of warming, say, above two degrees of warming above pre industrial levels, and the extent of climate change that results from that, will ultimately be very disruptive for economies and for investors. And so if you see that risk, if you see that there is disruption from climate change in our future, it becomes feasible to understand that governments, and industry, and investors might want to intervene to prevent the worst effects of that climate change. And so the basic idea is that, as soon as it becomes clearer to the policy community, to the corporate community, that we’re heading off track, that we’re heading towards too much warming, that there will be, what we call, an inevitable response, using policy mechanisms to drive emissions down lower.

And unfortunately, because we’re already heading in a very high emissions trajectory, and the prospect of above two degrees warming seems extremely likely at the moment. When that response comes, that policy response comes, it will have some of its own disruption. The reason policymakers will consider it is because they’ll believe that intervening with policy measures and causing some transition, disruption to a lower carbon economy will ultimately be less disruptive, or not as bad, as waiting for higher levels of warming, which could be much more disruptive for economies and investors.

Stone: So the longer we wait, the more expensive it will be, the more disruptive as you just said, it will be. It’s interesting. In in the development of this whole idea, you put a very specific date on it. 2025. Can you tell us why that’s such an important date when the policy response is expected to happen?

Fabian: Yeah, so there’s a couple of reasons why we think the mid-2020s are really important. And it’s worth noting that this is a scenario, this is a view of the future. And so the precise timing is not definite. But there are some pointers to 2025 being quite important.

So, the first is that we have a global agreement in place that is tracking emissions performance by countries, and there’s a requirement for countries to disclose, even if there’s not a requirement for companies to reduce their emissions. And so, there is what’s called a ratchet process built into the global agreement on emissions..

Stone: That’s the Paris Agreement? 

Fabian: That’s right. And every five years, there’s a global review, a stock take. And a preparation to tighten or reduce the emissions targets for each of the countries signed up to that agreement.

Now, our view is that it’s already becoming evident, that the global stock take, that will shortly commence for 2020, is going to demonstrate that there is an underperformance on emissions reductions, that were lagging the reductions that should we should make and they were agreed when the Paris Agreement was first made. And internationally, especially because of the position of the U.S., progress on that ratchet agreement and the UN taking on deeper emissions reduction target is going to be very difficult in the next couple of years.

We then move out to the next ratchet period, a global stock take leading up to 2023. And our view is by that time the gap, between the necessary emissions reductions for well below two degrees under Paris and the actual emissions, will be really clear. And we’ll be dealing with potentially a new political situation in the United States. And a clear gap, a clear underperformance inemissions reductions. And we think that’s the point at which industry and governments and investors are starting to say, unless we bring on some level of policy intervention here, unless we bring on some level of disruption now, we’re going to be dealing with a much deeper disruption later on.

There are some other trends that are contributing to this at the same time. We know that technological developments are reducing the costs of transition to a lower carbon economy and the level at which costs are reducing every year means that in eight years time,  seven years time from now, we should be having even lower cost of policy intervention than today. And secondly, it’s becoming clear that public awareness of the physical impacts of climate change are increasing.

And there is much more reporting today, there’s much more sensitivity from the public. And events like the publication of the IPCC report with a 1.5 degree analysis in October, just recently demonstrates that the concern, the response to that report, demonstrates that the concern in the community is rising. We think that’ll put extra pressure on policymakers, political pressure, at the same time that industry and investors coming to this point of wanting to avoid deeper disruption later.

Stone: One related question, this is very much focused from the perspective of policy driving this change, policymakers implementing more ambitious climate policies to address the ambition gap that you spoke about. Are there other factors from industry or from the business community that could drive this? I’m thinking about, for example, insurers as they see certain investments, less insurable, would that also send a message that this economic response would happen?

Fabian: Yeah, insurance is a very interesting market because insurers have among the best data sources on the changing climate and the exposures, the financial exposures, in our global economy to a changing climate. And of course, the insurers will be able to forecast the financial risks that they will face if climate events increase in severity.

And the likely response to that, of course, is an increase in premiums, or, in fact, withdrawing insurance to certain markets. Which then raises an interesting question for governments and brings the economic pressure in. The question for governments will be, is there a role for the public purse for public finances, to take up some of the insurance price risk for parts of the community, this obviously puts enormous pressure on the public purse, or perhaps even worse, if insurers, if private insurers withdraw from ensuring certain types of property or transport infrastructure, will, again, the government’s and the public monies have to go into ensuring and protecting, or much worse even replacing assets, if they are damaged by climate events.

So this is a good example of how intensifying climate risk over time, leading to a potential withdrawal of private insurance services, puts additional public pressure or pressure on the public finances. And this is a type of pressure that would encourage governments to move a little earlier to bring on the transition rather than waiting for later.

Stone: What are the impacts that we’re going to be seeing on financial markets investments, from this whole process? It sounds like a pretty fundamental rewiring of the economy, as fossil related investments become more exposed and riskier. What will we see?

Fabian: Yeah, so we know that to keep warming below, well below two degrees, that we need to have net zero emissions in the economy in less than 30 years time from now. And so, it’s true that that means taking the fossil fuels out of the global economy or being able to capture almost all of their emissions through some kind of capture and storage process. So that is a massive transformation in economic infrastructure, and provision of services, for transport, for buildings, for agriculture, for manufacturing, for material sectors, and so you’re right, this is going to be a big transformation.

The risk for financial markets is in mistiming, or misjudging, this transformation and not building it into their investment strategies today. And so the International Energy Agency, for example, has this very interesting idea of a policy misread by industry. And it would say that to limit warming to around two degrees today, there is only a foreseeable $300 billion worth of stranded assets under that scenario but if there is a widespread policy misread, and the gap in emissions and the necessary reductions grows, causing a harder policy response later, then that stranded asset figure could be much higher across those emissions intensive sectors.

And so that’s the risk of financial markets, misjudging the long-term trend, assuming that they can time the exit of some of these assets and industries, and then finding themselves stuck in what is a potentially volatile economic transition driven by a policy intervention. And of course, that is not something that’s attractive to investors if they have long term liabilities or obligations to pay pensions, or annuities, over a long period of time.

Stone: What will the policy tools of an inevitable policy response be? Are we talking about carbon pricing or other means of lining economies with climate priorities?

Fabian: Economists will tell us that carbon pricing and taxes are the most efficient type of policy intervention. And that’s because they can be widely applied and they’re relatively transparent. And the market can trade and make decisions.

What we’ve seen is that governments have struggled with carbon pricing. And it’s often hard to connect carbon pricing regimes across different countries or different markets. And so, there’ll be other policy tools that we expect to get used a bit more deliberately. So, there are regulations that might require certain sectors to reduce emissions, or there might in fact be specific emission standards. So we’re requirement that a certain type of infrastructure like energy, for example, could only emit a certain level of CO2 or CO2 equivalent gases in the provision of their energy services.

And then, of course, you’ve also got supply side policies. And we’ve got to remember that there’s well over $600 billion of fossil fuel subsidies going to increase the supply of fossil fuels every year. It’s very likely that you see a reduction in the subsidies over time, which put price pressure on fossil fuel industries and make them less price competitive with other sectors. And so, that’s an area we’re likely to see more policy action in the future. In fact, it’s one of the few that a lot of the governments globally have jointly committed that they think they can bring back subsidies over time.

And then of course, you might see specific abatement requirements. So, an obligation to use certain technologies like carbon capture and storage, and the provision of land and physical space for the capture of those emissions in order to allow certain types of fossil fuel services to operate. And of course, the implication being if they can’t respond and provide those additional resources and technical capacity to capture those emissions that they won’t be able to operate.

So once again, carbon prices and taxes are the most efficient policy measures. And we think, even though they’ve been hard politically in the past, they start to become more attractive, if there seem to be applied to the emitting companies, and not directly on affecting citizens. But countries will use other measures where they have to compliment those price based policies.

Stone: What response have you seen from policymakers?

Fabian: So this is really an interesting question, because there’s a variety of responses around the world. We know that in California, and on the east coast of the U.S., at a state level, there is quiet aggressive, what I would call a strong or strident policies on disclosure of financial risk and obligations for corporations and investors to do a long term risk assessment and think about how climate transition will affect their financial position. These similar policies are being taken up around the world in Europe, in the United Kingdom, in China, we’re seeing the Japanese think about these policy responses.

And so in that area of policy reform in financial markets, I think it’s quite clear the direction we’re heading. It’s going to be more transparency, more long term planning, more risk assessment, higher obligations on directors and investors. So I think that’s quite clear on the actual pricing of emissions, or regulations to take assets out of the market, it’s a real patchwork of different policy responses globally. We know for example, in Europe, that there will very soon be a new long term climate strategy, which will have new climate policies and emissions reduction targets, that will have to be taken up by the 27 member states. We know that renewable energy policy, so incentives are favored in many markets of the world. Because you can increase the competitiveness and reduce the cost of renewable and low carbon energy sources. And these have been, although some controversy when they’re removed too quickly, broadly, these policies have been seen as being less controversial in carbon pricing. And so they’ve been favored in many markets.

So, as I say, we see different types of instruments used. And I think the other dimension to this question is the level of policy ambition. And, unfortunately, what we’re going to see in this first climate action stock take, around the Paris Agreement, is the level of follow through on the nationally determined contributions under the Paris Agreement, which is each country’s plan to reduce emissions, we’re going to see that the policies have not been ambitious enough. And so the gap that we think leads to the inevitable policy response is going to start to become very clear, even in the next few months.

Stone: In the report on the inevitable policy response, you outline three phases, and their impact on markets and investment. Can you explain that trajectory from the point that a response would be announced til it’s carried out and how that will impact markets?

Fabian: Yeah, we do see three phases. And the first phase is this pre-announcement phase that we’re in now. And it’s characterized by some uncertainty over the timing and the severity of the policies that might come in. And during this time, it’s really only the investors who are seeing through the inevitable policy response for a longer term outcome around energy transition, especially, who can start to take some steps in their portfolios now to reduce the risk.

But later on, you can as policymakers start to act, you come to phase two. And we call this a maximum volatility phase. And in this stage, we have governments undertaking different levels of policy intervention and causing disruption in markets in an attempt to bring down emissions in their markets and their countries and to force some capital reallocation in the private markets to less emissions intensive assets. During this phase, there’s a higher probability of assets becoming stranded, and countries really forcing some level of financial loss on their investors and their private companies.

And then the third phase, interestingly, returns more to a level of stability. And we call phase three, a stability phase in which the losses have been absorbed by the market. And the pricing signals are being set on a much longer term trajectory, meaning that investors at least will have some comfort on asset pricing going forward, but they will have already absorbed the portfolio losses. And the question then is, again, around the timing of IPR, the extent of those losses, if it’s an earlier intervention, the losses are less, if it’s a later intervention, the losses are much higher.

Stone: So Nathan, have we ever seen a similar dramatic policy response? In the past that may be instructive? Give us an example of what might be happening here.

Fabian: Well, the truth is that we have seen dramatic policy interventions in moments of national and global crisis. And if we think about pre-war mobilization of resources and efforts and public acceptance of a necessary level of policy intervention, there are some interesting parallels to draw. Now, we can’t overstate it. People won’t accept at this stage that were on a war footing on climate transition.

But it’s interesting to think about the fact that when the danger appears to be near term, and quite severe, which we expect to be evident on climate change once we get to the mid-2020s, or even more acutely, so if it goes on before there is a policy response. We expect the public to be more demanding a very strong policy interventions. And so we’ve seen that policy interventions that are very strong to cause a redirection of economic activity have happened in the past, and we believe it can happen again.

Stone: So what preemptive actions should investors take?

Fabian: Yeah, so investors can take action in their portfolios today. And although it’s not PRI’s role to provide specific investment advice, we do analyze the risks. And it seems to us that there are some high cost, high economic cost assets, that are also high emitting that are the most vulnerable to energy transition generally, but especially vulnerable in an inevitable policy response.

And so we, for example, conducted research with a group called Carbon Tracker, who identified well over $2 trillion worth of fossil fuels reserve assets, which would be priced out in a more rapid emissions reduction scenario. And so investors can identify these assets, we publish the database on our website. So it’s possible to identify these highly exposed assets and the companies that own them. The second thing is, investors should engage with the companies that they own, on their corporate strategies, and on their management of capital. It’s investor’s money after all. And so if companies are investing that money without an understanding of the transition that we believe is definitely coming because of increasing climate risk, then they’re not really being attentive investors to ensure that these companies have sound strategies and risk management plans in place. So understanding those companies strategies, especially for institutional investors. And if you’re a retail investor, who can’t really engage directly with a company very easily, then you’ve got to select your companies very carefully.

And then the third thing is, of course, to seek opportunities in low carbon sectors. Now, what we are going to experience in the coming years is a substantial reallocation of capital, from emissions intensive, energy intensive sectors, to low emissions, low energy intensive sectors and activities. And that doesn’t mean that an emissions intensive company today can’t change their business model, their technologies, and their services so that they make the jump to the future. But investors really need to take some time to identify those companies that can and if they’re going to be new companies with new technologies, understanding where those technologies are coming from, and how they can be invested in. So we encourage our thinking traders and investors generally, to spend time understanding those opportunities for their future capital allocations.

Stone: And as you just said a couple minutes ago, it’s a really important for investors to understand what the risks are to any given company that they’re looking at. And along these lines, in October, a group of institutional investors with a combined $5 trillion in assets, delivered a petition to the Securities and Exchange Commission here in the U.S. requesting uniform disclosure rules related to climate change. And essentially, the group wants companies to be more transparent about the risk that climate change poses to their businesses. Can you tell us about the types of risks specifically that you and investors believe need to be disclosed?

Fabian: Yeah, well, the real issue here is understanding, for an investor, the likelihood of receiving investment returns from company revenues in future years. So investors want to know how a company will be placed in a low carbon world. Will that company services be demanded? Will they be price competitive? And so ensuring that the company is disclosing an understanding of that future, a some kind of transition plan or strategy so they can thrive in that future, and then plans for the growth and investments of the company to support that transition.

And so unless the companies are disclosing their strategies, their risk management plan, the metrics that they’re using, to gauge their progress and the future, and some kind of forward looking framework and thinking about how they’re going to manage this transition, investors then start to get very concerned. And this is why large institutional investors in the U.S. are going to their company saying, hang on, where we’re invested across the market here, we own a lot of your stock. We want to know if you’re going to be able to provide investment returns in the future. Because this climate issue is real. And we know it’s going to affect your earnings. So many of these disclosures are captured in something that is being worked on by the investment community globally called the Task Force for Climate Related Financial Disclosures Framework. And it sets out a range of disclosure areas as I’ve just described that companies should be providing to the market.

Stone: Let me ask you one final question, if I may. Should an IPR come to pass in the timeframe that you foresee? How will the economy look fundamentally different say in the year 2040.

Fabian: It’s really important that we do think about how our economy will look in the future and in 2030, and 2040, and beyond. And some things won’t change a lot. We will still need energy, we’ll still need mobility, we’ll still need food and water, we’ll still need to be able to communicate to each other. But the truth is what will change is the business models, the technologies, and energy sources that are used to provide these services.

And so we see a change away from fossil fuels. We see much more use of localized distributed energy in community settings, rather than in very broad centralized networks. We see energy being provided inside transportation vehicles, through batteries or other types of energy generation. There are many changes coming. And in fact, we can’t predict them all today. But it’s important to note that communities and citizens will still need all these basic services is only the way these services are provided that we’re going to change and that our economies can still flourish, as long as we’re alive to the necessity of this change, and we invest in change our economies early.

Stone: Nathan, thanks for talking.

Fabian: It’s my pleasure, Andy. Thank you.

Stone: Today’s guest has been Nathan Fabian, Chief Responsible Investment Officer with Principles for Responsible Investment. Thanks for listening to Energy Policy Now. If you’d like to keep up to date with developments in energy policy and news and research from the Kleinman Center, sign up for our Twitter feed @kleinmanenergy, or visit our website, kleinmanenergy.upenn.edu. Thanks for listening to the podcast and have a great day.

nathan-fabian headshot

Nathan Fabian

Chief Responsible Investment Officer, Principles for Responsible Investment
Nathan Fabian is chief responsible investment officer with Principles for Responsible Investment in London, UK. His work focuses on sustainable financial markets and the expected economic impacts of an Inevitable Policy Response.

Andy Stone

Energy Policy Now Host and Producer
Andy Stone is producer and host of Energy Policy Now, the Kleinman Center’s podcast series. He previously worked in business planning with PJM Interconnection and was a senior energy reporter at Forbes Magazine.