15 May 2024 4 min read

Challenges in a changing world: financial discipline and systemic risk

By Stephen Beer

In the first instalment of a new series, we explain how our expectations of companies are evolving as key climate milestones approach.

Nodding-donkeys.jpg

Humankind continues to pump greenhouse gases into the atmosphere and our world continues to warm.

The Paris objective of keeping the average rise in temperature to 1.5˚C by 2100 is still viable, but the number of routes to achieving it is reducing. The key net zero date of 2050 remains, but we are getting closer to it.

At the same time, the pace of transition in some sectors has accelerated beyond expectations.1 The economy is transforming, requiring increased agility from companies and investors.

This series examines the implications for our investment stewardship expectations.

A warmer future

The impacts of a warming world are varied and complex. Some effects may be experienced near term, while others, such as rising sea levels, are expected to continue for hundreds of years. There is also a risk of ‘tipping points’ when natural systems change suddenly and irreversibly, leading to further and faster change than assumed; the uncertainties are considerable, and the impact-weighted risks could be enormous.

Climate change increases risks across society, including for investors. We believe it is important to evaluate and mitigate these risks to help ensure financial objectives can be met.2 Limiting the extent of climate change itself is vital. Investors have a role in understanding what changes are likely to be required and helping ensure that the companies in which they invest, as well as the wider corporate sector, are not increasing those risks or preventing risk reduction. Investors are likely to look to companies to invest sufficiently in adaptation.

An investment stewardship approach is required, addressing systemic risks linked to climate change across the global economy and markets.

COP28 and the direction of travel

The commitments made at COP28 fell far short of securing a 1.5˚C outlook, but this possibility was not eliminated. While a reference to the managed phaseout or phasedown of fossil fuels was not included in the final agreement, delegates did state that the world should be “Transitioning away from fossil fuels in energy systems, in a just, orderly and equitable manner, accelerating action in this critical decade, so as to achieve net zero by 2050 in keeping with the science.”3

This was the first reference to transitioning from fossil fuels in a climate COP agreement, indicating the direction of travel even if the speed is currently far too slow.

The energy crisis and beyond

Russia’s renewed invasion of Ukraine in 2022 pushed up energy prices, which were already elevated post-pandemic, leading to what the IEA called “the worst energy shock since the 1970s”.4 Reductions in the supply of oil and gas, alongside aggressive efforts to mitigate future disruptions, increased the levels and volatility of prices. The energy outlook appeared to change in just a few months. Even with supply adjustments and increased storage, prices remain highly sensitive to geopolitics.

When oil and gas prices were low and transition dates appeared distant, it was relatively easy for a company to project a transition to net zero. But at higher prices, and as time moves on, harder choices must be made and the decisions required for transition, by companies and wider society, are shown in starker relief. Conversations with companies can therefore become harder-edged; not more difficult but more focused.

Higher energy prices increased gains to oil and gas companies and prompted changes to assumptions about future prices, increasing the attraction of potential oil and gas projects.5 However, higher energy prices also increased the relative attractiveness of renewable energy to consumers, and have increased demand for and innovation in battery storage, potentially leading to renewable energy with storage in some geographies being more competitive than electricity from coal or even gas.6

While structural bottlenecks such as planning constraints remain and energy demand continues to grow, the transition pull has increased substantially.7 Energy efficiency has also increased. Some reports suggest the transition may have been accelerated by up to a decade as a result.8

Strategic and financial discipline in focus

Assessing the relative impacts of both effects is not straightforward. The outcome depends on the extent to which price changes affect demand and supply.9 Energy demand and supply are also linked to economic growth, OPEC actions, the supply of critical minerals required for renewable energy, transition actions by companies, and what happens as increased fossil fuel and renewable supply comes into the market.

Meeting energy security needs can be done in a manner consistent with net zero commitments. Despite the long-term nature of energy requirements, it takes strategic and financial discipline for companies to avoid over-responding to sharp price moves and potentially increasing systemic risks.

Corporate history contains examples of over-expansion followed by large write-offs of unprofitable assets. We believe part of the role of a responsible investor is to help keep company managements focused on sustainable profitability, sound investment decisions and reducing systemic risks.

In the second part of this series we’ll examine the energy transition, explaining why it may turn out to be anything but smooth and orderly.

 

1. In its World Energy Outlook 2023, the International Energy Agency notes faster growth in electric car sales and accelerated deployment of solar PV than it projected in 2022.

2. Financial risks themselves are also an output of and sit within wider contexts which risk being jeopardised by climate change.

3. Outcome of the first Global Stocktake, UNFCC December 2023, paragraph 28d.

4. World Energy Outlook 2022, IEA.

5. There is always the risk, or even likelihood, that companies focus on potential returns in the two years ahead and underestimate oil price volatility.

6. See Batteries and Secure Energy Transitions, IEA, April 2024.

7. Renewable energy roll-out broke records again in 2023: see IEA Renewables 2023.

8. See War and subsidies have turbocharged the green transition | The Economist (The Economist 13 February 2023).

9. Short-term demand for oil and gas is inelastic – short-term changes in price have relatively little impact on demand – but more elastic over the medium to longer term. Demand elasticity increases in part with the supply of alternative energy sources.

Stephen Beer

Senior Manager - Sustainability and Responsible Investment

Stephen Beer oversees LGIM’s investment stewardship engagement with companies on climate and alignment with net zero, particularly via our Climate Impact Pledge, as well as engaging with companies on other issues. His career has been focused on responsible investing and investment stewardship for pensions and charities. Prior to joining LGIM in 2022, he held the combined role of chief investment officer and head of ethics/ESG at the Central Finance Board of the Methodist Church and Epworth Investment Management. He has also been a portfolio manager, investment strategist, and pension scheme trustee. He writes and speaks on ESG issues. 

Stephen Beer