Challenges in a changing world: not so smooth, not so slow

Investors should not assume that the energy transition will be smooth or orderly. Fundamental changes of economic leadership can happen relatively quickly and surprise by dramatically changing both economies and societies.¹

New technology does not only lead to new solutions to existing problems; it leads to new things to do and new ways of doing things that were not previously imagined.

It is a mistake to assume that, as clean energy replaces fossil fuels, societies will continue as before. This is not simply because economic power will shift between countries as demand for fossil fuels and critical minerals change rapidly. The disruption is likely to be still more significant.

Switching to clean energy to generate electricity is fundamentally different to swapping between coal and gas. The cost of fossil fuel power generation is volatile, but the marginal costs of renewable energy are relatively low. As innovation in battery storage continues and supply grows, we think new possibilities for using energy will be found with the tantalising prospect of near zero marginal cost energy one day for some countries and sectors. At some point, making best use of energy may in practice mean using more, not less.²

We believe the widespread transformation of economies accompanying the transition will benefit humankind, but there is scope for this disruption to be mismanaged. Big changes produce winners and losers in different time frames. A shift to a net-zero emissions world will be no different.

Preparing for the transition

Risks include a rush for access and control of critical mineral resources, increased inequality as some economies benefit but others lag, and energy security crises. Those whose livelihoods are dependent on fossil fuel production face particular challenges. Other societies may risk facing a new version of the ‘resource curse’, where gains from minerals are disproportionately accrued and distributed, with adverse consequences for society and functioning markets. Many others dispersed throughout the global economy are likely to benefit, in our view. Should those challenges be ignored, support for transition may decline. We believe policymakers need to be preparing now for the new economic environment.

While there are sound economic reasons for a just transition in addition to the value societies place on reducing inequality, it should be noted that climate change brings its own unjust outcomes. The IPCC states that:

“Even at low levels of warming, climate change will disrupt the livelihoods of tens to hundreds of millions of additional people in regions with high exposure and vulnerability and low adaptation in climate-sensitive regions, ecosystems and economic sectors (high confidence). If future climate change under high emissions scenarios continues and increases risks, without strong adaptation measures, losses and damage will likely be concentrated among the poorest vulnerable populations (high confidence).”³

It is unlikely that such traumatic outcomes will be meekly accepted. Companies perceived as complicit in or enabling climate change could find that their ability to operate is challenged, as could companies seen as hoarding – gaining excess economic rent from – transition innovations. Increasingly, this includes the risk of legal action; where GHG emissions are the link between the defendant and a plaintiff, this can take place across international borders.⁴ Moreover, such disruption affects markets and operations.⁵

In pursuit of the aim of mitigating the systemic risks associated with climate change, we believe there are advantages for the world in aiming for a timely and relatively smooth transition.

The energy transition does not exist in a vacuum

Climate change, with transition changes, is not the only disruption taking place. It is interacting with other changes, such as invention and innovation in transport, food and artificial intelligence. The potential for a major transformation of society is significant.⁶

While this is happening, global demographic changes are affecting wages, interest rates, prices and investment. This stimulates new opportunities but also creates challenges which could slow widespread positive change.

There are catastrophic risks associated with climate change, which mean we may have less time to change than we think, and the costs are not fully understood. At the same time, many are underestimating the pace of transition for some parts of the economy, potentially making some 2050 targets appear complacent.

It currently seems likely that the pace of societal transformation will differ widely between countries, sectors and income groups. Failure to address this, and in the case of climate to pursue a ‘just transition’, could hinder cooperation, stimulate conflict, raise risks, and limit the potential for significant global development and increase in wealth.

The cost of complacency

The scale of disruption and change is not fully appreciated. Plans based on smooth transition curves alone are not realistic and risk returns as, in contrast, do companies that in practice ignore the energy transition taking place.

Successful companies need to be highly agile. Companies failing to transition effectively face both climate risks and risks they fall out of step with the market. In both cases their behaviour also affects the systemic risks of climate change.

This is why we believe an effective investment stewardship approach also needs to be agile, engaging extensively with companies to understand the changing environments they operate in and setting clear expectations linked to transitions to be net zero aligned. For example, through LGIM’s Climate Impact Pledge, we engage with potentially influential companies throughout the value chain.

As key climate milestones draw ever closer, the potentially disruptive nature of transitions, the need for financial and strategic discipline from corporates, and the role of investors in encouraging action to address climate risks as they allocate capital, are coming further into focus.

It is clear that, in a fast changing world, all parts of the global economy must play their part if net zero is to be achieved.

 

Sources

1. Where some past big shifts appear to have taken decades, as infrastructure and knowledge took time to be renewed, the reasons will have included supply, demand, and ease of transition.

2. Eg “In Spain, Europe’s sunniest country, electricity is practically free during the day” Carbon emissions are dropping – fast – in Europe The Economist 27 April 2024.

3. AR6 Climate Change 2022: Impacts, Adaptation and Vulnerability — IPCC TS.C.10.3 page 67.

4. Eg Who pays for climate change? The Peruvian suing a German utility  https://www.ft.com/content/e26c5813-354b-4b6b-8bc1-70b39ef9837c

5. Even limiting global warming to 1.5C requires significant adaptation measures.

6. The development of Artificial Intelligence, in the form of Large Language Models launched in 2023, illustrates how quickly business models can be upended and transformed – not simply boosting the efficacy of ‘business as usual’ but changing economic and societal relationships and leading to new possibilities.