No Time Toulouse

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No time Toulouse

For the past few decades, the simple message “no time to lose” has fallen on deaf ears, leaving many of us pushing for climate action feeling like Eric Idle in the homonymous Monty Python skit, in which he goes out of his way to help Michael Palin utter the four words — Michael Palin, in this analogy, is the policy community.

Well, it was not Toulouse, but Paris, that made the cut. Not only did the governments note the “urgent need” to get pledges on track with “holding the increase in the global average temperature to well below 2°C,” they also committed to achieving a net-zero carbon economy by 2050.

Reaching that goal will require action on shorter time horizons than the 2050 target might suggest. “If you were thinking 2030, 2050, erase that. The target is now 2020,” Christina Figueres reminded investors at the 2016 investor summit on climate risk.

This, says a new report by the European Systemic Risk Board’s Advisory Scientific Committee, is critical not just for the climate, but for the financial sector as well. “Today the European Systemic Risk Board joins the Bank of England and the G20 Financial Stability Board in correctly highlighting how a late and abrupt transition to a low carbon economy could have implications for financial stability,” said Ben Caldecott, Director Stranded Assets Programme, Oxford University.

The underlying reason is quite simple: the more the world waits to comply with the Paris agreement, the stronger the emission reduction effort will have to be once we decide to comply. This not only increases the abatement costs (since costlier emission reduction options will have to be pursued), it also increase the value and range of assets at risk of becoming stranded by climate action.

For instance, while any transition to a low-carbon economy is bound to leave some amount of fossil fuel assets stranded, a late start on the Paris decision – or “hard landing” scenario as the report calls it – could decrease the market capitalisation of oil and gas companies by up to 50%.

Not that this is the only context under which oil and gas companies can suffer. Today’s 12-year-low oil price has already hit the value of their reserves quite hard, with 2016 levels less than half what they were in 2014, and more than $100 trillion below the 2013 high, according to data from Bloomberg.

oil drop cost
Source: Bloomberg

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But a “hard landing” scenario would expose more than just the oil and gas industry, notes the report, as the need to achieve more emissions reductions in a shorter time period could require us to abruptly reduce other carbon-intensive economic activities. And with carbon-intensive companies making up a third of global equity and fixed-income assets, it is clear why a sudden shock could have a strong impact – and spread throughout the system.

“This paper is an important reminder for policy makers to implement the Paris Agreement and European 2030 climate energy framework with a high degree of ambition and urgency in order to deliver substantial reductions in global greenhouse gas emissions,” notes Stephanie Pfeifer, CEO of the Institutional Investors Group on Climate Change.

Divest, Disclose, De-risk

Insurers are increasingly aware of the impact this could have on their portfolio. Axa and Allianz, for instance, have already started divesting from coal.

Divesting only reduces the direct exposure to the transition risk, however. Protecting against second-order effects requires stress testing the sensitivity of the portfolio to different climate action scenarios – something that Axa intends to do this year.

The problem, notes Caldecott, is that, “without better data on asset-level and company-level exposure to these risks effective stress testing will be challenging.” As we’ve argued in a previous post, this makes the disclosure of climate risk a central pillar of the effort against climate change. And it will be required for both private and public entities.

Defining the standards for climate disclosure and climate stress tests will take time. As these get developed, efforts will be needed on prudential tools that can help de-risk exposure. Some listed by the report include (verbatim):

  • building systemic capital buffers (for example, to protect against the macroeconomic and macro-financial implications of a “hard landing”);
  • regulatory loss absorbency requirements to, for example, encourage the issuance of “carbon risk bonds,” the payoff of which would be contingent on a contractually defined critical event (e.g. the imposition of a prohibitive carbon tax);
  • specific capital surcharges based on the carbon intensity of individual exposures; and
  • large exposure limits applied to the overall investment in assets deemed highly vulnerable to an abrupt transition to the low-carbon economy.

Quite a program; and just a few years to get it right. The pythons were right: “No time Toulouse” indeed.

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