The unintended side-effects of decarbonisation and the net zero emissions target

20 Apr 2020

Decarbonising the world could save humanity from its greatest threat, but is there a danger that in solving one problem we create another?  

Theresa May’s influence over politicians, investors and consumers will still be felt more than 30 years after her three-year reign as prime minister ended in failure. After struggling to deliver Brexit she quit Number 10 in 2019, yet the legacy she left behind in another area will shape life in the UK for decades to come.

One of the few laws May successfully passed through Parliament during her leadership was designed to protect us from the greatest threat to humanity: climate change.

High levels of carbon dioxide, or CO2, in the atmosphere not only causes global temperatures to rise but increases the prevalence of natural disasters. Indeed, the floods witnessed in Northern England earlier this year, bushfires in Australia as well as droughts and typhoons in the US are set to make regular news headlines as rising levels of carbon in the atmosphere stops heat from the sun escaping back into space.

Extreme weather events are not the only treat that burning fossil fuels causes. Land being swallowed by rising sea levels, disruption to the food chain, a heightened risk of heat stroke and asthma-causing air quality are other consequences.

To protect future generations May enshrined in law that by 2050 the UK must be a net zero producer of greenhouse gas emissions, of which CO2 is the main culprit. An overnight ban on fossil fuels would mean that the world cannot function, so companies need to offset their harmful gas discharges by planting trees or using carbon capture and storage technologies to match the levels of CO2 they release. 

The 2050 target is highly ambitious and there is going to be pain along the way

Tom Atkinson, Newton Investment Management

Climate change is today’s problem and while May should be applauded for making sure that the issue stays on the political agenda, the target she set to switch from a carbon-powered economy to a greener one in a little over 30 years is ambitious, according to many of the professional investors and consultants I have spoken to.

“In theory it is achievable; in practice it will be quite difficult,” says Ed Lees, senior portfolio manager, sustainability thematics at BNP Paribas Asset Management.

Hard target

To achieve the 2050 emissions target, we need to change how we make and use energy. Protecting forests, not making single-use plastic and eating less meat are also high on the agenda, as is removing carbon from the atmosphere.

Every area of society must become sustainable, from how we grow food and power our homes and businesses to how we travel from A to B and construct buildings. The problem is that we can’t just ditch fossil fuels until viable alternatives are perfected and reach a suitable scale to feed the National Grid and fuel longer journeys for cars, trucks and buses.

Yet cleaner forms of energy are gaining momentum. Renewable sources of electricity powered by wind and the sun were the largest contributor to the UK’s national grid in the third quarter of 2019, according to the latest available data (see chart below). This pushed fossil fuels to their lowest level on record, with oil and coal only contributing 1%. When the figures for nuclear are included, cleaner forms of energy accounted for almost 60% of the electricity that powered Britain’s homes and businesses during those three months.  

“There is a changing of the guard when it comes to the energy system,” says Laura Sheehan, an oil and gas equity analyst at Newton Investment Management.

So the UK has been quite successful in phasing out coal, but there is work to do in other areas of the economy. Replacing petrol and diesel engines with those powered by electricity and fuel cells is an example, but it is a shift that not only needs regulation to make it happen, but government funding, too. “Green buses are a good start, but we need ongoing subsidies to help the consumer make that transition to electric vehicles, which involves an extra upfront cost,” Lees says.

The government is aware that its role goes beyond just setting the target. In the first Budget since the low carbon goal became law, Chancellor Rishi Sunak unveiled policies designed to move the UK towards a low-carbon economy.

To reduce air pollution Sunak cut the tax breaks on red diesel for industry vehicles, aside from those used in farming and on the railways. He also reduced the tax on renewable power, while increasing the duty on gas. Funding for research and development focused on cleaner forms of energy was doubled to £1bn.

While there is a great appetite from government to achieve the target, Jennifer O’Neill, an ESG and responsible investment consultant at Aon, points to a lack of a clear direction in how to get there. “Time is marching on. We have 30 years to reach it and the pathway is still being mapped out,” she says.

Yet the government is working to guide the controllers of huge pots of private capital in this area. Earlier this year, it amended the Pension Schemes Bill by setting recommendations and potential requirements around environmental disclosures linked to a scheme’s investment portfolios.

A just cause

If we are not careful, by decarbonising the country too quickly we may reduce temperatures and improve air quality but destroy communities.

“The 2050 target is highly ambitious and there is going to be pain along the way,” says Tom Atkinson, a utilities analyst at Newton Investment Management.

There is a social cost of eradicating carbon from the atmosphere. Jobs disappear when coal-fired power stations are switched off or we stop pumping oil out of the ground.

We need to have a just transition; in that it is socially equitable as well as being economically feasible.

Jennifer O’Neill, Aon

Indeed, the European Union has proposed a similar net-zero emissions law to the UK’s, and so 450,000 jobs in mines, coal-fired power stations and related services across the bloc are under threat. There are whole communities relying on industries that are heading for extinction. The European Commission has cited a nameless region in Poland that could see 41,000 jobs disappear if the transition is successful.

There is a social element to ESG and as such the transition should not just be about stopping climate change but providing decent jobs to protect local communities, too.

Trade unions are campaigning for a “just transition” to protect workers’ livelihoods as the world moves to more sustainable energy sources. The goal is that as well as being greener, society will also be more inclusive.

O’Neill says that you need to take people with you, not leave them behind. “We need to have a just transition; in that it is socially equitable as well as being economically feasible.

“Adhering to that would mean that there is consideration given to those in society who might be at risk if it is not financed in a just way,” she adds.   

But RobecoSAM’s Roland Hengerer points out that perhaps one need is much greater than the other. “The choice will be between some economical local damage or global damage to 8 billion people,” he says.

That is a powerful argument, but the transition doesn’t have to be so black and white. Technological advancements make some processes or industries redundant, but they also create new jobs. So re-training old economy workers into new economy workers should be part of the transition.

“That is a policy challenge of how we re-train the workforce to participate within the energy transition and in the technology-enabled economy,” says John Anderson, global head of corporate finance and infrastructure at Manulife Investment Management.

This is already happening. The offshore oil and gas industry in the North Sea is not as big as it was, but offshore wind in the area is growing. There are transferable skills here as engineers who once worked on oil rigs now service windfarms. “Rigs closing is causing pain, but on the flip-side there is growth in newer industries,” Atkinson says.

Such a change in how some people do their job is no different from carriage drivers having to deal with the advent of the car, Lees says. “It is a natural progression and hopefully governments can smooth it out so it is not too much of a shock for any locality, but they cannot deny that change is coming,” he adds.

Energy company Drax is working towards a just transition. When it closes two coal-fired power plants in North Yorkshire in the next two years 230 jobs will close with them. To help with the transition, Drax has established a zero-carbon skills taskforce to build a workforce that is ready to reap the rewards of a net-zero economy in the region.

Come together

“When Theresa May came out with these objectives for 2050, an internal government report estimated the cost at £1trn, which is just under half of UK GDP,” Sheehan says. “You cannot hold these numbers with certainty because there are so many evolving parts.”

Yet the hit to the economy of not transitioning could be even higher thanks to countless climate change induced environmental disasters, such as floods and pollution. “The cost of climate change over the coming decades will be significant,” Atkinson says. “There are going to be increased costs one way or another.”

So achieving the transition, just or otherwise, is not only in the interest of governments. Action needs to be co-ordinated across politics, industry, investors and consumers as this is everybody’s problem.  

This is especially an issue for investors. Keeping temperature rises low and improving air quality make good business sense for those with a long-term horizon. The economic disruption that Covid-19 is causing markets and the global economy shows what could happen if there is a series of natural disasters. And then there is regulation.

Indeed, the Bank of England estimates that as much as $20trn (£16.8trn) of assets are at risk of being stranded by transition-driven regulation.

Investors need to look at their assets and wonder if their value could suddenly fall in the years to come. No investor wants to be holding the wrong assets when the music stops.

There is a lot more to the transition than renewable energy and banning fossil fuels

John Anderson, Manulife Investment Management

This is not just about oil and gas companies; sustainability should be a consideration in every investment decision made across equities, all debt and real assets, such as backing real estate and infrastructure made from sustainable materials and which use less energy and water.

Private capital is at the heart of the Bank of England’s plans to help achieve the government’s goal of eradicating carbon from the economy. The now former Bank of England governor Mark Carney said in February: “To identify the largest opportunities and to manage the associated risks, disclosures of climate risk must become comprehensive, climate risk management must be transformed and investing for a net-zero world must go mainstream.”

So news that most defined contribution schemes are failing to explain how they are protecting savers from the effects of climate change will not be welcomed by the Bank and those pushing for private capital to influence a just transition.  

Yet some stewards of trillions of dollars in assets are pressuring companies to change their practices, through networks such as Climate Action 100+ and the Net Zero Asset Owner Alliance, while a survey by the Prudential Regulation Authority found that almost three quarters of UK banks are treating the risks from climate change like other financial risks rather than viewing them simply as a corporate social responsibility issue.

The message, it seems, is getting through.

Transitioning your portfolio   

There is more to achieving the transition than starving oil and gas companies of funding or refusing to insure their assets. “Divesting from fossil fuel companies does not solve the problem. It is more nuanced than that,” O’Neill says. “Supply chain logistics and transport are exposed to petrochemicals, so the question of dealing with climate change is not simply restricted to one or two sectors, it is much broader than that,” she adds.  

So the political will to end climate change should be factored into every decision an investor makes. “There is a lot more to the transition than renewable energy and banning fossil fuels,” Anderson says.

Investing in the creation of a low-carbon economy is not limited to renewable energy. Electric vehicles, energy efficient buildings, energy storage, infrastructure such as inter-connectors and recycling as well as sustainability consultancies are other specialist options, but there are only a few general companies that will not be affected by this law.

“The transition effects every sector of the economy and companies are looking for a way to participate,” Anderson says.

For Manulife, decarbonising portfolios is a company-by-company call rather than a sectorial strategy. “We are looking at how companies within any given sector are playing it, are putting the transition in their strategy,” Anderson says.

It’s always easier to avoid pollution than trying to clean up the mess afterwards.

Roland Hengerer, RobecoSAM

O’Neill points to the trend toward cloud computing, which consumes a lot of energy, as a potential area for innovation, while Lees describes the potential in transport as “exciting”.  

“There are lots of interesting places to invest across the value chain in the electrification of transport, from batteries to sensors to software,” he adds.

Anderson points to studies showing that the “biggest bang for your buck” in reducing carbon could come from investing in energy efficiency, but this is not yet an institutional market. “A challenge with efficiency investments is that they are frequently small and widely dispersed,” he says.

Capturing the bad guys

Carbon capture and storage is another angle. If CO2 can linger in the atmosphere for thousands of years, as some scientists claim, cutting the level of harmful gas emissions will not help achieve the lower than 2-degree Celsius rise target set by the Paris Accord.

But this is not a case of just accepting our fate because the damage has already been done. Planting trees, conserving forests and investing in tech that removes harmful gas from the atmosphere are ways to reverse some of this damage.

The issue is that the carbon capture and storage industry needs to mature. “It is not something that is easy for someone to invest in public equities and capture the upside,” Lees says. “That is going to need time before the technology becomes more widespread and cost competitive.”

A barrier for investors is that the market is not yet an institutional asset class. “Carbon capture technology is in its infancy and is untested,” Anderson says. “It is an area the market has not cracked the code on how to do it successfully.”

In addition, there is also an unattractive economic case. “To make carbon capture economic, what you are capturing needs to have some value,” Sheehan says, adding that she has heard quotes of $400 (£322) per tonne for carbon capture directly from the air, which is “crazy economics”. Carbon capture solutions at point of power generation are far lower and economically viable today.

So the carbon capture market needs more attention from regulators. “If there was a higher price for carbon, there would be a greater incentive to capture it and do something with it,” Atkinson says. “Progress and policy on that front is lagging.”

The European Union’s Emissions Trading System was created to put a price on carbon, but, unfortunately, only 15% of global carbon emissions are priced, according to Atkinson, and only 1% is priced at Paris levels.

“This is an example of market failure,” Atkinson says. “Carbon emissions impose a cost that is not being paid for. Through a tax or a market-set carbon price we could correct that.”

He prefers a market mechanism to a levy. “A flat tax is not ideal because a company could take the hit, pay the tax and, in theory, pollute as much as they want,” Atkinson says.  

Hengerer describes carbon capture as being at an early stage but believes the world should prioritise stopping harmful emissions. “That’s where the low hanging fruits are. It’s always easier to avoid pollution than trying to clean up the mess afterwards.”

He adds that fining companies for breaching emission caps could be a good way to reduce greenhouse gas levels. “If polluting a river is fined, why not polluting the atmosphere, too?”

Despite the lack of interest in carbon capture, Hengerer remains optimistic that the world can build the tools needed to decarbonise the world. “It will require a global effort, but if one country managed to fly to the moon within a decade, the whole world should be able to build up the required industries – from mostly existing technologies – within three decades,” he adds.

Engaging in the transition

One of the reasons why renewables have surpassed fossil fuels is that using coal to generate energy in the UK is being phased out and will be illegal from 2025.

Electricity generator Drax plans to close its coal-fired power plants in North Yorkshire three years ahead of the deadline and will stop using coal earlier than that. It has re-positioned itself away from fossil fuels. This has, Drax’s chief financial officer Andy Skelton says, made the company the largest renewable power generator in Britain, which also controls the biggest decarbonisation project in Europe.

In 2016, 30% of Drax’s energy was generated by coal; by 2019 this fell to 3%. Indeed, it produces 12% of the UK’s renewable energy, which can power 13 million homes during peak time.

“The transition is going to close some doors and open others,” Anderson says.  

Drax wants to be carbon negative within 10 years. It will use bioenergy as well as carbon capture and storage technologies to achieve this. The plan is to remove 16 million tonnes of CO2 from the atmosphere annually.

We have to encourage big oil companies to become big diversified energy companies, to be part of the solution as opposed to cutting them off completely.

Ed Lees, BNP Paribas Asset Management

However, biomass involves burning wooden pellets to create energy, thus contributing to climate change. Skelton makes it clear that Drax does not cause deforestation as it’s bioenergy is generated from sustainable sources, such as sawmill residues. It also supports forest replanting programmes.  

Drax, in partnership with the National Grid and Norwegian energy company Equinor, is part of the Zero Carbon Humber initiative, which aims to establish a net zero industrial cluster by 2040.

So cutting off Drax’s funding would stop it from contributing to driving to UK towards net carbon neutrality, proving that divestment should be a last resort and not a transition strategy.  

“Given the growth in demand for energy globally, through GDP growth and population growth, it is impossible to imagine how the world could function without fossil fuels in some capacity in the next 20 years,” Lees says. “We are going to need them. We have to encourage big oil companies to become big diversified energy companies, to be part of the solution as opposed to cutting them off completely.”

This transition is a marathon not a sprint. There are industries that have a large carbon footprint, but we need them to keep the economy moving, such as transport, energy and concrete. Investors cannot just starve them of new capital. We need them, especially as they may also be huge contributors to funding the sustainable products needed to make oil and coal redundant.

Dong Energy in Denmark is the model. It switched from using oil and gas to wind as its source of energy. It changed its name to Ørsted after a physicist to reflect its new identity as a renewable energy company. So divesting may not be the best option for those looking to decarbonise the world.

A risk-adjusted view

“Returns may be lower in absolute terms, but you must risk adjust them,” Sheehan says, explaining that oil companies typically sanction projects that have internal rates of return of at least 15%, while a renewable project could earn 10%.

“Oil companies warrant a higher return because their projects are riskier,” she adds, pointing out that renewable projects are more stable and have better security of purchase than oil projects, which typically go out to market.

Wind farm operators and oil companies are in different industries, are of different sizes, different scales and supply chains.

Fossil fuel projects are subject to a fluctuating price whereas, renewable projects could sell their energy for a fixed price to corporates through a power purchase agreement.

“Over time, as renewables grow in scale and improve their supply chain, the returns should improve; the market is a moving target,” Atkinson says.

The oil industry has not always made positive returns over the long term as prices can fall sharply.

Lees says that putting the Covid-19 induced crash aside, solar and wind companies have strong growth profiles. “There are estimates that suggest that the global offshore wind market is going to grow at double digit compound annual growth rates for the next 20 years.

“There is a huge amount of growth that has to happen in solar, wind and electric vehicles globally [to meet the transition],” Lees adds. “It is a staggering expansion that has to happen.

“So you have an area that logically has more of a chance to produce above average returns for investors because you have above average growth,” Lees adds. “A lot of these areas also have shrinking cost curves because solar batteries are getting cheaper year by year, while oil, putting aside the most recent crash, has become more expensive to extract per barrel.

“Solar has become factors of 10 cheaper and oil has become factors of 10 more expensive, while solar has improved its cost base relative to oil by 1,000 times or more,” he adds.

Technological advancements have changed how we generate energy and there will be further improvements to come. “Only 20 years ago people thought solar and wind energy was way too expensive to make a meaningful difference in the energy mix,” Hengerer says. “Similarly, nobody would have predicted the incredible advance in electric vehicles in just 10 years.

“The biggest challenge is not technology, but political will, and resistance from companies that benefit from the current energy regime,” he adds. “Hopefully the current crisis will help to focus the minds of politicians and voters alike on what really matters – a healthy and sustainable society.”

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