Dealing with climate risk

More than 180 countries, led by China, the US, and the EU, have affirmed high-level political policies for combatting approximately 90% of the world’s energy-related emissions. If realized, these pledges could work towards the divestment of projects with high-level greenhouse gas emissions – thus limiting dangerous global temperature rises.  And as the United Nations Convention on Climate Change (COP21) progresses in Paris, many are looking for governments to act on these commitments and set new climate change regulation in stone. In particular, the development of an advanced carbon market, which allows for international emissions trading, is seen by some as a top priority.

At the same time, increased renewable energy projects and energy efficient technological advancements – essential to meeting the ambitious climate change targets – require substantial investment. Incentivising the private sector to finance renewables will be crucial for governments making the energy transition. Key to this will be factoring increased environmental and climate-related risks into the creditworthiness of companies.

Driving decarbonisation

Certainly, the global curbing of CO2 emissions will have considerable repercussions on carbon-intensive sectors. Particularly, companies involved with energy production – accounting for about two-thirds of global greenhouse gas emissions – will need strong incentives to move away from a heavy reliance on fossil fuels. But certain market mechanisms can help to motivate the divestment from carbon-intensive sectors, and re-orient funds to low-carbon alternatives.

For instance, the establishment of an accessible, international carbon market is a key focus of the Paris talks, with a major element being the wider application of emissions trading systems (ETS). These systems limit the level of emissions that companies can produce before they must buy allowances (or face fines) – such allowances can then be traded on an open carbon market. This would increase the divestment from fossil fuels on a global scale, allowing more countries to take part in incentivising the reduction of emissions.

What is more, emissions can be increasingly combatted through carbon taxes which place a price on greenhouse gases. For example, the EU plans to increase its market price for carbon dioxide, which will further reduce the attractiveness of investing in fossil fuel production.

Climate risk to credit

Such pricing mechanisms also ensure emissions are recognised as a risk to economic security. As such, environmental and climate change-related risks must be taken into account when assessing the creditworthiness of companies.

In fact, organisations such as the Bank of England have already made progress in this regard, having stressed the risks of carbon emissions to financial investment planning and officially recognising emissions as a negative factor in the creditworthiness of companies.

Indeed, Standard & Poor’s are increasingly considering climate-related risk in their ratings. In fact, Standard & Poor’s cited natural disaster as the main risk factor in at least 60 rating downgrades. Most at-risk is the creditworthiness of companies in the energy sector.

Clearly, the pressure is on for carbon-intensive assets, such as coal-fired power stations, which are increasingly losing economic value and becoming “stranded assets” as a result.

Financing sustainability

Of course, making the transition from fossil fuels to cleaner, greener energy on an international scale requires considerable investment. The International Energy Agency (IEA) estimates that in order to limit global warming to 2 degrees, low-carbon projects and energy efficient technologies will need investment of around US$13.5 trillion by 2030.

Here, the private sector increasingly represents a key source of financing. In fact, lower electricity prices from wind and solar power – incentivised by reduced production costs – have led to rising investment in renewables. Meanwhile, lower capital costs for energy efficiency infrastructure is helping to attract investment in the long term.

It is clear that the renewables market is maturing and the hope is that the conference in Paris will provide impetus to further climate change regulation and policy. That said, addressing private-sector motivations could offer alternative avenues for divesting from carbon – and investing in a sustainable future.

Michael Wilkins is Head of Environmental Research, Standard & Poor’s Ratings Services.

The report “Climate Change: Building a framework for the future” is available at Climate Change: Assessing The Potential Long-Term Effects.