- A recent U.S.-sponsored Climate Summit underscored the U.S. reentering the Paris Agreement as well as several large economies heightening their National Defined Contributions (NDCs) in advance of this year's Climate Change Conference of the Parties (COP) 26.
- The signatories will need to work out myriad details in the coming months before setting out to tackle these new targets, but we should expect a blend of large investment programs and new environmental regulations, as well as a growing pace of sustainable debt issuance.
- Given the magnitude and speed of the reductions to achieve, we anticipate transition risk to be an increasingly potent credit rating factor in the years ahead. Few sectors will be spared from the energy transition fallout, though each sector is likely to see both winners and losers.
- As highlighted by recent history, hastening the carbon transition will require addressing many social and political hurdles across numerous regions to maintain momentum.
During the April 22 Leaders Summit on Climate hosted by the U.S., several major economies, including Canada, Brazil, Japan, and the EU, increased the extent of their Nationally Determined Contributions (NDCs) in pursuit of the six-year-old Paris Agreement. S&P Global Ratings believes these heightened public policy commitments are major milestones, confirming widespread momentum across regions to decarbonize, on top of the significant milestones achieved to date.
Additionally, U.S. President Joe Biden returned his country to the pact several years after his predecessor, Donald Trump, removed the U.S. from the the accord. The announcement that the U.S. aims to reduce carbon emissions 50%-52% by 2030 not only marked a sharp pivot from the past four years, but even doubled the ambition of the Obama Administration's goal, originally established in 2015. This most recent NDC amendment by the U.S. heralds a new era of cooperation among the largest economies to contend with what we believe to be the gravest collective challenge the world will face over the next three decades.
The heightened goals respond to the growing urgency of climate promise, as articulated in the most recent Intergovernmental Panel on Climate Change (IPCC) report. But they also reflect growing optimism, globally, about the ability to meet existing targets due to improvements in cost and technology, and growing cognizance that there's an ability to decarbonize across a wide swath of sectors, with financial markets following close behind.
Renewable Options Are Up And Costs Are Down
According to the U.S Department of Energy Office of Science's Lawrence Berkeley National Laboratory (Berkeley Lab), the costs of generating electricity from solar and wind have been declining consistently since 2008, with solar prices falling more rapidly than wind prices. Cost-reducing advances in technology, growing benefits from economies of scale, and government subsidies have increased the share of renewables in the energy system. Many forms of clean energy have become price-competitive, even without considering any implicit carbon price. Still, in coming months, we anticipate that governments around the world will more fully embed carbon pricing (even if not fully reflecting the social cost of carbon), which will further enhance the competitiveness of renewable technologies as their efficacy improves. Ongoing progress in cost reduction will be essential to facilitate the energy transition and meet Paris Agreement goals.
The Social Cost Of Carbon
The social cost of carbon (SCC) is an estimate, in dollars, of the economic damages that would result from emitting one additional ton of greenhouse gases into the atmosphere.
Big Promises, Little Detail
Still, by admission, details remain scant for the remediation plans of some of the world's largest economies. And, given the increasing size of the commitments (e.g., the EU's goal has also reached 55% by 2030), we expect the scope of activities requiring redress will multiply, and a growing suite of policy measures, investments, and technologies will need to coalesce to reduce emissions and financial implications are likely to follow. As highlighted by the recent downward revision of our oil and gas exploration and production industry risk, transition risk will likely be an increasingly significant rating factor in the years ahead. The accelerated speed of transition needed to meet Paris agreement targets will potentially introduce further unseen disruptions in a variety of sectors. Transitioning to renewables could be undermined somewhat by political and socialobstacles as well as economic, land availability, or technological considerations, which could stunt the current momentum if not properly addressed.
Most industries will shoulder some responsibility global decarbonization, especially the largest greenhouse gas (GHG) emitters. The WRI Climate Analysis Indicators Tool (CAIT) data shows the most significant emissions in 2018 in the U.S. stemmed from electricity/heat (36%), transportation (30%), building (9%), manufacturing (8%), and agribusiness (7%). The economy wide decarbonization plan target areas include coal mining, emissions reduction from power plants, several measures relevant to the oil and gas sector, as well as earmarking emission reductions from forestry and agriculture.
Consequently, these sectors are likely to bear the most direct, measurable, and immediate impacts from energy transition as required by the new mandates. The Biden Climate Plan, for instance, will catalyze several clean technologies related to clean transport, green buildings, water management, renewables, among others--especially hydrogen, solar, and wind power, carbon-capture systems, renewable aviation fuels, and batteries. They're bound to be transformative to those traditional industries, but are also likely to indirectly affect other sectors that rely on these, such as consumer goods.
The Pact Leaves Lingering Questions
We expect that a few key steps will define how likely success will be in meeting the Paris Agreement target of holding the temperature rise to two degrees Celsius. The upcoming COP26 conference in Glasgow toward the end of 2021 will undoubtedly be pivotal for addressing climate change, but we think the bulk of the work toward achieving NDCs will have to be undertaken at the national or regional level. As such, uncertainty lingers, and we have a few questions that we'll seek answers to, in order to better understand the effects on these various sectors from a credit perspective and beyond. And, importantly, we anticipate the answers will be the product of engagement with numerous stakeholders, all of whom will be essential to meeting the targets.
- With increasing goals, it remains to be seen what incremental mechanisms will be put in place to help achieve them. Carbon pricing signals are already present in the EU and certain parts of the U.S., Canada, and China, but we expect the social costs of carbon will keep rising, as well as more ambitious, immediate goals. These signals may have to change and become more ubiquitous and fungible, not to mention more aggressive. But more importantly, what disclosures will be required by different regulators about how companies are seeking to align with these goals? Only a small minority of companies globally, and fewer still outside Europe, are committing to net-zero targets.
- Also, we will seek to understand how these vast expenditures will be financed. We anticipate that some combination of sovereign, subnational, and corporate debt will help underwrite this infrastructure, but we are also keen to understand how investors will receive this newfound focus on climate change. Will there be an appetite to reflect the diminished embedded carbon risks associated with green financings? If so, will the market be liquid enough that a "greenium" could at last be realized consistently?
- How will developing economies respond? Compared with the newly aspirational goals of the U.S. and Canada, as well as the already lofty targets of the EU, the incremental commitments of China and Brazil were more modest. China's coal consumption will decline in relative terms, but it didn't commit to including a cap target for coal-fired capacity, the amount of which is likely to be higher in absolute terms in 2030 than today, while Brazil promised only to end illegal deforestation. China is now the largest emitter in the world, contributing close to 15%, and other developing economies are quickly catching up. Will these large and rapidly growing economies undermine the delivery on the global agreement, or, at least, defer it? Or will they adopt or deliver more ambitious carbon reduction targets? Could these be accelerated if developed economies were to impose carbon import taxes and certificates, like on steel, if not produced through less-polluting processes?
- Finally, we will observe how the private sector responds to these goals. For instance, even though the Trump Administration removed the U.S. temporarily from the Paris Agreement, companies of all sizes headquartered in the U.S. continued to act as if this was still a binding arrangement during the past four years. And, to be sure, companies worldwide are developing strategies and frameworks that align with Sustainable Development Goals, in part because investors seem acutely aware of the significant and growing financial risks climate change poses. But how will they develop new technologies that make these national goals more reachable? As mentioned, this has been successful in bending the cost curve favorably so far, but we remain eager to see which technologies could be next, and whether carbon-friendly technologies like batteries, electric vehicles, or hydrogen could improve as rapidly as solar.
Cost And Funding Uncertainties
These innovative solutions are likely to carry with them with a whopping price tag, possibly exceeding $3 trillion per year globally, even with ongoing cost and technology improvements. The World Bank estimates a total of $90 trillion could be necessary globally to facilitate the transition. Aside from the staggering price tag, investors also must now contend with one of the most pressing, yet least quantifiable long-term risks facing the sectors, which heightens the uncertainty and suggest a need for greater discourse.
Green bonds, or debt instruments that fund environmental and sustainable projects, will play a key role in helping to close this gap. We expect their growth to be substantial. In 2014, green bonds gained some significance with $37 billion issuance, but have demonstrated even more impressive growth since, reaching $295 billion in 2020, accumulating over $1 trillion since inception, according to Environmental Finance and BondData.org.
However, our research indicates that markets continue to have trouble pricing in the risks of either the physical impacts of climate change or energy transition. Aside from that, assessing probabilities and magnitudes of acute or chronic events and pricing externalities based on simplifying assumptions that may change with regulation or shifting attitudes could result in a less-than-optimal allocation of capital to help combat climate change. Still, we believe the sustainable debt market will continue to grow globally, as discussed in our recent Sustainable Debt Forecast, likely surpassing $700 billion in 2021. And, importantly, it's likely to diversify as well, broadening to capture new financing vehicles, such as sustainability linked loans, and unconventional issuers. As mentioned earlier, numerous sectors will likely have to transform to aid in decarbonization efforts, and some don't have obvious means for abating GHG emissions. We anticipate the transition finance market, which can help less conventionally green industries become more sustainable, could constitute one-third of all green finance during the next decade.
The World Bank 2018 data shows proceeds were committed and disbursed to the following major areas: renewable energy and efficiency (44%), clean transportation (25%), agriculture, land use and ecological resources (11%), water and waste water (10%), and resilient infrastructure and build environment (9%). Each of these asset classes and mor will be critical in ensuring the meeting of climate change obligations, whether funded by green bonds, other sustainable debt, and more conventional issuance.
Job Growth Or Loss?
Still, the benefits of accelerating the energy transition could extend far beyond the goal of remediating the existential repercussions of climate change. The Biden Administration's nascent infrastructure plan highlights the job creation aspect of overhauling the country's energy sector and physical infrastructure, as well as its social infrastructure, for instance. At issue in this fierce debate is whether the outcome is net positive or negative given transition costs that affect workers. New burgeoning industries are likely to grow at the expense of dwindling ones that may be inconsistent with the energy transition that is soon to accelerate, creating stranded assets. Government policies are imperative to mitigate those impacts and generate a just transition that is inclusive, but should also create incentives for the sort of innovation that will be required to ensure this transition actually happens and does so equitably, with training for employees whose jobs may be displaced, chiefly by the energy transition, but also by the physical impacts of climate change. This carbon transition could lead to net positive job creation, but what remains clear is that climate change, including both transition and physical risk, presents a once-in-a-generation disruptive force that will cause some reshuffling of labor markets globally.
It's for this reason that even diverse groups such as the National Coal Mining Assn. have supported the American President's recent infrastructure plan, despite that the U.S. emissions commitment likely means all coal power plants will need to close by 2030. Globally, the push to reduce emissions even further, and more immediately, coincides with the world's looming recovery from the economic calamity driven by the COVID Pandemic. Different regions may be recovering unevenly, but all are bound to seek a form of economic stimulus to regain full employment, and overhaul of carbon-intensive power and energy systems may be one such antidote. Still, in coming months, we expect to see more details revealed about how it is the world's largest economies will rally together to address this multigenerational problem, and how resourceful the private sector can be in helping to mitigate climate change.
- Environmental, Social, And Governance: How Sustainability-Linked Debt Has Become A New Asset Class, April 28, 2021
- Transition Finance: Finding A Path To Carbon Neutrality Via The Capital Markets, March 9, 2021
- The ESG Pulse: 2021 Lookahead, Feb. 11, 2021
- Environmental, Social, And Governance: Sustainable Debt Markets Surge As Social And Transition Financing Take Root, Jan. 27, 2021
- Sustainability In 2021: A Bird's-Eye View Of The Top Five ESG Topics, Jan. 28, 2021
- The Change To The Industry Risk Assessment For Exploration & Production Companies And What It Means For Issuer Ratings, Jan. 25, 2021
This report does not constitute a rating action.
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