Our changing climate is a long term investment risk that is already unfolding, creating risks and also opportunities. Fossil fuel energy stocks are already feeling the pinch and future growth is unlikely to rely on them – though there are likely to be short term underpricing opportunities amid this long term shift. Judicious active stock picking is likely to be better than an index approach in this unpredictable transition as new opportunities can be more readily adopted.
Energy consumption share of oil and coal will fall and gas is expected to rise. Returns from coal are likely to fall significantly over the next ten years as global behaviour adapts for a more sustainable planet. Conversely, renewable energy can be expected to rise over the same period by an opposite amount.
In the UK renewable energy use recently surpassed coal. EU renewables were 13% of their energy consumption in 2013 and they’re targeting 20% by 2020. Renewables used in the US are also around 13% and renewables in China are about 9%, mainly from hydro. Unfortunately for the planet, most of our energy in Australia is still from fossil fuels, mostly coal. As coal is the cheapest energy source, it is likely to still be used significantly for many years. Global energy requirements continue to grow and annual coal consumption growth is still predicted to be 9 billion tonnes by 2019.
If we could keep global temperature rises to a tolerable level that science suggests is 2C, then normal investing decisions (apart from fossil fuels) may apply. However, we seem on a path to more extreme temperate rises with Greenland’s melting ice cap potentially raising sea levels by about 500mm. If it is already too late and such extremes occur, then it will be difficult to succeed with growth investing, so investing more defensively may be preferable. Indeed in a no growth environment, income is all that matters. Even so, in a more extreme ~4C scenario, Australia is highly vulnerable and South Australia in particular – as it’s the driest state in our driest continent.
The geo-political effect of the recent Paris attacks may galvanise the West to move faster on renewable energy research to overcome its dependence upon Middle East fossil fuels. If so, the Paris climate change talks may start to show this renewed focus. Australia will get some stick and our leaders need a face saving reason to encourage renewables – the tax reform discussions may be another face-saving pathway back to a carbon price/tax.
China is trying to extricate itself from coal, though it will be slower than they’d like. Solar with batteries, augmented by some wind power, hydro and other renewables will be seen as the future for the West. It will all take many years to achieve but the pace of change needs to pick up. For investors, this means adjusting your strategies.
Climate change will stimulate global development of climate resilient, energy efficient technologies that emit minimal carbon. The timing and likely effect of this on existing investments is unclear, so investors need to watch for policy changes and technological developments themselves. One possible example is Tesla’s ‘Power Wall’ battery pack that when teamed with a rooftop solar array may allow householders to disconnect from the electricity grid. We must watch for other renewable energy and energy storage solutions that may affect our transition from fossil fuel dependence.
Low carbon industries should benefit in future. With more dramatic climatic events, fire and general insurance has become a volatile sector that is difficult to price, with higher cash flow risk. Real estate decisions would need to be mindful of location risk. Infrastructure will face major change, creating potential losses and gains. Among other changes, agriculture will also be affected as the ‘Goyder line’ moves south.
Investment strategies need to identify climate-related risk and decide on its likely time sensitivity. Do you aim to reduce the carbon emissions intensity of your portfolio over time or reduce exposure to fossil fuel reserves and exploration? Perhaps you’d like to invest part of your portfolio in future low carbon opportunities? Companies will be encouraged to report on their carbon outputs and transitional progress on climate change.
Identifying climate sensitive industries is a building block in this. Some issues include disruption to operations or supply chains from extreme weather events, damage to crucial infrastructure, transport difficulties and water limitations. Others relate to shifting Government policy and technological change. For example, banks will experience higher default risk on loans to those in climate vulnerable situations. Another is whether current energy providers will change smoothly from fossil fuels towards renewables or will they go the way of the blacksmith?
If Australia’s high uptake of solar panels is augmented by affordable battery storage (as Tesla anticipates), then keen pricing will be required to encourage retention of a grid connection. CSIRO research suggests only a few will disconnect entirely, most preferring to keep a fall-back grid connection with limited use. But the recent over-investment in energy distribution infrastructure will become a cost to society and presumably the distribution companies. Origin and AGL may suffer from this when pricing pressure intensifies.
This climate sensitive investment effect will unfold over many years and some will move too early, others too late. As always it is difficult to read future investor behaviour, but this is what drives prices. Carbon needs to be included in the normal investment measures of price, earnings growth and cash flows for various investment alternatives.
Investors need to be aware of change ahead and keep focused on future income while judiciously navigating a diversified, balanced path forward. In scanning the horizon, we should also resist looking too far ahead lest we miss short-term opportunities.