02 September, 2019

How Will Markets Price The Cost Of Climate Change?

I love capital markets - they are how we are able to express our views of what the future may hold. On almost any theme or idea, we get to invest capital based on how we perceive the risk of things staying the same or changing.

Whether that’s electric vehicle adoption, the future of media and information, medical marijuana, plant-based protein or interest rates. Capital markets allow us to invest in our views and be proven right or wrong.

Investing in our ideas is about having a view of the future, and then applying a subjective risk of that occurring, with a simple relationship: the longer the timeframe we are forecasting, the more risk we are taking and the more potential outcomes that exist.

Investors need to be considering strategies for their assets that span not only today but look at the world that we want for our children’s children - as opposed to the three-year economic and political cycles people tend to focus on.

Currently this is focusing us on three key areas shaping our markets:

  • The environment – what will our planet look like in 20 years and what might change?
  • Infrastructure – what will need to be built to accommodate those potential changes?
  • Agriculture – New Zealand has a strategic advantage in agriculture. How will that develop in the future?

Today, we are faced with a capital market where passive investing and interest rates have completely distorted valuations. The average price-to-earnings ratio in New Zealand is higher now than most places in the world, at the same time our own economy and our global peers face fresh risks.

The issue this causes is twofold. Firstly, to find acceptable returns, investors are taking on more risk which create materially higher potential outcomes. Secondly, those investments are increasingly expensive, so they require us to take a view about a growingly distant future.

The problem when considering so many potential outcomes is that with each there are a multitude of uncertainties. What will regulation be in 20 years? Who will the CEOs and leaders be? How will consumers behave? Will interest rates and technology change? The outcomes and risks in some cases are simply beyond our imagination.

It is human nature to focus predominantly on risks only in a negative light. But any idea has three potential outcomes or risks. One – it goes as we expect, two – it goes better, three – it is worse. We often fail to consider that there are two alternative scenarios to our base case idea and investment strategy – and that the alternative scenarios can be vastly different.

For example, I think it would be fair to say most people underestimated just how quickly Xero would succeed and overestimated how quickly Orion Health would. The problem with looking into the future is the longer we need to look, the more unknown the outcomes and the greater the risks we need to consider.

When it comes to investing, the same logic applies. The shorter the timeframes being considered, the easier the risks are to predict. Short dated bonds, term deposits and stocks on single digit price-to-earnings ratios have the most visible risks, and stocks trading on record multiples require us to look sometimes several decades out to consider the risks.

It seems every day we are reading about towns running out of water or having record heat waves. So, when we are looking at risks, the one with the most impact currently to our markets is the understanding of climate change and the response happening around us.

Climate change, or climate crisis, depending on your view, is not a new concept. But it seems the past three years of extreme weather has turned it from someone else’s problem to an accepted fact that the world will warm by 1.5 to 2.0°C by 2035. And to prevent it doing so by more will require significant investment, research and change. What the future holds for our environment and how we can protect it is reshaping our world politically, economically, commercially and socially, on an unprecedented scale.

Most of the developed world has adopted the Paris Agreement which is a non-binding agreement to maintain temperature expansion to 1.5°C, and New Zealand has committed to being carbon neutral by 2050.

To achieve that will require significant changes. It will require governments to place a price on carbon so that there are concerted efforts to reduce greenhouse gas emissions. It may lead to incentives on clean green choices. It will require corporates to accept responsibility and it will require consumers to change behaviors.

New Zealand is in a relatively good position because we have an established carbon market. By allowing carbon to freely trade we allow industries that can quickly reduce carbon to do so and, in turn, give the ones that can’t the ability to buy their carbon while technology catches up to help reduce their emissions. This ultimately incentivises capital into projects that help the environment.

We also have a government that is encouraging electric vehicle (EV) adoption and we are seeing consumer choices towards better options for the environment, such as plant-based protein and phasing out single-use plastic bags.

“The changes matter from an investment perspective because the response to climate change will eventually force the market to explicitly value their carbon cost and transfer that to their customers and shareholders.”

This will manifest in four ways that we will need to consider:

  • Government - new regulations will continue to be introduced. However, governments are voting machines with a short-term bias, so will lag the changes required putting the burden on corporates
  • Corporates - will instead take it onto their mantel to deal with this issue ahead of regulation, using it to differentiate themselves to their customers and investors
  • Investors - large investors ultimately reflect their underlying retail investors. Hence the continuing trend from retail investors to invest ethically will change the valuations of companies that don’t consider their carbon cost, and company boards will make choices to be ethical because it will impact their share prices
  • Consumers - ultimately, this will all come down to the consumer. Consumer choices will continue to drive demand that will change corporate behavior, which will mean that governments will regulate because it will be electorally palatable

New Zealand and other countries have signed the Paris Agreement as a first step to collectively manage global climate change. As yet, there is a serious lack of actual information from the government to New Zealand companies and investors when it comes to what this will mean for their future.

The world’s response to climate change and the effects of that response is going to be one of the new risks investors must consider when constructing long term portfolios.

Whether it’s consumer choices, government regulation, or changes to the cost of capital, our markets have no choice but to consider the implications of climate change to their investments.

Over the coming months we will look at what the Paris Agreement means to our capital markets and then who is impacted the most and what we need to consider when building our investment strategies.

A version of this article was published on the New Zealand Herald on 31 August 2019. 

This article reflects the opinions and views at the time of publication, and is not to be relied upon as a basis for making any investment decision. Please seek specific investment advice before making any investment decision. Jarden is an NZX Firm, a broker disclosure statement is available free of charge at www.jarden.co.nz. Jarden is not a registered bank in New Zealand.

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