The effects of climate change are no longer a distant threat. The latest report from The Intergovernmental Panel on Climate Change tells us that urgent and more ambitious action is needed. Consequently, governments, companies, institutional investors, and financial institutions are focused on developing strategies to effectively reduce greenhouse gas (GHG) emissions, slow down environmental degradation, and mitigate climate transition risks.
In this blog, I highlight how global policy responses to the climate crisis and the targets set within them could affect business strategy and operations. I also outline what investors can do to evaluate this transition risk among portfolio companies. We’ll delve into the European Union’s Fit for 55 package, as it provides examples of the most ambitious policy response to the climate crisis thus far, and has far-reaching implications for companies supplying goods and services to the EU market.
How Investors Can Assess Climate Transition Risk
As part of their response to the current climate crisis, institutional investors and financial institutions are assessing the climate transition risks in their portfolios. To do that, they need to understand the GHG emissions budgets for the companies they invest in. The emissions budget is the amount of GHG emissions a company is allowed each year until 2050, if its activities are aligned to a 1.5-degree Celsius global temperature rise.1 The budget is dependent on the pace of climate policy implementations in the coming years.
To help prepare institutional investors for the risks and opportunities related to an acceleration of policy responses to climate change, the United Nations Principles for Responsible Investment commissioned a consortium called Inevitable Policy Response (IPR) to develop the Required Policy Response (RPR) scenario. The IPR forecasts that, to address the climate crisis, “governments will be forced to act more decisively than they have thus far, leaving financial portfolios exposed to significant transition risk.”2 This scenario may seem questionable, given the uncertainty on whether governments will actually become more decisive. However, there are already several examples of climate laws implemented just as the IPR presumed.
The Fit for 55 Regulation
The Fit For 55 regulation package is a real-world example of the required policy response. Legislation has also been passed outside of the EU, such as the coal capacity market reforms in India,3 the announced end of fossil-fueled cars and vans sales in China4 and South Korea5 by 2035, and the 100% clean power standard in several states of the U.S.6
The Fit for 55 legislative package explicitly aims to set the EU on a decarbonization path reducing carbon emissions by 55% by 2030 compared to 1990 levels. Several key pieces of the package, including the revision of the Emission Trading Scheme, the Carbon Border Adjustment Mechanism, and the Social Climate Fund, were adopted by the European Council in April 2023.7
The Fit for 55 legislative package, along with new requirements for renewable energy use and energy efficiency, has the potential to transform the economy. The most ambitious Fit for 55 measures target industries with high energy consumption: buildings, heavy industry and transport. Most measures will come into effect in 2024 and 2025, with a planned surge in energy efficiency and low-carbon fuel use targets in the years leading up to 2030 and 2050.
For instance, planes flying from EU airports will have to use a minimum of 2% sustainable aviation fuel (SAF) starting in 2025, increasing the minimum uptake in small increments until 2030. The minimum target for SAF use will then ramp up to 70% by 2050, which is an ambitious target, given the current state of airplane fleets and existing technologies (current maximum certified SAF blending percentages are between 10% and 50%).8 Similarly, the carbon reduction target for shipping moves from 2% in 2025 to 80% in 2050, despite no definitive low-carbon alternative fuel for large container ships.
Table 1. Select List of Regulations Included in Fit for 55
|ReFuel Aviation Directive||Carbon Border Adjustment Mechanism (CBAM)|
|Fuel EU Maritime||Social Climate Fund (SCF)|
|Revision of Alternative Fuels Infrastructure Regulation||Revision of the Emissions Trading Scheme (ETS)|
|Energy Taxation Directive||Amending the regulation on greenhouse gas emissions and removals from land use, land use change and forestry (LULUCF)|
|Energy Efficiency Directive||Revision of CO2 emission performance standards for cars and vans|
|Renewable Energy Directive||Review of Effort-Sharing Regulation (ESR)|
|Methane Emissions reduction||Notification of the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA)|
|Buildings Energy Performance|
Source: Fit for 55 package Under the European Green Deal. For informational purposes only.
How Companies Can Prepare for Increasingly Ambitious Carbon Reduction Targets
1. Prepare Assets for Efficiency
Given the increasingly ambitious energy efficiency and sustainable fuel use targets set out in the Fit for 55 package, we must acknowledge the time it will take for companies to implement the necessary changes in their businesses and supply chains. Take the ReFuelEU Aviation regulation, setting gradually progressive targets on SAF and e-kerosine uptake for aircraft departing from EU airports. Most aircraft can already run on a mix of SAF and kerosene. The challenge to come is in building aircraft that run mostly or solely on SAF. This will require airline companies to renew their airline fleets; a major investment that cannot be done overnight. At the same time, the supply chain needs to prepare to assure sufficient SAF supply and the infrastructure to deliver it.
2. Coordinate Across the Business Ecosystem
Having targets that accelerate towards 2050 will give industries a shared trajectory so that interlinked production processes can shift together. For instance, the Alternative Fuels Regulation targets airports, highways, and marine ports to ensure sufficient electric charging points and hydrogen refueling points. This has major consequences for energy suppliers, contracted building and construction companies, the airlines and shipping companies operating at airports and marine ports, and, ultimately, the capacity of the electricity grid.
Since these measures will be dependent on an entire business ecosystem — an ecosystem that will need to deliver on technological innovation, suppliers shifting production processes to different materials, the development of existing production sites and technology, as well as different skills within the workforce — a common point on the horizon is necessary to move all businesses in a supply chain in the same direction.
3. Account for Future Measures in Current Business Planning
Furthermore, businesses will need to account for future policy measures in their current planning. Car manufacturers that will no longer be able to sell combustion engine vehicles after 2035 will need to start investing today in building the factories to manufacture electric vehicles, training their workforce on these technologies, and setting up supplier relations for a completely different set of materials. Additionally, car manufacturers will need to consider the change in pricing and the taxation of raw materials like steel and aluminum as a result of the Carbon Border Adjustment Mechanism.9
Considering the system-wide transitions required for carbon reduction, it is understandable that the measures in the Fit for 55 package will need to be implemented gradually. This should help to avoid economic shock, widespread unemployment, price instability, and immediate supply shortages. These policy measures and associated economic shifts require careful planning at the micro and macro level. If companies do not start making changes today, they could experience larger implementation shocks closer to 2050.
Measuring Climate Transition Risk in Investment Portfolios
When assessing the climate transition risks of portfolio companies, investors need to assess companies’ management. Does the company have management structures in place to adopt the measures needed to meet their net-zero commitments and keep the global temperature rise to 1.5 degrees by 2050?
Most companies will have to drastically change their business models, supplier relations, technical know-how, employee skill sets, infrastructure, and factories today if they want to be aligned with that objective a few years from now. Investors can use assessments like the Low Carbon Transition Rating (LCTR) to determine company readiness and align their portfolios accordingly. The LCTR shows how well-prepared companies are for the 1.5 degrees scenario and the required policy response. Our analysis finds that most companies are misaligned with the 1.5 degrees scenario, but companies that are most severely misaligned could face the highest risks to their business continuity when regulatory targets accelerate.
Ambitious climate policies and targets are a welcome invitation to companies to start planning their alignment with these measures. However, the longer companies wait to act, the more stringent, destabilizing and financially impactful the transition will be.
- Sussams, L. 2018. “Carbon Budgets Explained.” February 6, 2018. Carbon Tracker. https://carbontracker.org/carbon-budgets-explained/.
- Principles for Responsible Investment. “What is the Inevitable Policy Response?” n.d. https://www.unpri.org/inevitable-policy-response/what-is-the-inevitable-policy-response/4787.article.
- Chaganti Singh, S. and Varadhan, S. 2023. “India amends power policy draft to halt new coal-fired capacity.” May 5, 2023. Reuters. https://www.reuters.com/business/energy/india-amends-power-policy-draft-halt-new-coal-fired-capacity-sources-2023-05-04/.
- Reuters. 2021. “China targets 1.8% cut in average coal use at power plants by 2025.“ November 3, 2021. https://www.reuters.com/business/cop/china-cut-coal-use-power-plants-300gkwh-by-2025-2021-11-03/.
- World Economic Forum. “China joins list of nations banning the sale of old-style fossil-fuelled vehicles” November 2020. https://www.weforum.org/agenda/2020/11/china-bans-fossil-fuel-vehicles-electric/.
- CBS News. “Chinese Province Plans to ban the sale of Gasoline Powered cars”. August 2022. https://www.cbsnews.com/news/chinese-province-plans-to-ban-the-sale-of-gasoline-powered-cars/.
- Just Auto. 2022. “South Korea to phase out ICE vehicles by 2035.” March 2022. https://www.just-auto.com/news/south-korea-to-phase-out-ice-vehicles-by-2035/#:~:text=South%20Korea's%20president%2Delect%20Yoon,2035%2C%20according%20to%20local%20reports.
- Clean Energy States Alliance. Table of 100% Clean Energy States. n.d. https://www.cesa.org/projects/100-clean-energy-collaborative/guide/table-of-100-clean-energy-states/.
- Council of the EU. 2023. “’Fit for 55’: Council adopts key pieces of legislation delivering on 2030 climate targets.” April 15, 2023. Press release. https://www.consilium.europa.eu/en/press/press-releases/2023/04/25/fit-for-55-council-adopts-key-pieces-of-legislation-delivering-on-2030-climate-targets/#:~:text=Presented%20by%20the%20European%20Commission,achieve%20climate%20neutrality%20in%202050.
- Destination 2050. 2021. A Route to Net Zero European Aviation. February 2021. https://www.destination2050.eu/wp-content/uploads/2021/03/Destination2050_Report.pdf.
- European Parliament. 2023. “Carbon border adjustment mechanism as part of the European Green Deal.” May 20, 2023. Legislative Train Schedule web site. https://www.europarl.europa.eu/legislative-train/package-fit-for-55/file-carbon-border-adjustment-mechanism.
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