With the publication of its ‘Synthesis Report’, the Intergovernmental Panel on Climate Change (IPCC) – the UN-convened body responsible for climate science – closed its “6th Assessment Cycle (AR6)”1. The assessment is the result of nearly a decade of research and collaboration by the world’s leading
climate scientist, economist, and academics. It provides the most comprehensive update on climate science, mitigation, and adaption since the release of AR5 in 2014.
The findings from AR6 will form the backbone of climate policy and will inevitably shape the framework that the financial sector operates within. Hence, any investors interested in manoeuvring the complex climate space needs to be cognisant of AR6’s key findings. All the reports are ratified at international plenary negotiations in which governments formally approve the summary for policymakers, ensuring high credibility in national and international policymaking.
We provide key messages from the AR6 cycle that are relevant to investment management. The message of urgency is clear; we are not on track to achieve the Paris Agreement goals, climate finance flows need to grow immensely, investors must adequality price climate-risks, and the often-held perception that financial climate risks are a “future”- and not a “now”- problem is firmly dispelled. There is also a clear message of opportunity – that investments in mitigation and adaptation are likely to be a major economic growth area in years to come, opening up new and expanding areas for investment.
Where are we now?
It is an “unequivocal” fact that humans have caused global warming. The impacts are already severe and widespread, with those who have contributed the least disproportionally affected.
Summary: The IPCC is clear that we are already experiencing climate change, dismissing any myths that climate impacts are only future risks. A key scientific advancement is the confidence at which scientist can now connect increasing extreme weather events to anthropogenic warming.
Today, between 3.3 and 3.6 billion people live in contexts that are “highly vulnerable to climate change”. Increasing extreme weather is reducing food and water security in many regions – exposing “millions of people to acute food insecurity” – while regional economic damages are observed for sectors like agriculture, energy, and tourism. Climate change is contributing to humanitarian crises.
For example, floods and droughts have increased acute food insecurity and malnutrition in Africa and Latin America, while displacement and migration after climate extremes has perpetuated global vulnerability. In all regions, increasing extreme heat has resulted in “human mortality and morbidity”.
Implications: Extreme weather events continue to shock the global economy and supply chains. For example, the 2022 heatwaves across the US, Europe, and China, led to factory closures, crop yield losses, and wildfires, with knock-on impacts on global supply chains. In China, as well as disrupting livestock and crop yields, the heatwave pushed electricity demands to extreme levels in many regions, forcing prices up and directly impacting the region’s energy-intensive industries such as steel, fertilizers, and chemicals. Investors should ensure that companies in sectors with high vulnerability to extremes (such as food, electric utilities, and real estate) are building resilience now and are accurately measuring and reporting on exposure to climate risks.
Climate change impacts are becoming “more complex and difficult to manage” and we are likely underestimating the financial costs of systemic climate risks
The IPCC describes how multiple climate events interacting, such as the concurrence of heat and drought events, can generate new sources of vulnerability and compound overall risk exposure for many regions. An example used by the IPCC is how food production is threatened by both concurrent heat and drought events, as well as heat-induced labour productivity losses. In addition, local food impacts can reverberate through global supply-chains, pushing up food prices, impacting global supply and demand dynamics. The unavoidable interaction of risks means that looking at risks in isolation will lead to underestimations of climate induced losses.
The wide range of economic estimates, along with a lack of consistency in methodologies, limits the IPCC’s ability to accurately predict a range for the global “aggregated economic losses” from climate change impacts2. Challenges to understanding aggregated climate costs include models not being able to account for systemic complexities, such as the interactions between the climate system, the biosphere (like ecosystem damages and biodiversity loss) and social changes. Models also struggle with ‘tail events’ (so-called ‘tipping-points’) such as large-scale ice sheet melting – which will likely be triggered at certain temperature thresholds. The report also notes that model inputs, like the discount rate, as well as assumption about the value of damages, impacts the wide range of outcomes.
Implications: The complexity noted by the IPCC has crucial implications to how we understand the financial impacts of climate change. As recently put by the Bank of England “the fact that there will be impacts is foreseeable”. However, gauging the manifestation and magnitude of these climate impacts is complicated by the fact that historic economic datasets are bad predictors of future climate losses. The IPCC indicates that new sources of vulnerability, for example generated by concurrent events, can create risks that we are unable to see by looking at the current climate picture alone. Applying simplistic assessments of financial risks (such as looking at an assets vulnerability in isolation of macroeconomic impacts) may lead to mispricing of climate related losses.
Key takeaways for the investment community: (a) that methodologies for translating climate hazard into economic impacts is still nascent and (b) the costs are likely higher than expected. Scenario analysis and stress testing are tools used across the industry to understand climate risk exposure. These analyses can be done at company or portfolio level, highlighting areas of more significant risk exposure. As the data availability grows, we see this type of exercise becoming a cornerstone in risks management. We have written a separate piece about this particular topic which can be accessed here.
Some changes are “unavoidable and/or irreversible”
Summary: Amongst the reports most sobering conclusions is that many of the changes we are seeing now – particularly to the ocean (such as acidification, warming and loss of oxygen), sea level rise and melting ice sheets – are irreversible over the next thousands of years.
This means that in many cases we cannot reverse damages once done, and even if we halted all emissions today several impacts of climate of change will still play out over the next years, decades, and centuries. However, it is crucial to recognise that the rate and magnitude of these changes still depends on future warming. For example, we are looking at between 0.3–0.6 m sea level rise3 by 2100 even if we keep emissions below 1.5°C, compared to 0.6 – 1 m under higher emissions scenarios. In the long term sea levels are “committed” to rise by about 2 to 3 m over the next 2000 years, while the Greenland and West Antarctic ice sheets will be lost almost completely, causing “several meters” of sea level rise, if temperatures are sustained between 2 and 3°C.
Implications: The IPCC clearly indicates that some changes are here to stay. Even small changes to the climate have outsized impacts on society. For example, the costs to just coastal US cities, for less than 1 m sea level rise, could be over US$1 trillion. Other recent studies have estimated that US residential properties exposed to flood risks may already be overvalued by over US$200 billion, this likely systemic mispricing of risks leave markets vulnerable to corrections, which could have impacts on investors much sooner than expected. To protect from costs such as asset damage, increasing insurance premiums, asset deprecation and write-offs, investing in resilient infrastructure, as well as other adaptation solutions is crucial.
Where are we heading?
The world is likely to exceed 1.5°C of warming in the next decade
Summary: The 1.5°C target4 is likely to be exceeded in the “early 2030s”, though the speed at which we reach this limit will be defined by future emissions reduction actions.5 This was a headline finding in the global press in 2021 – at the release of the IPCCs report on “the physical science basis” – as well as at the release of the final synthesis report. The finding has already had major reverberations into the political arena. For example, the breakneck speed at which we are approaching the 1.5°C limit was a cornerstone of debate at COP27 in Sharm-El-Sheik, where Alok Sharma pronounced that the 1.5°C target was on ‘life-support’6. We predict it will continue to be so at COP28 in Dubai.
A way of understanding how close we are is to look at the remaining ‘carbon budget’. According to the IPCC the remaining budget in 2020 was around 500 billion tonnes of CO2 (GtCO2) for a 50% chance of staying below 1.5°C. If we continue to emit as much CO2 as we did in 2021 that give us just over a decade to stay within the budget. Even more sobering, the “projected CO2 emissions from existing fossil fuel infrastructure” will alone exceed the remaining 1.5°C budget, according to the IPCC. It is, however, important not to limit the debate to binary targets as the IPCC clearly states that the damages from climate change will grow “with every increment of global warming” implying that a future with just over 1.5°C of warming is still much better than one in which we approach 2 or 3°C.
Implications: It is not news that the totemic 1.5°C limit is at risk, and though the layers of complexity and detail in the 1.5°C debate matter, at the heart of the report is the message that the more done now to reduce GHG emissions, the more society will be protected from the climate impact.7 Clearly financial institutions have agency in this. Allocating capital to companies and technologies that enable a net-zero transition is crucial for enabling the transition. Reputational damage is a real risk for companies and investors who are unable to create and action on clear decarbonisation strategies.
Policy action on climate change is accelerating globally – but national climate pledges are still not in line with limiting warming to 1.5 or 2°C
Summary: Policies and laws addressing climate mitigation have “consistently expanded”. For example, by 2020 over 20% of global GHG emissions were covered by carbon taxes or emission trading schemes (note: this number has increase significantly since) and well over 50% of GHG emissions were covered by ‘direct’ climate laws. In many countries, polices have enhanced energy efficiency, reduced rates of deforestation and accelerated technology deployment. The market for green bonds, ESG and sustainable finance product have expanded significantly since the last round of reporting (2014). Still, public, and private finance flows to fossil fuel are greater than those for climate adaptation and mitigation and, in sum, current national pledges and action still make it more likely than not that we will see warming of well above 2°C.8
Implications: As investors, the growth of sustainable and green finance has been a noticeable trend, and changes in subsides and incentives, such as the US Inflation Reduction Act and the EU’s “fit for 55” package, have significantly impacted the investment landscape. But, as noted by the IPCC, current policies do not put countries on track to achieve the cuts needed to reach net zero. As such, it can be expected that further policy interventions (such as carbon prices) as well as incentives (such as subsidies) will be implemented, if countries are to realise the net-zero pledges and targets set in the international arena. The IPCC suggest that “regulatory and economics instruments” can support deep emissions cuts.
Policy interventions will likely have a sustained impact on several sectors, particularly those exposed to high-carbon emissions such as energy, utilities, transport, and heavy industry. Companies with fossil fuel infrastructure (such as oil and gas or coal-fired steelmaking) with long lifetimes may be at risks from asset stranding and value destruction. It is therefore incumbent on investors to understand the ‘transition’ risks to companies, evaluate how these are modelled and managed, and to allocate capital to those who are prepared for the (predictable) increase in mitigation policies and regulations.
What can we do?
Mitigation actions are needed now as we are facing a “rapidly closing window of opportunity to secure a liveable and sustainable future”
Summary: To limit warming, we need “rapid and deep and, in most cases, immediate greenhouse gas emissions reductions in all sectors this decade.” Emissions continue to grow, and fossil fuel combustion and industrial processes are the main sources of emissions. It is encouraging that the rate of growth has slowed slightly, but despite this GHG emissions have reached the highest levels in human history, and temperatures will not stop rising until GHG emissions are zero. Unless removed, once in the atmosphere CO2 stays there for centuries, locking us into future warming.
As such, there is a role for carbon dioxide removal (CDR), particularly for the hard-to-abate sectors. Often ignored – but part of the equation – is the ‘net’ of ‘net-zero’. The ‘net’ refers to carbon removal, which can occur through increased growth of organic matter (such as more trees or algae) or by other nascent technologies like Direct Air Capture and Storage (DACCS). There are, however, risks and trade-off for CDR, including pressures on land and reliance on technologies with high upfront costs. There are also methods of ‘natural’ carbon removal which can bring multiple co-benefits to ecosystems and biodiversity, such as “reforestation, improved forest management, soil carbon sequestration, peatland restoration and costal blue carbon management” which should be prioritised.
Implications: Here the IPCC is clear in its urgency; the more that is done now to mitigate climate change, the more we can protect from the worst economic and social impacts. Delayed mitigation would “lock-in high-emissions infrastructure, raise risks of stranded assets and cost-escalation” as well as reduce the feasibility to ensure a “liveable” future for all. Investors have been looking towards the nascent CDR market as one with strong potential for value creation and growth. At the same time, there is an increase in the scrutiny of the carbon removal space, with calls for clearer rules, regulations, and frameworks. CDR is no “silver bullet” solution; due to the sustainability trade-offs and cost challenges, carbon removal should not distract from transition.
There is enough capital in the system, but barriers to redirect it to climate solutions persist
Summary: There have been sustained decreases in the unit costs of low-carbon technologies like solar, wind and lithium-ion batteries, and large increases in deployment over the last ten years. Despite these clear measures of progress, financial flows to mitigation and adaption would need to increase “manyfold” and there are still clear “barriers to redirect capital to climate action”.
Some of the barriers to the deployment for commercial finance include “inadequate assessment of climate related risks and opportunities” and “limited institutional capacities”. Clearer signalling by governments and the international community, including higher level of public sector finance, will also reduce uncertainty and transition risks for the private sector. Another key finding is that innovation has lagged in developing countries due to “weaker enabling conditions”, and that much more work needs to be done to ensure that developing nations can access mitigation finance.
Implications: Several analysts have estimated that the global “mitigation market” or the “green economy” is worth many trillions USD already. The IPCC report suggests that the opportunities within low-carbon investments, technology and services will continue to accelerate. The report also underlines the crucial symbiosis between policymakers and private finance, with it incumbent on governments to give private sector the visibility and guarantees needed to allow for green investments. At the same time private finance needs to work to create enabling conditions, including increasing capacity and capability in the areas of climate risk and opportunity.
Closing the adaptation-finance gap: near-term actions and investments determine future economic losses
Summary: The IPCC concludes that actions implemented in “this decade” will determine the resilience to climate risks. Policy awareness of future climate risks has grown rapidly. However, the report finds that the current global financial flows – from both public and private finance – are “insufficient” for adapting to incoming climate damages.
The IPCC emphasises that the earlier adaptation measures are implemented, the more benefit they will have. From an investment standpoint the report is clear: by investing in adaptation now, the world will avoid higher investments in the future, due to fact that the benefits of adaptation outweigh costs in the long term. The report also stresses that the costs of adapting to climate change will drastically increase as temperatures increase, for example, regional adaptation costs for Africa are estimated at USD 50 billion per year by 2050, under a 1.5C scenario – but the costs could be as highs as USD 350 billion per year if we see high levels of warming.
Implications: Only a small proportion of climate finance is targeted for adaptation, and this has come predominantly from public sources. As the needs for adaptation are so transparent, some analysts, including at the Bank of America, suggest that the “adaptation market” could be worth over 2 trillion per year by 2026, creating a clear investment opportunity. This could include investment into resilient infrastructure and agriculture, clean water supply, as well as flood- and wildfire prevention. A mis-reading of climate risks (seeing it only as a future risk) could mean investors are not considering this an area of growth on investment-relevant timescales – however, as the IPCC shows, many of these costs are near-term. These investments often come at low capital expenditure and can offer faster payback to investors. Investing in adaptation may also be a way of balancing risks, by serving as a hedge against exposure to climate events.
1Along with three special reports, the IPCC released three major reports as part of AR6: ‘The Physical Science Basis’ (June 2021); In March 2022, “Impacts, Adaptation and Vulnerability” and ‘Mitigation of Climate Change’, released in April 2022. The final “Synthesis Report” summarised the key findings and messages of the complete AR6 assessment cycle.
2The Cross-Working Group Box on page 2507, ‘estimating global economic impacts from climate change’ summarises the work and main findings on aggregate economic damage.
3The IPCC measures sea level rise relative to 1995-2014.
4Defined as degrees of warming relative to preindustrial levels (1850-1900)
5Under B.1 (Possible Climate Futures), see table SPM.1, of the “Physical Science Basis”
6The World Meteorological Organization states that there is a 50:50 chance that temperatures could average 1.5°C or above in one of the next five years. This, however, should not be confused with “exceeding” 1.5°C or “breaching the Paris target”. The IPCC defines the ‘threshold-crossing time’ as the midpoint of the first 20-year period when the global surface air temperature averages higher than that target.
7For a deep dive into the debate and consequences of 1.5C this (16/03) Financial Times editorial is useful.
8Note: the report was published pre COP27, however this should not alter the findings significantly as new targets were scarce.