The net-zero transition requires the rapid development at scale of new technologies, energy-efficient infrastructure, and carbon capture and storage. A carbon price, together with the elimination of fossil-fuel subsidies, would give investors powerful incentives to finance these and other imperatives.
The quest for carbon neutrality has begun in earnest. More than 70 countries1, including the world’s biggest polluters, have set net-zero targets for carbon dioxide emissions, with hundreds of cities, companies, and investors committing to complementary strategies. But a successful net-zero transition will require a fundamental transformation of the real economy. Russia’s invasion of Ukraine, which has roiled global energy markets, has reawakened concern with energy independence. Now is the time to put a price on carbon as it is essential to drive the shift from our current overwhelming dependence on fossil fuels.
By allocating society’s savings, financial markets shape the economy. Investors’ choices depend on two factors: information and incentives. It is only when investors have both that financial markets can do what they do the best: allocate capital toward its best and highest use.
To understand this dynamic, consider the evolution of investors’ understanding of risk, an ambiguous concept until 1952, when Harry Markowitz defined it as volatility, which has mathematical properties and is thus quantifiable. In 1964, William F. Sharpe built on this contribution to create his capital asset pricing model, which describes the relationship between systematic risk and expected returns, thereby putting a price on market risk. Together, Markowitz and Sharpe revolutionised how investors analyze investment risks and opportunities and thus how financial markets allocate capital.
A similar revolution in investors’ understanding of climate risk is needed today.
High-quality climate-risk data, gathered through mandatory disclosures, is vital to enable the development of useful analytical tools. Fortunately, both the US Securities and Exchange Commission (SEC) and the International Financial Reporting Standards Board are beginning to recognise this imperative, and have proposed2 new requirements3 for climate-related disclosures.
That disclosure is necessary, but not sufficient. Incentives matter, and they are currently skewed in the wrong direction.
The first problem is that the fossil-fuel industry is cossetted by massive subsidies. The Glasgow Climate Pact4, agreed at last year’s United Nations Climate Change Conference, notes that such “inefficient subsidies” currently are equivalent to half of the total investment in fossil fuels.
The second factor distorting financial markets and preventing efficient capital allocation is the free ride CO2 emissions are getting. How is it that the “polluter pays” principle has not yet been applied? After all, these unabated emissions cause global warming which poses an existential threat to humanity.
This is where a carbon price comes in. The net-zero transition requires the rapid development at scale of new technologies, energy-efficient infrastructure, and carbon capture and storage. A carbon price, together with the elimination of fossil-fuel subsidies, would give investors powerful incentives to finance the necessary energy transition.
Before the 2015 UN Climate Change Conference in Paris, more than 340 investors representing over $20 trillion assets under management released a statement5 calling for plans to phase out fossil-fuel subsidies and introduce carbon pricing. Their call was, for the most part, politely ignored. But as the International Energy Agency began to map the costs of the transition, it became clear that governments alone could not foot the bill; the trillions of dollars in financial markets must be mobilised.
The Paris climate agreement recognised private markets’ essential role in marshaling the finance needed to keep global warming “well below” 2° Celsius relative to pre-industrial levels, and provides guidance for establishing cross-border emissions-trading schemes. So far, 40 national and 25 subnational jurisdictions have put a price6 on carbon, covering about 15% of global greenhouse-gas emissions.
Add to that the 46 additional carbon-pricing initiatives that are in the works – including in major economies like China and Brazil – and around 25% of global emissions are set to be subject to a carbon price. That is a step in the right direction, but not nearly enough.
Meanwhile, the SEC has made the modest suggestion that companies need to report the carbon price they are assuming in their financial planning. This reflects the recommendations of the Commodity Futures Trading Commission, whose authoritative committee on climate risk – which includes asset managers, banks, and commodities firms – signed off on the obvious: Unless we put a price on carbon7, we cannot manage the energy transition effectively.
Addressing climate change requires behavioral change, and people change their behavior in response to incentives. Pricing the negative externality of climate change explicitly will drive companies to reduce emissions, and consumers to make the necessary lifestyle changes. A carbon price would also generate revenues, which can be allocated to the development of green technologies or distributed to the public in a way that supports a just transition. In short, carbon pricing can achieve economic, climate, and social goals simultaneously.
In Oscar Wilde’s Lady Windermere’s Fan, Lord Darlington quips that a cynic is someone “who knows the price of everything and the value of nothing.” Investors are currently in precisely the opposite position: We know the value of tackling climate change, but we have not established the price. Climate change poses a systemic risk that investors cannot simply diversify away. Unless that risk is accurately priced, the costs will be incalculable.
Author: Yu (Ben) Meng, Ph.D. Executive Vice President and Chair of Asia Pacific, Franklin Templeton. If you want to find out more about Franklin Templeton solutions talk to your financial adviser
ENDNOTES
- Source: United Nations, Net zero coalition.
- Source: U.S. Securities and Exchange Commission, “SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors,” March 2022.
- Source: International Financial Reporting Standards Foundation, “ISSB delivers proposals that create comprehensive global baseline of sustainability disclosures,” March 2022.
- Source: 2022 United Nations Framework Convention on Climate Change, The Glasgow Climate Pact – Key Outcomes from COP26.
- Source: DownToEarth, “Institutional investors call for carbon pricing to tackle climate change,” September 2014.
- Source: 2022 United Nations Framework Convention on Climate Change, About Carbon Pricing.
- Source: Commodity Futures Trading Commission, “CFTC’s Climate-Related Market Risk Subcommittee Releases Report,” September 2020.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Franklin Templeton and our Specialist Investment Managers have certain environmental, sustainability and governance (ESG) goals or capabilities; however, not all strategies are managed to “ESG” oriented objectives.
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