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Financial markets should take climate policy more seriously

The number of climate change laws on the statue books of the world’s leading economies grew from less than 40 in 1997 to almost 500 at the end of 2013. Most leading countries now have legal provisions…

Is the city shrouded in a carbon bubble? Lars Plougman, CC BY-SA

The number of climate change laws on the statue books of the world’s leading economies grew from less than 40 in 1997 to almost 500 at the end of 2013. Most leading countries now have legal provisions on renewable energy, energy efficiency, carbon pricing, land use change, transport emissions, adaptation to climate risks and low-carbon research and development.

These efforts do not yet add up to a credible global response that will limit the rise in global temperatures to less than two degrees Celsius – the objective of international climate negotiations. So we may expect not just more laws but also more rigorous laws over the coming years. But what relation does this have to financial markets?

Britain’s Environmental Audit Committee has recently warned that global efforts to combat climate change could in due course pose a risk to financial stability. Coal, oil and gas companies are a substantial part of the stock market, certainly in the UK, and their share price is determined, among other factors, by the size of their fossil fuel reserves.

The carbon contained in these reserves is three times more than we can burn if we are to avoid dangerous climate change. In other words, unless we find a cheap way to capture and store carbon, two-thirds of the fossil fuel reserves of coal, oil and gas majors will have to remain under ground. These companies, it would appear, are overvalued.

There is little evidence that the market shares this concern. Optimists and green investors point to a growing interest in environmental, social and corporate governance investment. Green bonds are booming, although they are issued mostly by blue chip companies and investors are sheltered from actual green risk.

But much of the energy industry has a very different view. Here, the talk is of a new age of fossil fuels, of abundant new reserves from unconventional sources – in particular shale gas, which has already transformed the energy market in the US.

So who is right: those who look forward to a resurgence of fossil fuels or those who warn about unburnable carbon?

It is hard to blame hard-nosed city analysts for being doubtful about tight carbon constraints, especially if their valuations focus on the short-term. Few countries have made a significant dent into their greenhouse gas emissions. Where emissions have come down, it has often been because of unconnected factors, such as the economic crisis in Europe or the advent of shale gas in the US.

City analysts will also point out that climate laws do not guarantee policy certainty. In the 2008 Climate Change Act the UK has one of the most sophisticated climate change laws, which gives UK climate change policy a clear long-term direction. But it has not prevented short-term policy alterations, as today’s budget statement may again show. Australian investors will make a similar observation about their policy environment.

It is also the case that not all climate change laws are as authoritative as the UK’s Climate Change Act or Mexico’s General Law on Climate Change. Particularly in developing countries climate policy is often made by executive order rather than passed by parliament.

But these provisions can be powerful too: China’s current five-year plan includes constraints on carbon emissions per GDP that are on a par with Britain’s carbon budgets, if these were expressed in the same way. The UK’s third carbon budget translates into a reduction in carbon intensity of 39% by 2020, relative to 2005, compared with China’s ambition of a 40-45 per cent cut.

More tangibly, policy makers are increasingly willing to penalise emissions by putting a price on carbon. The EU Emissions Trading Scheme may be ailing, but through a combination of taxes, trading schemes and regulation OECD countries impose carbon penalties. Prices range from less than £8 per tonne of CO2 produced in Mexico, New Zealand and the United States to over £70 per tonne of CO2 in Germany, Japan, Norway, South Korea and Switzerland.

The impact of these measures on firm performance has so far been modest, but they have given an edge to firms that are willing to cut their emissions.

A tentative finding from the analysis of the 500 climate laws so far is that one of the most powerful drivers of climate legislation is the number of climate laws passed elsewhere. There appears to be a strong element of peer pressure and intergovernmental knowledge exchange. If this is confirmed, it would point towards a self-reinforcing cycle.

The more climate change laws are passed – and the current pace is one new law per country every 18-20 months – the more ready policymakers become to take further action. The financial sector would do well to take note.