Most of the traditional valuation methods likely underestimate the true cost
The race is on to reduce greenhouse gas emissions and fight climate change. But does the global economy have the finances needed to achieve net zero emissions?
McKinsey’s The Net-Zero Transition report published in January gives us an in-depth perspective in terms of the cost associated with net zero by 2050 so as to keep the average global temperature rise below 1.5 degrees Celsius.
Around 450 financial institutions and asset managers with over US$130 trillion of assets on their balance sheet made net zero pledges at the United Nations climate conference or COP26 in Glasgow late last year. The pledges are powerful but the question is whether they can follow through.
The McKinsey report puts it bluntly. To achieve net zero emissions by 2050 would require substantial capital allocation by governments and the private sector to transform the global economy – approximately US$9.2 trillion in annual spending on physical assets in energy and land use systems over the next 28 years. The net zero scenario has been estimated to cost around 7.5 per cent of global gross domestic product, while the increase in spending required over current levels works out to around half of all corporate profits and one-quarter of all tax revenues in 2020!
History repeating itself
Nine years ago, McKinsey estimated that Southeast Asia needed US$8 trillion for infrastructure capital spending between 2010 and 2020, with a growing need for innovative private sector financing solutions to meet any financing gaps. But in a 2018 update, the available infrastructure funding for projects in Asia was 10 per cent of what was needed.
Are we biting off more than we can chew when it comes to all these lofty spending targets, once in infrastructure spending and now in net zero emissions? Shouldn’t experts across the board be looking at the net zero targets and financials once again and then proposing feasible solutions such that we don’t end up with another financing gap?
Valuation
As business schools taught us, you cannot manage what you cannot measure. How does one go about estimating the costs associated with net zero? The standard MBA textbook approach to estimating costs is net present value (NPV), which is based on the time value adjusted costs and revenues over the period under consideration, say 2022 to 2050.
NPV, however, does not give you the flexibility to adjust investment decisions or defer an investment to a later date, also known as the flexibility option. It is hence our view that most traditional methods will likely underestimate the true cost of attaining net zero.
An alternative valuation approach could be real options analysis (ROA), which accommodates changes that may arise due to the uncertainties of an ever-changing world. The classic capital budgeting approach such as NPV ignores these features, whereas ROA recognises the ability to adapt in response to these changes. Some of the net zero projects are of high risk and are irreversible; ROA is hence directly applicable in this scenario. In fact, traditional valuation methods could potentially lead to sub-optimal net zero investment decisions.
Net zero also cannot be simultaneously reached for all groups since there are high emitters and low emitters in a group. Low emitters will likely reach it earlier than high emitters if they have sufficient resources and funding. The costs associated with high emitters achieving net zero would be substantial relative to low emitters.
Aside from this, the biggest problem isn’t the ambition to get to net zero, but how we get there. How should high emitters such as India and China, get to net zero in a feasible and efficient manner? India, for example, could focus on decarbonising its electricity sector. Soaring energy prices can also help support the financial attractiveness of clean energy generation.
Opportunities for asset managers
Climate change is creating new forms of investment opportunities and financial risks that asset owners and asset managers need to consider when allocating capital. It is imperative that asset managers consider the disclosure of climate investments and risks since they transform to investment risk in their books, and need to be measured, sized and scoped.
Asset managers need to be part of the global economic transformation conversation and not just be writing up investment policy statements that simply echo the net zero pledges.
Walking the talk
To move the needle on climate action, mainstream economies need to get in step with climate science. Countries – and the asset management industry – should therefore not lose sight of the substantial economic benefits from investments in decarbonisation. It also means walking the talk. As fiduciaries, asset managers should avoid greenwashing and excessive public relations stunts involving sustainable and net zero investing.
We need a joint all-of-government, academic and private sector effort to establish proper estimates of costs, set reasonable targets commensurate with those costs, disclose well-defined risks so that investors are aware of them, form economic policy that considers the urgency of climate issues and provides the appropriate “nudges”, and calculate economic growth adjusted for emissions such that it gives a true picture of the state of the global economy and helps guide sound, science-based public policy.
The article is an edited version of the one first published in Asia Asset Management.