The green transition presents a major global challenge, which has recently been aggravated by a number of new obstacles. Geopolitics has affected policy-makers’ priorities, high interest rates are creating uncertainty among investors, and global competition is re-writing the rules. At the same time, while the seriousness of climate change has not been called into question, the changed operating environment foments doubts about whether the foreseen targets can be met.
Real economy or financial markets?
The green transition means, first and foremost, a transition towards a low-carbon society and energy production in the real economy. Countries are working to fulfil the commitments set out in the Paris Climate Agreement in order to achieve substantial emission reductions. The process is being supported by government action and the big and small decisions made by consumers, companies and investors.
The financial markets are also involved in this process. However, they are largely a mirror image of what is actually happening or expected to happen in the real economy. Financial markets follow trends in the real economy and reinforce them through their behaviour.
The pioneering role of financial markets is illustrated by the call for carbon reporting by companies. Thanks to the Carbon Disclosure Project, companies now report their carbon emissions and carbon intensity scores. As a result, investors find it easy to use the data to monitor their own performance and influence companies' choices.
Risks associated with the transition path
Typically, climate change risks are perceived in terms of the immediate physical risks posed by global warming (extreme weather events such as hot and cold spells, floods and storms) and the risks associated with the green transition itself (‘stranded assets” and lines of business, economic losses, etc.). These two risks are frequently invoked in an attempt to explain all that the transition involves.
In July 2021, I posted an article in VoxEU entitled ‘Integrating climate change into the financial stability framework’, which dealt with the risks stemming from the green “transition path”. I also discussed these risks at a seminar organised by the Bank for International Settlements (BIS). To describe the risks, I selected four areas in which they could arise. They relate to policy decisions, investment risks, present value and metrics.
First, the green transition is not a linear sequence of right decisions; instead, policy decisions may vary in terms of not only content but also timing. All of them represent major risks to asset values as well as the variables that affect the transition positively and negatively. For example, emission pricing may vary, and emissions taxes (or trading mechanisms) may fluctuate over time. All these factors determine the profitability of investing in and financing the green transition business.
Second, investing in innovations, such as green transition innovations, always involves risks. They can include rapidly changing and evolving technologies that replace previous inventions, innovations and products.
Third, changes in interest rates may increase the risk of a ‘hype cycle’ created by the green transition. During the ICT bubble, we were all in a position to witness true investor madness. The ICT trend led to a huge increase in values in the late 1990s, followed by a steep fall in the early 2000s. When interest rates rise, values may plummet.
Fourth, the metrics used by investors and businesses may change. Many people recognise that the indicators commonly used by investors are inadequate in the face of the challenge posed by a real climate change. Carbon intensity, commonly used by investors, measures the amount of emissions relative to turnover. While this is just one of the many indicators available, it is easy to use and the financial markets are accustomed to tracking it. New, more advanced indicators may be introduced in the future while changes in focus of interest may create new risks and offer new benefits for some.
Many of the transition path risks have already materialised
A lot has changed since 2021, and we have already had a foretaste of these risks. Russia's war of aggression has changed political priorities, higher inflation has pushed up interest rates and the pricing of the green transition has been partly redefined.
In the United States, a new anti-woke movement has been gaining ground, questioning the relevance of ESG criteria in procurement and investment decision making. Accordingly, purchase decisions should be based purely on financial considerations in lieu of ESG variables. This new trend is aptly illustrated by the book titled ‘The Dictatorship of Woke Capital’, which argues that ESG has been overemphasised at the expense of economic factors. Recently, many companies have been downplaying ESG to the extent that ‘greenhushing’ is becoming a reality in some insititutions.
In conclusion
Climate change remains a major challenge for humanity and nothing has changed in the big picture. However, the developments in the past few years have thrown a spanner in the works of the green transition.
Yet there are also some positive developments. The IRA funding package in the United States will give a major boost to green transition investments, while Europe has been investing in renewable energy in record time. These are all indications that there is no reason to lose optimism regarding the green transition. Strong action is needed to tackle climate change, and the financial markets have an important role to play in this.
Writer is VER's CEO Timo Löyttyniemi
