How to invest and take advantage of net zero

It’s easy to be pessimistic about the idea of green growth. At the end of last year, a study from economists at the University of Barcelona and the London School of Economics and Political Science (LSE) argued that curbing global warming would only be possible if advanced economies moved to a ‘post growth’ era. By their reckoning, global warming could only be limited to 1.5C if world growth dropped below 2 per cent – a gloomy prospect given that it is only 3.1 per cent today. 

Some even question whether economics is equipped to grapple with environmental problems at all. Last year, S&P Global chief economist Paul Gruenwald argued that “the traditional view of economic growth has largely ignored growth's environmental impact and how economic agents may value the environment”. He added that we need to fundamentally change the way we think about the ‘cost’ of producing goods and services by ensuring that environmental damage is priced in. 

Then there was the pandemic: Covid-19 policies decimated economic growth, but had the knock-on impact of reducing emissions, as the chart shows. Some see other connections, too: an image by cartoonist Graeme MacKay did the rounds at the time: it showed a wave labelled ‘Covid-19’ engulfing a city. Behind it followed a far bigger tidal wave, this time labelled ‘climate change’. 

The parallels might seem tempting, but they are also unduly pessimistic: shutting down economies is not the only way to tackle a warming world. Given advances in technology and economic tipping points, there is reason to hope that we could be on the cusp of an era of green economic growth. 

A persuasive case?

Thomas Malthus’s 18th century conviction that population growth would outstrip increases in food supply feels like something from a firmly bygone age. Technology has triumphed over economic pessimism before (consider Victorian fears of streets overrun with horse manure), and many economists think that it could ride to the rescue again today. According to economists at S&P Global, “continuous innovation, rather than reining in output, is the best way to minimise the adverse impact of economic activity on the environment”. 

There is even an argument that green technology will make the economy more productive in the long run, too. It’s an obvious point, but a crucial one: wind and sun energy are ultimately a free resource. This means that energy generated from these renewable sources should end up cheaper than extraction and combustion from fossil fuels. Barclays analysts put it in economic terms: if we expend less capital and labour to generate energy, we should enjoy even higher living standards than in today’s fossil-fuelled world. As the table below shows, we could see positive supply-side shocks as green innovations boost productivity overall.

But there is also very real scope for negative shocks, especially over the shorter term. As the green transition progresses, carbon-dependent infrastructure will need to be replaced, and pollution is likely to be taxed at increasingly punitive rates. This means that, initially, reducing carbon emissions will act as a huge supply shock. Even if we do achieve an economy with net zero carbon emissions by 2050 as per the current target, growth will stutter as the economy adjusts. Barclays analysis suggests that even under a best-case scenario, total GDP could decrease by 4 per cent by 2050, before the economic drag imposed by the green transition starts to taper off. 

This feels unpalatable, but it is probably a whole lot better than the alternative. The blue bars on the chart above show that although the costs of climate inaction start small, they rise rapidly as global temperature targets are missed. Barclays analysis suggests that the hit to output would start off at around 2 per cent of GDP, rising to 8 per cent by 2050 and 20 per cent by the end of the century under current policies. 

This might sound extreme, but economists stress that the costs of climate events are already substantial. In 2019 climate change was linked to at least 15 extreme weather events costing between $1bn and $10bn each. Recently, we have seen severe drought in Argentina (which knocked 3 per cent off GDP), floods in Pakistan (8 per cent off GDP) and the 'Black Summer' bushfires in Australia which delivered a $2.8bn (£2.2bn) hit to total output and cost over 7,000 jobs. 

And if the last few years have taught us anything, it is that supply side shocks often come with a nasty inflation chaser. In the first two weeks after Russia’s invasion of Ukraine, European oil, coal and gas prices soared 40 per cent, 130 per cent and 180 per cent respectively. In the UK, the headline rate of inflation peaked at 11.1 per cent in October 2022 – with almost four percentage points of this directly attributed to energy costs. 

Transitional troubles   

There is no doubt that the green transition will impact inflation, and economists (who can never resist a good portmanteau) have come up with several new terms: we could see ‘climateflation’ from natural disasters and extreme weather events, ‘fossilflation’ as carbon taxes are imposed, and ‘greenflation’ as firms face higher costs from switching to renewable energy sources. 

Yet a green energy price spike should be very different to the energy price surges we have endured in the past, not least because changes should be well signposted by governments, and gradually phased in. While surging fossil fuel prices send revenues to energy-producing countries, domestic governments would get to keep the proceeds from any carbon taxes they implement. These could be used for grants and subsidies elsewhere, limiting the pass-through to households and firms. 

This should all result in significantly lower inflationary pressure than we have seen over the past few years. Barclays’ analysts calculate that between now and 2030, ‘green inflation’ will add only 0.4 percentage points to the inflation rate, with the impact fading to between 0.2 and -0.2 percentage points by the middle of the century. But as long as we are bound by a narrow 2 per cent inflation target, this could still trouble central bankers. Nigel Greene, chief executive of financial advisory firm de Vere Group, warns that rate-setters will hardly be able to dismiss decades-long ‘greenflation’ as transitory. A longer-term shift towards higher interest rates could result. 

Broadly speaking, the higher rates of the past few years have been bad news for green stocks. Demand for residential equipment such as electric vehicle (EV) charging points and solar panels have been hit by higher borrowing rates, while large-scale investment projects such as offshore wind farms and battery factories have also been buffeted by a higher cost of financing. Peter Garnry, head of equity strategy at Saxo Bank, told the IC that because the green transition is so capital intensive, growth in new projects slows down with higher interest rates. 

Although their revenue and earnings growth characteristics can make them look like tech investments, these businesses are “quite different” to asset-light and scalable tech firms, notes Michael Rae, climate solutions fund manager at M&G Investments. Technologies such as renewable power plants and plastic recycling factories tend to be capital intensive, meaning that they are more vulnerable to cost overruns and delays than nimble tech firms. The green transformation and artificial intelligence (AI) might both be (buzzy) economic megatrends, but investors should be wary of overestimating the similarities between the two. 

Thomas McGarrity, head of equities at RBC Wealth Management, calls decarbonisation “one of the most critical and persistent structural trends for long-term investors”. He adds that “we are still in the relatively early stages of a multi-year capex cycle” of spending on areas such as electrification and energy efficiency. M&G’s Rae thinks we already weathered the downturn in clean technology for this economic cycle, meaning that the future looks “fairly constructive”. Analysts often refer to the green transition as a ‘secular trend’: one unfolding over decades, rather than years. This suggests that the green transition won’t be derailed by short-term economic fluctuations – and investors shouldn't be either. 

Tipping points

Across swathes of northern Europe, billions of tonnes of carbon are locked up in permafrost. But rising global temperatures are putting it at risk. As permafrost thaws, it can release greenhouse gases that have been stored for millennia, accelerating the rate at which the remaining permafrost melts. Scientists warn that releasing these gases could push the climate past a crucial ‘tipping point’, leading to irreversible and catastrophic change. The natural world is full of these ‘tipping points’, where a small move past a crucial threshold can trigger a swift and drastic descent. 

But we can also see more positive economic tipping points when it comes to the adoption of green tech. Incremental improvements in low-carbon technology, lower prices and gradual changes in consumer behaviour can work to reinforce each other, leading to an accelerated rollout of a low-carbon alternative. According to Janos Hidi, principal economist for sustainable investment at Cambridge Econometrics, these triggers will prove a major economic driver of the green transition.  

Recent energy price spikes may have even brought us close to a ‘tipping point’ for green energy. Conflicts in the Middle East and Ukraine have heightened concerns about energy security, and hastened plans to improve domestic energy supply, particularly in Europe. In some regions, solar and wind power are now the cheapest new sources of electricity – even when accounting for storage costs. Katrina Brown, director of responsible investment at Evelyn Partners, told the IC that “while the transformation may initially have been motivated by the need to act on climate change, high energy prices and falling renewable energy costs have accelerated it”. 

We could be approaching a tipping point in the beleaguered EV market, too. According to Hidi, production is now reaching levels where capabilities and prices are meeting the needs of regular consumers, making EVs a rational choice – even without government support. A wider rollout would be better news for manufacturers at the high end of the market (such as Tesla (US:TSLA) – whose share price has fallen almost a third in the year to date), and even better for the kind of lower-range cars made by manufacturers such as Chinese firm BYD. 

Being selective

Saxo’s Garnry notes that “we have gone from a period of all green transformation stocks rising to a period of investors focusing on high quality”. But a more punishing economic backdrop (not to mention the impact of tipping points) can make the distribution of winners and losers hard to predict. 

Willem Sels, global chief investment officer of global private banking and wealth at HSBC, warns that “as is the case for any technological innovation, the adoption rate can be uncertain and a new technology can gain an edge over an earlier solution”. He notes that ‘pure plays’ solely focused on sustainable technological solutions tend to be small caps and very growth-focused, leaving them more vulnerable to higher interest rates – and more volatile, too. 

Investors tempted by green upstarts can look to companies such as Ceres Power (CWR) and ITM Power (ITM), both early-stage companies developing cutting-edge hydrogen technologies, both of which have had more than their fair share of setbacks in recent years. At the other end of the spectrum are more stable energy infrastructure trusts such as Greencoat Renewables (GRP), Greencoat UK Wind (UKW), The Renewables Infrastructure Group (TRIG) and Aquila European Renewables (AERI). 

Sels also sees opportunities in the ‘circular economy’, where companies aim to reduce consumption by repairing, reusing, recycling or redesigning old goods. This could provide a growing market for companies such as London-listed Renewi (RWI), which collects various forms of refuse and transforms it into secondary materials. Economists at HSBC Global Private Banking see significant opportunities in the build-out of the energy grid, given the adaptations needed to deal with the more intermittent supply of solar and wind energy. If so, operators of electricity transmission networks, such as National Grid (NG.), stand to benefit over the years ahead, should its investment plans pay off as hoped.

But while some companies are obvious beneficiaries of the green transition, others face a double downside. Economists tend to look at climate change through the lens of physical and transition risks: threats related to climate events such as wildfires, and the risks resulting from policy action taken to transition the economy away from fossil fuels.

Both of these will have huge consequences for valuations, and some assets may even find themselves ‘stranded’ either as a result of climate change or policies to curtail emissions. As the chart below shows, the potential scale of stranded assets is huge. 

Unburned fossil fuel resources and infrastructure (think pipelines and coal power plants) are particularly vulnerable and risk becoming unusable before the end of their expected lifetimes. This would clearly be bad news for companies extracting oil, gas and coal, but could have knock-on effects for other energy-intensive sectors, too. Barclays analysts warn that aviation and some forms of agriculture risk becoming ‘stranded’ if they cannot adapt to a zero emissions world. 

Estimates of the total value of stranded assets are highly uncertain, hinging on the stringency of climate regulations and the natural disasters we face along the way. A lower bound puts the figure at around $1tn-$1.4tn. An upper estimate, accounting for risks outside of the fossil fuels industry, puts the figure somewhere closer to $10tn-$20tn. This would equate to almost 4.5 per cent of total global wealth. 

So far, the big oil and gas companies remain relatively unconcerned about their exposure to transition risk. Although they have invested in carbon-capture technologies, ExxonMobil (US:XOM) and Chevron (US:CVX) have continued with upstream investment despite calls for a pivot away from fossil fuels.

Yet Evelyn Partners’ Brown says that major carbon emitters could find themselves with the most opportunities arising from a move to a greener economy – as long as they adapt. Building materials giant CRH (CRH) spent over $2bn on energy in 2022. Brown said that its push towards low-carbon waste and low-carbon materials should allow it to reduce its footprint, and push down costs simultaneously. Meanwhile, Severn Trent (SVT) is now the largest producer of renewable energy from food waste nationally. The German utility RWE (DE:RWE) has also successfully pivoted away from fossil fuels, and is now Europe’s third-largest renewables player.

The threat of climate change is both unprecedented and relatively well signposted. It can be tempting to ignore the risks it poses, or make economic comparisons to things we have experienced before. Yet the green transition won’t be like a lockdown, nor will it mirror an oil price shock, and economists hope that over the next few years, market forces and technological improvements will lead to more positive 'tipping point' breakthroughs. The big question is whether this will be fast enough.

Progress on some fronts is encouraging. According to M&G, the world installed roughly 1GW of solar capacity in the whole of 2004. By 2010, this was running at 1GW per month, and by 2016, it hit 1GW per week. In 2023, the rate was 1GW per day. At this rate, solar panels could soon be as ubiquitous as laptops and mobile phones. But we managed the digital transition without stringent targets and the looming threat of more extreme climate events. The opportunities in the green transition are huge – but so is the pressure.