The urgent need for action on climate change means that investors need to think about carbon in their portfolios. And they need to do so from multiple perspectives.
To help investors do this, we have developed a carbon framework.
In this paper we explain the four pillars of the framework and focus on the first two, which investors can use to better understand how the supply of sustainable assets is evolving.
A later paper will cover the carbon-related assets that investors can purchase.
Introducing the carbon framework
We have focused on four pillars of activity in the investment economics of carbon. The first two represent policy research pillars; namely fiscal and central bank policy.
An understanding of these first two pillars helps investors assess the risks and opportunities that face their portfolios. A misunderstanding of the policy landscape could cause investors to fall behind in their understanding of the evolution of the sustainable investment landscape, exposing them to greater sustainability risks.
While we have focused on public policy in this paper, investors should also consider corporate and consumer behaviour.
The second two pillars represent the asset market pillars. Investors can buy and sell tangible assets associated directly with carbon. However, the investment and sustainability rationales for investing in these carbon-related assets differs markedly for the two pillars.
Pillar 1: How does fiscal pricing of carbon impact portfolios?
The fiscal policy pillar of our framework considers the impact of carbon pricing on investments, and here there are two main types of carbon prices: taxes and emissions trading systems. We discuss emissions trading systems in a lot more detail in part two of this series; here we focus on carbon taxes.
Carbon taxes are a cost-effective policy tool that governments can use as a part of their broader climate strategy. They create a financial incentive for companies to reduce emissions and address price barriers that face carbon-efficient economic development. Carbon taxes allow governments to assign a price to carbon emissions but lets the market determine the rate of emission reductions. In contrast, emissions trading schemes fix the volume of allowed emissions and let the market determine the price of those emissions.
Carbon taxes represent a key way in which climate change impacts businesses, and therefore investments. Carbon taxes can play a role in incentivising low-carbon activities by putting the cost of greenhouse gas emissions onto the companies that emit them directly. This not only curbs demand for fossil fuels, but also encourages businesses to develop low-carbon technologies and switch to using cleaner sources of energy.
An understanding of carbon tax policies around the world can help investors make better informed decisions when investing in businesses that operate with varying carbon intensities.
As of 2021, 35 carbon tax programmes have been implemented around the world. Finland introduced a carbon tax in 1990, becoming the first country to use a carbon tax as a tool for climate change mitigation. The original tax rate was $1.41 per ton of CO2 emissions; today Finland’s carbon tax rate is $73/tCO2e. Carbon tax rates around the world vary quite significantly by country, as seen in Figure 2. Taxes range from $0.05 in California to $137 per metric ton of CO2 emissions in Sweden.
But when thinking about the impact of carbon taxes, investors must consider more than just the tax rate. The scope of carbon emissions covered by the tax can determine how relevant a certain country’s carbon tax is to investors in companies in that country. It is worth also noting that some jurisdictions are applying ‘carbon border adjustment mechanisms’ which effectively allow one jurisdiction to impose its carbon price on other countries.
By way of example, in Singapore, the carbon tax only applies to direct emissions from facilities emitting at least 25 ktCO2e per year. Despite only taxing about 50 of their largest emitters, the coverage of Singapore’s carbon tax is one of the highest in the world, covering around 80% of its total emissions.
The scope of carbon tax also influences which sectors are impacted. Spain’s carbon tax only applies to fluorinated gases, taxing only 3% of the country’s total emissions. In contrast, Norway recently abolished most exemptions and reduced rates for certain sectors; now its carbon tax covers 66% of emissions.
Carbon taxes have been demonstrated to have a tangible effect on the real economy. In the UK, CO2 emissions have fallen to their lowest level since 1890 as carbon taxes prompted electric utilities to reduce their emissions. The 2013 carbon tax enacted a price floor for certain sectors, including electricity. That has encouraged electric utilities to rapidly switch from coal to somewhat cleaner natural gas and renewables, as shown in Figure 3.
An important impact of carbon taxes on investors’ portfolios is inflation. For carbon taxes to be successful in reducing emissions they must be sufficiently priced. With the adoption of net zero targets by many governments, we are beginning to see an increase in carbon tax rates. However, many countries’ carbon tax rates continue to fall short of what is needed to meet the goals of the Paris Climate Agreement.
To reach the target of 2˚C for global warming by 2050, our analysis shows carbon prices will have to be far higher than recent levels, reaching over $100/tCO2e. Carbon Value at Risk shows almost half of listed global companies would face a rise or fall of more than 20% in earnings if carbon prices rose to $100/t.
Price rises on this scale will reshape industry cost structures, opening competitive opportunities for better placed companies.
It is in this manner that we believe an understanding of the policy landscape will help investors to assess the risks and opportunities that face their portfolios – at the security, sector, country and even asset class level – and in turn understand the evolution of the sustainable investment opportunity set.
Pillar 2: How does central bank action on climate change impact portfolios?
In the face of recent net zero carbon emission commitments, central banks around the world are now having to develop a new response function to climate change. For investors this means central bank-watching now involves understanding how they might respond to one of the most important systemic threats to the world economy (and the world) in history.
So, just as investors have always done with traditional reaction functions. When investors think about the ‘reaction function’ of a central bank, they are aiming to understand how the central bank might respond to new economic data when making policy decisions.
We think they should have a framework for assessing the climate change reaction functions of central banks globally. This will help investors understand how likely it is that climate-related factors might cause significant behaviour changes by a given central bank. In turn, this will help investors understand what the impact of those changes in behaviour might be on the asset classes in which they invest.
When we think of central banks, monetary policy is often the first thing that comes to mind. However, in their efforts to tackle climate change, monetary policy is not central banks’ primary tool.
In our study of 41 central banks – where we looked at hundreds of central bank speeches and official documents – if a central bank reported ‘supporting the transition’ to net zero as its reason to act, it also reported one or both of “protection” and “monetary policy effectiveness”.
There were no central banks that prioritised the transition without protection, risk management or monetary policy effectiveness too. In defining central bank responses, we leaned heavily on the framework devised by the Network for Greening the Financial System (NGFS), which is a network of 83 central banks that has developed a set of recommendations for the role of central banks in tackling climate change.
The topic of monetary policy effectiveness is a double-edged sword: the physical and transition risks of climate change can impact monetary policy effectiveness, but the adjustment of operations to account for climate risks can itself impact the broad scope through which central banks can carry out monetary policy operations.
For example, consider a scenario where a central bank embarks on a corporate bond buying programme to provide emergency liquidity during a crisis. If the central bank’s policy is to not buy bonds of high-emitting issuers, the scope of their liquidity programme will be lower. Similarly, opponents argue that efforts to reflect climate considerations in capital requirements could result in greater financial instability in the short term, not less.
Crucially, monetary policy is not the only thing that central banks do. Many – if not most – central banks also take responsibility for macro- and micro-prudential risk management policy in their respective jurisdictions. In fact, most of the tangible action that has been taken by central banks so far is in the realm of macro-prudential policy as opposed to monetary policy. This is in line with our study that reveals ‘protection and risk management’ as central banks’ primary reason to act.
Stress-testing and scenario analysis are two key tools that central banks are using under the banner of prudential risk management policy. As stress tests and scenario analyses reveal the effects of physical and transition risk on company-level entities, we can – for example – assess in turn the impact on commercial banks through their lending exposures to those companies.
The European Central Bank’s economy-wide stress test is the best source of evidence we have for understanding such potential impacts. Its stress test categorises commercial bank exposures to companies grouped by country, sector, size, and other characteristics.
In Figure 6 we show the share of bank loans exposed to transition and physical risk by country. While transition risks are comparable across countries, physical risk is much more polarised. Investors can use this information to understand potential climate weak spots in their portfolios, and position for higher exposure to areas of relative climate resilience.
In comparison, the US Federal Reserve (Fed) has been much slower to move than Europe, and has stuck more rigidly to its aim to remain “neutral” on climate change when it comes to monetary policy. It only joined the Network for Greening the Financial System (NGFS) in December 2020.
The difference between the ECB and the Fed has important implications for investors.
The ECB’s active efforts to identify climate risks at granular levels suggests that its climate response function might be more targeted and specific, rather than broad-based. Not only could this lead to investor re-allocation between European countries and sectors, but it could even shift allocations between Europe and the US if investors were more comfortable with the goalposts being set in the former policy jurisdiction.
Taking a step back, it is worth considering why it might be important for investors to understand the central bank climate response function in the first place. Policymakers – mostly elected governments but also central banks – will play a significant role in defining the system-wide decarbonisation trajectory. Understanding this ‘benchmark’ trajectory will be crucial for investors in understanding how the supply of investable sustainable assets will evolve through time.
It is for this reason that we group central bank activity with fiscal policy in our carbon framework – they both help us to understand how the future will look, rather than directly providing us with assets to invest in.
In part two of this series of articles describing our carbon framework, we describe the investment implications of the two remaining pillars – the asset market pillars.
The policy research pillars of our carbon framework describe an important method investors can use to understand the future evolution of the sustainable investment landscape.
The first two pillars do not represent markets for carbon, or carbon-linked assets that investors can buy and sell. Rather, they are research pillars that investors can and should use to gain an understanding of what assets they might buy or sell in the future. Our policy research pillars reflect two streams of public policy, but investors should also aim to understand corporate and household policy, which will heavily interact with public policy.
System-wide decarbonisation will happen in a non-linear and unpredictable way. Investors need to understand the system-wide decarbonisation trajectory if they are to decarbonise their portfolios in an effective and responsible way.
 What net zero means for inflation, Schroders, February 2022.
 How rising carbon prices could cut company profits, Schroders, May 2017.
 State and trends of carbon pricing 2021, World Bank, May 2021.
 Net zero and multi-asset: what the transition means for portfolios, Schroders, October 2021.
 Macro-prudential policy is that which aims to preserve and enhance stability of the financial system. It is often – but not always – the responsibility of the central bank, albeit sometimes through a subsidiary. For example, the Financial Policy Committee (FPC) is the part of the Bank of England responsible for macro-prudential policy, in partnership with the Prudential Regulatory Authority which has a focus on micro-prudential policy (how stability of the financial system is impacted by individual entities within that system).