Net zero: How to navigate the transition risks

Markets are already pricing in transition risk, says Ninety One's Nazmeera Moola

As a signatory to the Net Zero Asset Managers Initiative (NZAMI), Ninety One has committed to ensuring that our portfolios achieve net zero emissions by 2050. But while net zero is the critical longer-term goal, we need to see tangible progress in the shorter term.  Therefore, managers that have committed to NZAMI are also required to set a 2030 commitment. 

It would be tempting to accept that companies simply need to specify the reduction required by 2030 and for that then to provide comfort that net-zero emissions will be achieved by 2050. However, the transition is unlikely to be linear or simplistic, especially for companies in carbon-intensive emerging market economies. We have been firm in arguing that it is sensible to remain invested in high-carbon emitters – whether countries or enterprises – on condition that investment is used as leverage to ensure they transition to net zero over time.

The good news is that we are starting to see corporates in emerging markets take the transition seriously, with several firms pledging to achieve net zero emissions by 2050. They even include companies from ‘dirty’ industries, like Mexican cement manufacturer CEMEX, Indian steel manufacturer, JSW Steel, and South African energy and chemical company, Sasol.

The bad news, however, is that the vast majority of companies – globally, but particularly in emerging markets – do not yet have a clear plan on how they’re going to get to net zero by 2050.

What would be great to see by 2030 is as high a proportion as possible of portfolio companies with viable plans to decarbonise by 2050. In order to assess transition plans, we have developed a framework that scores them on three key principles.

  1. Is the target ambitious enough?

This is not just about the 2050 target, but about the milestones they set along the way. We believe a sufficiently ambitious plan can be achieved via one of three routes. The first – and the simplest – is if the company or country somehow manages to reduce emissions by 7% a year, thus achieving the target of restricting warming to 1.5 degrees Celsius by 2050. Unfortunately, for most companies this linear 7%-a-year decarbonisation is a pipe dream, particularly if they are in emerging markets and in high-emission industries.

The next target we would then consider is whether the pathway set is broadly aligned with the country’s decarbonisation pathway, provided the country’s pathway is broadly 1.5-degrees aligned. Many aren’t, but it is considerably easier to assess corporate targets if a government has  a 1.5-degree aligned target.  If the sovereign’s plan is aligned, then when a local company has a plan broadly aligned with sovereign pathway, we would take comfort that they are aligned. The third route is one in which modifications will need to be made for hard-to-abate sectors like cement and steel. We are starting to see sectoral pathways being developed, which we would consider to be 1.5-degrees compliant. The reality is that some sectors require significant technological developments to achieve net zero by 2050. 

  • Is there a budget for the transition?

The second principle on which we evaluate plans is whether the company has considered the capital expenditure requirements, the impact on revenues and expenditures of this plan, and whether they can afford it. Very few companies have fully budgeted for their transition.

  • Can you monitor progress at least annually?

By monitoring progress, particularly in the early years, we don’t simply consider the carbon reduction achieved year to year.  Rather, we look for tangible signs of progress, including for example the capital expenditure being spent or the offtake agreements for a new fuel source. Importantly, we need real progress – not just promises of future progress.

If companies can satisfy us on these three principles, we would consider their transition plans strong and appropriate. For the bulk of companies, the development and implementation of aligned transition plans will take years. And for some sectors this will not be possible. 

In addition to these factors, companies also need to consider the impact of the transition on their employees and the communities in which they operate.  This increases the complexity considerably, but a transition that does not address the social impact will not prove sustainable in the long run. 

Market already pricing in transition risk

What we are noting globally and in emerging markets, is that transition plan risks are priced differently across sectors. In the coal sector, the pricing is very clear, and multiples are a third to half of what they were a decade ago. This is because the route to clean electricity production is already two thirds of the way there. We know renewables are cheaper; the only missing element is storage. For renewables to become viable base load, battery costs need to come down by 60% in the next three to five years.

By contrast, the world is still struggling to figure out what a viable transition plan for the cement industry should look like, which means that the divergent pricing has not yet materialised. So while PPC should be commended for their broad commitment to decarbonisation, they are still in the very early phases of mapping out their transition plan. 

The market has already started to price in transition risks – and we expect this to accelerate going forward. In due course we expect it to affect the pricing of government bonds.  It is imperative that emerging markets execute on their decarbonisation commitments.

Net zero offers both a threat and opportunity to high carbon intensity emerging markets.    Neither coal nor gas will support their long-term growth.  Instead, the abundance of renewable resources offer the opportunity for many emerging markets to build affordable power and build new industries like green hydrogen, which could underpin both GDP growth and job growth in these countries.