In a whirlwind of political hot air, combustion-engine cavalcades, clouds of carbonised Kerosine fumes and Scottish skies criss-crossed with the condensation trails of presidential and prime ministerial private jets, the world’s leaders (less a couple of notables, e.g. President Putin and General Secretary Xi) descended upon and departed from Glasgow all inside 72 hours. With them now out of the way, the hard negotiations about how really to save the planet are left to their minions to thrash out for the remainder of COP26.
Rishi Sunak waves a very big stick
Regular readers of these weekly musings will be entirely familiar with the decarbonisation programme being billed by William Hague as a “global revolution by coercion”. Coercion was out in force in Glasgow. One of the most provocative policy speeches so far at COP 26 was by Chancellor Rishi Sunak, leading with proposed regulation in the UK in an attempt to build a global consensus to force Big Business to meet the challenges of Paris 2050. His stick was big, while the carrot he was offering was a stunted, shrivelled apology for a vegetable. In essence what he is proposing is coercive legislation compelling every UK listed company to deliver concrete plans against prescribed government targets to cut carbon emissions, with significant sanctions for failure to meet commitments and milestones, including the ultimate penalty of being compulsorily de-listed from the Stock Exchange.
It is easy to see his motivation: under the legally binding Paris Climate Accord 2050 treaty, any country in breach of the agreed national carbon emission limits is liable to significant financial penalties. How then to mitigate against the national risk? Answer: set targets and milestones for achievement for all sectors whether public, corporate, institutional, or domestic households and ensure compliance. But his initiative, however much it is motivated by legal expediency or political grandstanding because we are the conference hosts, raises many questions to which there are precious few answers in an environment which is immensely complex.
Underpinning all is the fact that global societal and economic systems are attempting to go from Point A, today, those which have evolved over quarter of a millennium since the Industrial Revolution based entirely on fossil-fuel derived energy, to Point B, all in less than quarter of a century in which societies and economies are almost entirely reliant on alternative sources of energy. The trick is to achieve that while at least maintaining the standards of living and freedom we have come to expect as a right in the 21st century. The key, inconvenient to the likes of Extinction Rebellion, Friends of the Earth and Greta Thunberg all striving for zero carbon, preferably yesterday, is that the transition process needs to work in parallel between old and new technologies; progress is linear and lengthy but certainly not binary and immediate. As the big stick is waved, particularly at the oil sector, demonising sensitive industries pushes up the investment risk which in turn pushes up the cost of capital against which a higher return is required on future projects to make them viable. We have argued strongly in the past, as it faces an existential threat, the oil industry is alive to the need to develop replacement energy sources and logically becomes part of the long-term solution rather than simply the problem.
Physician heal thyself
Even at its most basic level, much must yet be defined. What is “green”? After intense disagreement in the summer, this week the EU headed towards resolution that both nuclear and fossil-derived natural gas are acceptable ‘green’ sources of energy, as much as anything to avoid open warfare breaking out between nuclear-powered France and gas-reliant Germany. Here in the UK, Boris was forced to defend the continued burning of wood pellets at Drax power station (the largest unit in the entire UK generation fleet) despite those pellets being imported 4000 miles from North America by sea. Joe Biden at COP 26 berated China and others about carbon emissions while simultaneously urging OPEC to open the oil taps wide to calm current primary energy prices. Politicians themselves, despite supping in the Last Chance Saloon, are still riddled with inconsistencies.
All will be touched
Obviously the principal focus is on energy production and heavy energy-intensive industries. But as every company will be required to produce mitigation plans, the nuances become much broader and far-reaching in terms of behavioural change and the economic and financial consequences. Take the cradle-to-grave carbon footprint of an office, for example: what should be the physical construction and components of that building and what should be the duration of its anticipated lifespan? As materials such as ubiquitous fossil-derived plastics disappear, what will replace them and how can we measure the energy footprint of substitutes? How should it be powered and heated? Should we still have offices at all? If so, employees need to travel there but legally whose carbon liability is their journey to work, their employer’s or their own? Business travel will change, notwithstanding that 30,000 official delegates (leaving aside the multitude of additional hangers-on) have just settled on Glasgow having flown there from all four corners of the globe. Thinking even wider in say the context of plastic packaging (apart from refrigeration, the biggest contributor to the post-war revolution in keeping foodstuffs fresh, especially in transit and storage), and the production of chemical fertilisers and pesticides, the ramifications for sectors such as agriculture, food processing and food retail are profound. No sector will be left un-touched.
Equity shareholders’ increasing exposure to asymmetric risk
We have argued before that capital tends to be more efficiently allocated by free markets rather than central government. “Free” does not imply “unconstrained”. Clearly markets must have regulatory frameworks to protect consumers, investors and other stakeholders from being taken advantage of in some otherwise wild west market free-for-all. However, the more central government interferes with the minutiae of the capital asset pricing model or creates rigid boundaries within which it is set, the greater is the asymmetric risk being borne by the owners those assets.
To illustrate the point, the current hiatus in international gas markets where prices have multiplied in months (none of which is in the UK government’s control) has rapidly led to business insolvencies among UK electricity suppliers whose inability to pass on those escalating input costs has been determined by a government-regulated price cap on retail electricity prices to domestic consumers. Those consumers affected have been inconvenienced by their supplier going bust and may be forced to pay more with their new electricity supplier, but shareholders have lost their money. That of course is the essence of risk capital. However, in normal circumstances the anticipated risk is reflected in the expectations of appropriate returns; in a situation such as this in which input costs are unregulated and volatile but output prices are not only regulated but with a fixed cap, so the risk reward becomes heavily stacked against the investor: hence asymmetric risk.
Playing the game of unintended consequences
From an investment perspective as the ESG (Environmental, Social and Governance) sands shift rapidly, Sunak’s initiative accelerates the change in status of the equity shareholder. Once the primary (indeed the legal) concern of corporate boards to look after shareholders first, that paradigm is rapidly changing. Arguably other stakeholders now have greater influence, even though it is not their capital at risk. When making significant capital expenditure plans, particularly in national infrastructure programmes in which the prospective aggregate investment is measured in trillions not just billions of pounds (e.g. in the automotive sector, as we transition from combustion-engine vehicles in the next decade, what will be the replacement technology and what infrastructure is required to keep us all free to travel in the manner to which we are used?) what common standards are required around which those investments can be assessed? With regards to compliance against government targets, who will be responsible for monitoring? The auditors? Are they equipped for the job? New independent statutory scrutiny bodies? Will we increasingly see company climate mitigation plans being challenged in court, as happened to Shell in Holland earlier this year (when Friends of the Earth (FoE) successfully rode a coach and horses through a shareholder vote supporting management decarbonisation plans on no stronger premise than FoE didn’t believe a word the company was saying in its commitments), raising questions of who really runs companies: the board? Activists? Court judges? If Sunak fails to win an international consensus for a level playing field with the UK, does he in effect create an “exchange valuation arbitrage” which reflects the additional regulatory cost imposed on UK PLC? And will some UK companies take fright and simply shift their domicile and listing as a result to a less burdensome regime? Who wins out of that? Already bound up in cables’ lengths of governance red tape which we know is a significant factor in many private companies’ boards considerations about a future listing, will Sunak’s plan provide more friction to an already slowing IPO market? Equally, some listed companies rapidly becoming bored with the governance burden imposed by being on the market might just think, “why bother?”, pre-empt Rishi’s sanction and take themselves private (clearly neither an option nor desirable for every market participant!).
These are revolutionary times with significant but as yet unknown and unquantifiable consequences. Opportunities abound, but there will be pitfalls a-plenty as we head towards net-zero 2050. Competition for capital will be intense but the political environment in which that capital is being priced is forever shifting, inherently unstable. Given none of us has been here before, it will pay to keep an open mind and your wits about you.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
The value of active minds – independent thinking:
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
Fund specific risks:
The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.
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