The Ukraine conflict is a ‘Matrix moment’ for climate change
by Joseph Noss, Senior Director, Climate and Resilience Hub, WTW
The Ukraine conflict is a ‘Matrix moment’ for climate change
The choices that governments make in response to the Ukraine conflict might either accelerate or delay the global transition to net-zero emissions. Financial markets also need better data, regulation and coordination from policy makers if they are to support this transition effectively.
Unfortunately, solving the problem of climate change is more complex than taking a blue or red pill. Bold decisions on climate policy can all too easily be reversed.
Nonetheless, Neo’s choice in The Matrix is akin to that governments face as they respond to the Ukraine conflict and associated rise in energy prices. Do they increase investment in fossil fuels, buying short-term energy security at the cost of delaying transition? Or do they seize on the crisis as a chance to increase investment in green energy? The policy prescriptions that financial authorities make over the coming months are also going to be crucial in determining whether financial markets can accelerate the transition to net-zero emissions.
The last six months It wasn’t always so.
A little over six months ago, governments came together at COP26 and made a series of commitments to tackle global warming. 130 countries pledged to reach net-zero emissions by 2050. 190 countries agreed to phase down coal power. The Glasgow Financial Alliance for Net-zero (‘GFANZ’) – a group of leading financial institutions – was also formed to accelerate decarbonisation and lead the transition to net-zero. This momentum might have been catalysed by concerns as to the effect of climate change on populations. For example, our research for this Index suggests that governments’ commitments to tackle climate change are stronger in emerging market countries where food supplies or human habitats are most imperilled by global warming (see Chart 1).
Fast forward six months and this progress has met setbacks. Greenhouse Gas emissions have increased sharply in line with the global economic recovery that followed the COVID-19 pandemic. Rising gas prices have also coincided with the increased use of coal – one of the dirtiest forms of energy.
The conflict in Ukraine also poses a series of challenges for governments globally. The first of these, of course, is how to respond to a humanitarian tragedy: lives destroyed; families torn apart.
But the conflict has also had severe implications for the global economy and energy markets. Energy prices have increased sharply, as countries have sought to reduce their dependence on Russian oil and gas. Inflation has soared in many economies. This, combined with weakening growth, has resulted in a ‘cost of living crisis’ here in the United Kingdom.
Chart 1: Climate-related threats to cities and food supplies vs. 'Commitment on Climate' ratings
Labelled countries, which have better 'Commitment on Climate' ratings, tend to cluster towards the upper right-hand corner of the graph, where climate-related threats are more severe.
The Matrix Moment The conflict in Ukraine also represents a ‘Matrix Moment’ for governments globally. How should they respond to this combination of rising energy prices and deterioration in economic outlook? In particular:
Do they take the blue pill – that is, increase investment in fossil fuels, quickly bringing online brown sources of energy that increase short-term energy security?
Or do they take the red pill, and seize on the crisis as a chance to ensure investment in green energy, as part of the transition to net-zero?
Obvious as the answer might seem, the red pill isn’t easy for governments to swallow.
This is partly because bringing online greener sources of energy – and the technology that enables them – takes time. The benefits of doing so can seem very distant. In contrast, the problems posed by rising energy prices and costs of living are very immediate. Investing in green energy therefore requires us to live with a degree of economic pain today, in the hope of benefits tomorrow. To many investors – not to mention politicians! – delaying transition is just too attractive.
How can we avoid such short termism? In theory, the financial system should help by sweetening the red pill. After all, finance is the plumbing through which investors channel their savings into projects that offer future profits. In doing so the financial system should be a means through which to lengthen societal horizons. Higher returns tomorrow on green investment projects should reward investors’ patience.
But for financial markets to be effective, prices need to properly reflect the risks and benefits of different investments – whether they be green or brown. It’s unclear whether this is currently the case. For example, the STOXX WTW World Climate Transition Index – an index of world equity indices that has been tilted to increase exposure to those equities likely to gain from the transition to a net-zero economy – has performed roughly equally to its un-tilted counterpart, over the past two years (see chart 2). This is consistent with those securities that are estimated to benefit from the transition not being priced at a premium to those at risk from transition.
Chart 2: The performance benefit for 'green' equities
In the shaded area, the outperformance of equities likely to gain from the transition to net zero has declined.
From matrix to market
How can governments help improve the pricing of climate-related risks and opportunities? First, the proper pricing of any investment is reliant on there being consistent and reliable data on its future risks and returns. The last century has seen a proliferation of such data across many sectors of the economy. Think of the GDP figures churned out by government statistical agencies that allow investors to compare the performance of countries’ economies; or the armies of accountants and auditors employed to give us confidence in companies’ earnings figures.
There are not yet, however, reliable metrics of the risks of climate change, or opportunities afforded by green transition. There’s no readily accepted analogue to GDP that properly captures the impact on economic activity – not to mention the human misery – wrought by heat waves and drought. Even the most diligent of auditors struggle to capture consistently the degree to which firms stand to gain or lose from net-zero transition. Investors therefore lack the necessary data to measure and compare the risks and opportunities across different investments and to price them accordingly.
It’s therefore important that governments advance recent international efforts to fill these data gaps. Key efforts include those by the Financial Stability Board, NGFS and IMF. In particular, authorities need to develop metrics that properly measure the risks and opportunities from climate change. My colleague David Nelson has written of the dangers of using individual firms’ emissions as a measure of the risks they present with respect to transition.
Second, if data are to be useful in investor decision making, they need to be disclosed regularly by firms and in comparable forms. The recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) have become a widely supported basis for firms’ climate-related reporting. The recent consultation by the International Sustainability Standards Board (ISSB) represents a first step in developing a comprehensive global baseline of sustainability disclosures that will help ensure that risks and opportunities are properly priced and managed.
Financial regulation is unlikely to stop at disclosure requirements. The proper management of climate risks by financial institutions will likely require banks and insurers to set aside capital against these risks. It’s not yet clear what form these requirements will take – and there’s an ongoing debate as to whether it is desirable or possible to reduce capital requirements for firms holding green assets. But whatever the details, such regulation should be signed in a way that means financial institutions offer finance to green and brown projects at a price that reflects their underlying risks.
Mixing medicines As any doctor knows, any course of pills needs to be carefully managed. Sometimes medics prescribe a combination of pain killers – which aim to make the patient comfortable in the short-term – as well as other drugs to treat their underlying condition. The response to the Ukraine conflict and rising energy prices might also involve a combination of near-term investment in brown energy, in order to stabilise prices, as well as longer-term commitments to green energy.
My final prescription concerns the need for cross-country coordination of these commitments. There’s a growing risk that governments disinvest from fossil fuels extraction, and invest in renewable alternatives, at radically different rates. In other words, they swallow different coloured pills at different times.
Recent research by WTW has highlighted that this sort of ‘disorganised transition’ could have a very disruptive effect on the financial system. Imagine, for example, if disinvestment in fossil fuel extraction in some countries ran ahead of investment in renewables in those countries where this energy was needed most. This could result in increasingly frequent bouts of high and volatile energy prices. Governments’ dilemmas between the red or blue pills – that is, investing in renewables versus rowing back on green energy commitments – might become increasingly frequent and stark.
Spoiler alert
The final film of the Matrix Trilogy ends with Neo’s death. Humankind need not meet the same fate from climate change. It’s not too late for governments to seize the opportunity to make credible commitments to invest in green energy and net-zero transition that are accelerated by financial markets. But doing so will require bold and coordinated action by both governments and financial authorities.
Joseph Noss is a Senior Director in the WTW Climate and Resilience Hub, where he leads engagement with the financial sector. He was previously a senior official at the Bank of England and G20 Financial Stability Board, where he led a variety of work on climate change, sustainable finance and technology. This included the publication of the FSB’s Climate Roadmap in 2021, which outlined initiatives being undertaken by governments globally on climate-related financial risks.
