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China's crucial role in the pursuit of global net zero emissions
NET zero emissions (net zero) is the scenario where the amount of greenhouse gases (GHGs) emitted, either by anthropogenic (originating from humans) or natural means, is offset by the amount of GHGs removed. This is also referred to as carbon neutral. Net zero is synonymous with the 2015 Paris Agreement temperature goals to limit temperature increases well below 2 deg C, and at no more than 1.5 deg C, by 2050. While naturally occurring, excessive amounts of GHGs are being generated from anthropogenic activities, trapping exceptional amounts of heat in the earth's atmosphere, and resulting in global warming and negative impacts to biodiversity and humans alike.
In August alone, extreme weather wreaked havoc in multiple locations globally. We witnessed the longest rainy season recorded in South Korea, the worst flooding in a century in China, and record-high temperatures and unprecedented heat waves in the US. These events triggered devastating floods and fires causing fatalities and severe damage to infrastructure as well as agriculture. For instance, flooding of China's Yangtze River affected 63 million people and caused US$26 billion worth of damage - 12.7 per cent and 15.5 per cent higher than the 5-year average respectively.
Rising interest in carbon neutrality
In Q3 2020, we witnessed a surge of countries and companies pledging to achieve carbon neutrality - the most noteworthy being Chinese President Xi Jinping's monumental commitment to take the country to net zero emissions before 2060. As China is currently the world's manufacturing powerhouse, as well as the largest emitter of GHGs, having overtaken the US in 2006, its latest announcement will have profound repercussions across the political, economic and investment spheres. It will be a herculean task requiring massive effort and investments to bring this behemoth nation to net zero.
Investors are also turning the heat on companies. In mid-September, the Climate Action 100+ (CA100+), a corporate engagement collaboration network of investors including Maitri Asset Management, announced a new Net Zero Benchmark for its members to assess the "net zero journey" progress of 161 companies, accounting for 80 per cent of the world's GHG emissions.
The CA100+ members, who collectively manage US$47 trillion in assets, are sending letters to the boards of these companies detailing what is expected from the Net Zero Benchmark in terms of scope and timeline, requiring science-based mid and long-term targets to be set. This approach aims to ensure alignment to this benchmark's definition of net zero, for example promoting the inclusion of Scope 3 emissions, commonly omitted by corporates due to the difficulty in assessment, from a company's value chain.
Putting the current net zero movement into context, in 2016 energy demands contributed to 73.2 per cent of global GHG emissions - used in industry, buildings and heating, and transportation - and will therefore require the most significant reduction. Given that the single largest GHG emitter annually is China's coal power sector, addressing this energy transition challenge is paramount to achieving carbon neutrality by 2060.
Growing green bond market
To achieve the goals of carbon neutrality on a global scale, electricity generated from carbon neutral sources must outpace electricity generated from fossil-fuels, if not completely replace it. This leads to investment opportunities, in both the bonds and equities markets, in crucial sectors such as clean energy production, electric vehicles and their component makers, as well as other carbon neutral infrastructure.
The green bond market is an obvious investment vehicle which was growing exceedingly well as 2019 hit a new record in global issuance. The pandemic halted growth in the first eight months of 2020, but in September green bond issuance doubled compared to the eight-monthly average and recorded a new monthly high. Demand for green bonds has outstripped supply many times, evident in recent green bond issues, eroding gains for investors which caused concern that their interest may start to weaken.
The German government's six-billion-euro (S$9.6 billion) foray into green bonds in late August helped keep the interest in the market as it serves as a risk-free benchmark for the green bond market, and another six-billion-euro issuance is expected before the end of the year. The highly anticipated removal of "clean utilisation of coal" from the People's Bank of China's list of eligible green bond projects is likely to further rally investors, as this would better align Chinese green bonds with international investors' benchmarks. In 2019, US$24 billion worth of Chinese green bonds were deemed as unaligned with international standards compared to US$31 billion which were aligned. In view of China's 2060 carbon neutral goal, the "clean coal" exclusion will almost certainly happen.
However, the financing is scarcely adequate for the net zero transition, given that approximately US$2.8 trillion worth of investments is needed by 2027 just to achieve the European Union's (EU) carbon neutral goals by 2050 (excluding Poland). China's GHG emissions are double that of the whole EU, and in Q1 2020 alone, China approved approximately half of 2019's coal-fired power plant capacity; each plant typically has a life span of 20-30 years. This means there is an even greater urgency for capital deployment towards neutralising this, exacerbated by the fact that power generation is a capital-intensive sector - estimates put the Chinese bill at US$15 trillion.
Mainstreaming green financing
This urgency points to an immediate need for a systemic shift in mindsets if green financing is to become mainstream. We can expect to see more impairments and write-offs of stranded assets, typically associated with the oil and gas sector, in real estate, as well as physical assets across the agriculture, manufacturing and industrial sectors since they will become increasingly at risk due to a rising frequency of extreme weather events.
The flooding of the Yangtze River in August was reportedly the worst flooding in a century, yet less than five years ago, a flood of similar severity occurred when water levels exceeded that of 1998's catastrophic floods. Memories of the epic 2018 Californian fires lingered through the 2019 intense Australian bushfires, and have now returned with a vengeance as the California fires rage on in 2020.
An entire generation of assets and infrastructure damaged or affected by extreme weather worldwide will need to be rebuilt, sometimes along the same "faultlines". Instead of being referred to as green projects, these developments should have climate adaptation and mitigation features built in from their conception phase.
This would mean responsible investors need not pay a premium for a limited number of qualified green projects, which have seen tightening margins. While the EU Taxonomy's "do no harm" criteria set a clear benchmark so that "sustainable project developers" know exactly the boxes to tick to become qualified, those that fall below the benchmark are likely to remain there and may even offer better returns given that they will need to be more attractive than sustainable ones.
As China joins the net zero transition now, it has a narrower timeframe to arrive at the same point as the EU. It is unlikely that China will develop its own sustainable taxonomy because all projects going forward should be working towards the carbon neutral goal, and this is the propellent for the systemic change.
Looking ahead, the environmental impacts of China's imports and exports will hopefully undergo an additional layer of scrutiny, and the value chain become more open to carbon neutrality. This means corporations must adopt and embrace change. The engagements with corporations through the CA100+ initiative will optimistically meet with less resistance than what we face today. From Maitri's view, serious ESG investors have plenty to look forward to.
- The writer is ESG practice lead, Maitri Asset Management