Exposure rates of the Dorval Asset Management Range – 29th October 2021

As the world gears up for the COP 26 climate conference in Glasgow, successive governments have announced support measures to shore up household spending power in response to rising energy prices.

This situation is a prime example of two approaches – and two potentially contradictory challenges – colliding, with climate issues standing on one side of the debate, and economic and social aspects on the other.

- Climate challenges require detailed CO2 emissions reductions targets and a corresponding timeframe. These climate imperatives involve risks for economic growth, as they propel us into an uncertain transition with hefty pressures for some sectors, while also taking the world on a path towards a greater degree of frugality, or even a decline in growth.

- Conversely, economic and social challenges incite towards a robust, sustainable and inclusive recovery, which flies in the face of monetary and fiscal orthodoxy. This need for economic reflation is a result of a series of factors, including the Covid-19 crisis, the fight against what some economists have labelled secular stagnation, and some painful lessons learnt during the 2010s decade of fiscal austerity, an experience that no-one wants to relive. Tellingly, this extremely Keynesian view of economic policy is currently driven by the central banks, which were previously much more conservative bodies.

Underlying this battle of economic vs. climate is a more fundamental question on the sustainability of growth. The majority of economists and central banks will tell us that growth and inflation have been overly sluggish in recent years and that we need to take the bull by the horns on this problem to safeguard social progress: so we need to do more.

However, the climate emergency shows that economic growth has become less sustainable due to global warming, a point that has fueled heated debate between on the one extreme those who feel that a decline in growth is inevitable, and the “technoptimists” on the other, who believe that new technologies will make all our climate problems disappear into thin air as if by magic.

Combining economic reflation and energy transition: Green Deal and carbon dividend

In our view, the most likely main scenario – which is already under way – is for more interventionist economic policies that will endeavor to build both “more” and “better” i.e. more but also better growth by stepping up the reduction in the ratio of CO2 emissions to GDP (cf. chart 1). This acceleration is crucial if the world wants to curb emissions without foregoing growth.

 

Economic activity and CO2 emissions worldwide
Base 100 in 1960: OECD source and projections for GDP

World GDP in volume terms / World CO2 emissions / Ratio of emissions to GDP

 

A practical way to reconcile these aspects of course comes from Green Deal programs, which seek to bolster investment and jobs by redirecting these resources to address carbon emissions reduction targets. This is one of the main focuses in the budget programs across the European Union and the United States, as well as China. In Europe, Eurostat has estimated that the projected 55% cut in CO2 emissions out to 2030 will require a 30% surge in public and private investment compared with the previous decade.

Another way to support the energy transition involves developing transfer policies to offset the transition’s dent to spending power for the least well off. This so-called carbon dividend policy would tackle what the world refers to as the yellow jackets effect. However, to be fully consistent, this approach would need to be carefully managed to ensure that the rise in carbon prices is not entirely pain-free.

Opportunities, but major risks and challenges too

This twofold reflation/transition dynamic involves two buoyant themes for investors out to the middle of the current decade i.e. the extension of the economic recovery to a large number of sectors on the back of fiscal and monetary support, and a more specific trend towards a boom in investment related to the energy transition, with new infrastructure, towns being organized differently, new economic channels, etc.

However, it is important to keep our feet firmly on the ground, as there are a number of uncertainties and risks inherent in these economic policies:

- Just what pace of world CO2 emissions is compatible with this momentum? There are too many variables to make any predictions.
- How will decisions be implemented – for example, will there be a carbon tax? Will it be worldwide or highly fragmented? What geopolitical tensions will emerge?
- What will be the extent of shocks resulting from rising commodities prices in terms of growth and transition-related unemployment in the most affected sectors?
- What tax will be applied and how will it be distributed? What resistance will emerge? For example, there may be possible tension on public debt and deficits in Europe, the US and elsewhere.
- What about interest rates if inflation and growth are higher than expected for the long term due to Keynesian policies? Is there a risk of bubbles?
- What financial shocks would be triggered due to stranded assets from the old economy, or as a result of more frequent ecological disasters?
- What technologies will take root (hydrogen or not, revisiting nuclear or not?)? What champions will emerge? Will companies in the most energy-extensive sectors be doomed or can they reinvent their businesses?

Initial lift for world GDP out to 2025

Despite these multiple uncertainties, economists still endeavor to develop formal projection models. For example, the IMF believes that a sufficiently cooperative and consistent climate transition scenario would lead to a bell-shaped curve (cf. chart 2), with initially positive net effects on GDP as the contribution from investment and subsidies would override the dent from prices and regulation. This effect should then reverse from 2025 to a low point in 2050.

So confirmation seems to be emerging that robust economic growth can be compatible with the energy transition, at least until the middle of the decade. Portfolio managers here at Dorval AM will continue to support investors in this changing world, with the ensuing opportunities and risks, via a wealth management philosophy that combines responsibility, pragmatism and steady navigation.

 

Effects of adapted climate policy on world GDP
IMF G-cubed model – % difference to scenario without climate measures – world GDP

Infrastructure investment / Total net impact / Disaster mitigation / Green subsidies / Impact of rise in carbon prices

 

 

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