Economic thinking is an important contributor to determining the sustainability of the complex ecosystem that supports civil society.
However, it cannot be divorced from the political dimension. Social norms and “ethical custom” play out through the influence of our political and legal systems, and both shape the incentives in our system for change.
In 2021, the National Intelligence Council (NIC) in the US published a report on climate change and national security. It considered how “climate change will increasingly exacerbate risks to US national security interests as the physical impacts increase and geopolitical tensions mount”.
Every four years, the NIC publishes long-term assessments of geopolitical risk scenarios. In the last report, Global Trends 2040, it is notable how demographics, climate change and economic competition are analysed as forces shaping our possible futures. Already many of the areas of concern – migration, food system strain, negative health consequences – are being manifested by real world experiences. The war in Ukraine, where Russia unsuccessfully attempted to use energy as a geopolitical weapon, is the most stark example.
Climate change and the inevitable policy response is already defining competition between nations and changing economic dynamics. The Inflation Reduction Act in the US is not only an important milestone in the greening of the US economy, but also a protectionist strategy that is sparking a response from China and Europe. After 40 years of relentless disinflation and expansion in global trade, inflation returned in 2021 as a macroeconomic factor that severely dented market returns.
At the centre of the surge in prices was energy and food, bringing profound social challenges around the world. Energy security concerns saw governments encourage additional oil and gas production even while recommitting at COP27 in November last year to their often legally binding net-zero pledges.
Politics is a pragmatic art and sets incentives in the system that look to the expediency of apparent short-term needs, even if it is at variance with science and evolving social norms. Oil stocks around the world had endured a tough five years until inflation began to rise at the end of 2021. The underperformance was not because of ESG, but historic overproduction and rising costs had depressed returns on capital, which then lend to a cut in exploration and development.
Anticipation of the inevitable policy response to climate change combined with depressed returns drove the sector to bargain basement valuations. The implied life of listed oil and gas assets was as low as three-years at the start of last year, implying a transition period to a low-carbon world that not even the most ardent climate activist would believe to be credible. As the war in Ukraine erupted and energy security trumped green agendas, oil and related fossil fuels leapt in price, in some instances trebling.
While incentives in the system, no matter how perverse, keep climate change as an externality in company valuations, fossil fuel assets may well remain attractively priced over the medium-term even if the long-term prognosis is far less favourable. The richest man in Britain, Jim Ratcliffe, runs the private petrochemical company, INEOS, which has for more than 20 years successfully exploited the inefficient pricing of ‘brown’ assets to build a $65bn revenue business.
This echoes a point made professor Alex Edmans in a recent paper, Applying Economics – Not Gut Feel – to ESG, that ESG is an input into assessing shareholder value-creation, not the sole determinant of success.
The recent lawsuit brought by ClientEarth against the directors of Shell, however, introduces a new dynamic into the equation. ClientEarth is using the increasing certainty of the science of climate change to personally sue the directors of Shell for not adequately preparing for the energy transition and mismanaging long-term shareholder value as a result. ClientEarth has already successfully sued the UK government on the inadequacies of its net-zero planning.
Investors and the energy sector will watch the outcome of this case, and a growing number of other legal actions, on how judges interpret responsibility against the science and growing concern by civil society on climate. Success will cause asset managers to scrutinise not only the implied asset life embedded in fossil fuel valuations. They will need to carefully consider the claims they make for net-zero aligned products. Inferring that a net-zero passive index product saves more carbon than giving up meat or flying will be a difficult one to uphold, despite the frequency of the claim by some activists.
