BLACKROCK INVESTMENT INSTITUTE

Positioning for the net-zero transition

June 2022 | The transition towards a decarbonized economy is underway. It will involve a massive reallocation of resources, inevitably impacting portfolios.

 

Navigating the transition in a portfolio requires taking a view on: 1) how fast the transition will be; 2) how to mitigate for volatility and possible supply constraints along the way; and 3) the extent to which the transition path is already reflected in market pricing.

worker standing on top of a windmill

Helping clients navigate economic transformation

As an asset manager, BlackRock’s fiduciary role includes helping our clients navigate economic transformations. The transition to net zero is one such transformation. As with all economic shifts, we help clients position their portfolios to be resilient to its risks, seize its opportunities and strive for more stable and higher long-term returns. This paper is focused on that investment objective.

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Tracking the evolving outlook

Football playground

The exact path of the transition from here is uncertain. Currently enacted policy is not sufficient, even with available technology, to limit global warming to 1.5°C above pre-industrial levels.
The transition path will likely be determined by an intricate interplay of three key drivers:

  • Technology — Technological progress is making it cheaper to switch from carbon-intensive to alternative energy sources
  • Societal preferences — Consumer and investor preferences, including for greener products and assets, could shift more quickly as physical damage from climate change, and its human and economic cost, becomes more evident
  • Climate policy — Climate-specific policies, and broader energy, industrial, infrastructure and land use policies, vary by region. The West’s decision to reduce its dependence on Russian energy means Europe, in particular, is now doubling down on its efforts to get to net zero, as reflected in the proposed RePowerEU plan.

We believe there is a real possibility that these three drivers will ultimately combine to accelerate the transition from the path implied by current policy.

/blk-one01-c-assets/documents/charts/energy-burden.csv line-chart % line-chart Energy burden as a share of GDP (%) true
Europe’s energy conundrum

Sources: BlackRock Investment Institute and BP Statistical Review of World Energy 2021, with data from Haver Analytics, June 2022. Notes: The chart shows the cost of oil, gas and coal consumption in the European Union and U.S. as a share of GDP. We use regional energy prices, converted to U.S dollars, and divide by GDP in U.S. dollars. Data for 2022 are based on IMF’s latest GDP forecasts and the year-to-date average of daily commodities prices (expressed in U.S. dollars).

Watching for bumps ahead

Regional differences in speed and supply shocks could make the transition a bumpy ride.

 

The war in Ukraine may have sped up the transition in Europe, where energy security and affordability objectives support reaching net-zero emissions, but it has not had the same effect in other regions.

 

We don’t think the war will have the same impetus in energy-producing countries like the U.S., where there is less concern about finding new green energy sources to secure supply. And the “carbon tax” of high fossil fuel prices is proportionally lower. As the chart shows, the share of GDP the U.S. spends on energy is almost half that of the EU.

Supply shocks key to inflation

Fundamentally, the transition is a handoff from carbon-emitting production methods to zero-carbon ones. If carbon-intensive production falls faster than lower-carbon alternatives are phased in, there could be periods of supply shortages and high prices for the carbon-intensive outputs that the economy can’t yet function without.

These imbalances will likely be the dominant driver of the inflationary consequences of the transition. The impact will depend heavily on the speed of the transition.

We estimate:

Increase4%
in consumer prices by early 2030s

If the cost of eliminating carbon emissions is passed onto consumers, prices could rise by around 4% by the early 2030s.

0.4
percentage points on inflation each year

Without demand and supply imbalances, the transition could be only modestly inflationary. But more prevalent supply shocks will mean more inflation volatility.

Taking a view on transition pricing

As the economy rewires, both the expected value of, and uncertainty around, future company cashflows will change. Ahead of those changes actually happening, markets are repricing risks. As with other views on economic and company fundamentals, investors should consider the extent to which their view of the transition path is currently priced by markets. We think company valuations still need to adjust further to reflect how exposed companies are to, and how prepared they are for opportunities in, the transition.

 

Those companies that are better prepared and more able to benefit should be perceived as lower risk and could enjoy a lower cost of capital. Their future expected cashflows may be valued more highly. That would mean, all else equal, the prices of those assets should go up. That effect is reinforced as investor preferences shift towards greener assets. As the repricing unfolds, owners of those assets could potentially earn higher returns than they would otherwise.

 

We posited in 2020 that this repricing would happen – and that it would take time, based on the evidence that financial markets haven’t tended to immediately price in slow-moving trends.

Getting exposure to the transition

A possible acceleration from the current path, plus repricing that could have further to go, make an investment case for including investments linked to the transition in a portfolio. And that doesn’t just mean companies that are low carbon already.

 

Most of the investment needed to decarbonize the economy is in sectors that are currently high carbon. So, investing in the transition also means investing in carbon-intensive companies that have credible transition plans or that supply the materials, equipment and services needed for the transition.

 

As repricing progresses, we believe the return uplift our analysis revealed for “already-green” companies and sectors could broaden to these transitioning companies.

Journeyman inspecting large pipes

Mitigating the impact of bumps

Investors should also consider how to mitigate the impact on their portfolios of possible supply constraints during the transition. If carbon-intensive production falls faster than lower-carbon alternatives are phased in, there could be periods of supply shortages and high prices for the carbon-intensive outputs that economies can’t yet function without.

 

Excluding carbon-intensive exposures could mean portfolios are less able to weather these supply shocks.

 

Investments in companies that are carbon-intensive today but have credible transition plans could potentially achieve two objectives at once: get exposure to the transition, while also helping portfolios weather those shocks along the way.

 

Exposures to other carbon-intensive companies can still be consistent with the transition. For example, even with a rapid transition, investment in oil and gas production will still be needed to meet future energy demand. These exposures carry risk – for example, if fossil fuel demand erodes faster than expected and renders some of those assets less profitable or even stranded. Investors need to balance those risks against the benefit of mitigating the effect of supply shocks on portfolios. Engaging with companies to understand future plans is key.

Authors

Alex Brazier
Alex Brazier
Deputy Head of BlackRock Investment Institute
Mark Hume
Mark Hume
Portfolio manager- Blackrock Fundamental Equities
Vivek Paul
Vivek Paul
Head of Portfolio research-BlackRock Investment Institute
Laura Segafredo
Laura Segafredo
Global Head of Sustainable Research-BlackRock ETF and index investment
Christopher Weber
Christopher Weber
Head of Climate Research, BlackRock Sustainable Investing

BlackRock Bottom Line script : Taking stock of the energy shock

*** EMEA markets: “Capital at risk” at start of video

Speaker ID: Alex Brazier, Deputy Head of BlackRock Investment Institute

 

Russia’s invasion of Ukraine has caused a horrific humanitarian crisis and the world has responded. Nations and governments have severed financial and business ties with Russia and are seeking to reduce their reliance on Russian oil and gas. 

This action presents a fresh energy supply shock to many countries that were already facing high inflation from the restart of economic activity.

BlackRock Bottom Line open sequence

Title: Taking stock of the energy shock

The impact will vary by region and it will also depend on the speed at which the West cuts its imports of Russian energy.

We believe the switch away from Russian energy will make inflation persistently higher while slowing growth in the short term, with Europe at higher risk of recession now. We find that the cost of Europe’s energy bill has soared to its highest levels since the 1970s following this shock, that’s twice the increase seen in the United States.1

1Source: BlackRock Investment Institute and BP Statistical Review of World Energy 2021, with data from Haver Analytics. March, 2022. Notes: chart shows the cost of oil, gas and coal consumption in the European Union and U.S. as a share of GDP. We use regional energy prices and divide by GDP in U.S. dollars. Data for 2022 are based on IMF’s latest GDP forecasts and the year-to-date average of daily commodities prices.

Energy security concerns are likely to make the global transition to net-zero carbon emissions more divergent. More fossil fuel output from the United States and other non-Russian sources will be needed to meet the world’s energy demands. But in Europe, we believe recent events will reinforce the transition in the long term. In particular, we see the region making a bigger push to renewables and electrification as it looks to wean itself of Russian energy.

The bottom line: the energy shock will further boost inflation and dampen growth in the near term while making the global transition to net zero more divergent.

Disclosures

This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities, funds or strategies to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The opinions expressed are as of March 2022 and are subject to change without notice. Reliance upon information in this material is at the sole discretion of the reader. Investing involves risks.

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Taking stock of the energy shock

We were already in a world shaped by supply and now we are seeing a textbook energy supply shock, more like the 1970s, layered on top of the economic restart from the pandemic shutdowns.

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