Investing Lessons from Climate School, Class of 2023

Spotlight on Emerging Economies in the Energy Transition

Why do we need to study emerging markets in the context of climate and geopolitics?

Dr. Luisa Palacios, Senior Research Scholar, Columbia University’s Center on Global Energy Policy: It is imperative for investors in emerging markets to have a clear understanding of policy decisions in this context as they relate to climate change mitigation and adaptation, and energy transition strategies, for three reasons.

First, emerging markets represent the future of energy demand. Future electricity demand will be particularly relevant for the Asia-Pacific region. China and India will be of utmost importance. But all emerging markets are going to see electricity demand growth. Some will be fueled by economic and population growth, but other sources of energy demand will be fueled by improving access to electricity, which is the case in Africa. And there’s another component, which is that, because of climate change, there is going to be an increase in demand for cooling activities.

Which leads us to our second reason: that emerging markets will bear the brunt of the physical risks of climate change and, therefore, financing needs for adaptation and mitigation. The third reason has to do with emerging markets representing the lion’s share of future fossil fuel supply. The bulk of fossil fuel supply already comes from emerging markets and is poised to increase. In any energy transition scenario, emerging-market countries will continue to provide the bulk of the world’s oil and gas supply needs.

How do we close the financing gap in clean-energy systems in emerging markets?

Dr. Guatam Jain, Senior Research Scholar, Columbia University’s Center on Global Energy Policy: In emerging markets ex China, at least $1 trillion of clean energy investment is needed per year. However, in 2022, only $150 billion was invested, so that’s a gap of about 85%. To close this financing gap, we need governments and state entities to play a major role, as well as development banks, commercial banks, private equity investors and public markets.

With time, thematic bonds will probably become the most important source of this financing. One of the reasons for this is that, compared with loans that you get from commercial banks, thematic bonds are market instruments, so they’re liquid, they’re tradable and they generally carry a lower cost. In addition, you can match the life of the bond to that of the project, so they have a lot of advantages for both the issuer and the investor.

This asset class has grown substantially, from under $100 billion in 2015 to almost $4.5 trillion today. Moreover, given that the total bond market is roughly $130 trillion in size, thematic bonds are still a fraction of the total market, with significant room to grow, especially in the context of rapidly growing demand for sustainable and ESG funds.

How do you integrate environmental risks into your assessment of sovereign credit risk?

Katrina Butt, Senior Latin America Economist, AllianceBernstein: Our framework achieves three things: First, it conceptually matches how we think about ESG risks for sovereigns and provides a quantitative score that standardizes our thinking across countries. Second, it allows us to compare trends across countries and across time. And third, it provides enough detail so that we can understand exactly what is driving the scores and allows us to overlay our qualitative assessments when what we are seeing on the ground doesn’t match what some of the data might suggest.

The environmental factors that we include in the model are things like the geographic locations of the country and the potential for more frequent or more severe hurricanes, tornadoes, droughts, flooding, etc.; biodiversity; pollution; greenhouse gas emissions; contribution and exposure to the energy transition; and many other factors that we think are financially material to the country.

"Emerging markets represent the future of energy demand. They also represent the lion’s share of the future fossil fuel supply," Dr. Luisa Palacios, Columbia University’s Center on Global Energy Policy.

Legacy Energy: Challenges and Opportunities in Decarbonizing China

What’s the outlook for China’s energy economy?
Kevin Tu, Non-Resident Fellow, Columbia University’s Center on Global Energy Policy: The Chinese energy economy is full of contradictions. While China is the largest carbon dioxide–emitting economy in the world, accounting for nearly one-third of global total emissions, the country is also the largest clean energy market in the world and accounts for more than one-third of global wind and solar energy capacity, as well as electric vehicle stock.

China is an indispensable part of any global solution on clean energy. From a medium- to long-term perspective, if China was to meet its carbon neutrality goal by 2060, non-fossil fuels’ share in China’s energy mix would drastically increase from less than 20% to at least 80% by 2060. In other words, China’s energy mix will be entirely turned upside down in less than four decades, and the future of coal in China is not promising at all.

How are China’s national oil companies (NOCs) balancing their energy security and decarbonization agendas?

Dr. Erica Downs, Senior Research Scholar, Columbia University’s Center on Global Energy Policy: Ensuring oil and natural gas supply security is job number one for China’s NOCs. The reason for this is that China depends on imports for more than 70% of its crude oil and more than 40% of its natural gas. A number of developments over the past few years have increased the importance of energy security to China’s leaders. One of these is the US-China trade war. Another is the power shortages due to extreme heat and extreme drought that China experienced in the summer of 2022. And finally, the Russia-Ukraine war has also heightened concerns about supply security.

In 2020, President Xi Jinping announced China’s goals of peaking carbon emissions by 2030 and achieving carbon neutrality by 2060. The NOCs have responded by setting their own carbon peaking and neutrality targets. They’re all investing in wind and solar power, and in carbon capture, utilization and storage. They are all looking to increase the role of natural gas in their energy mixes as a bridge to China’s lower-carbon future. And there are some differences in what each NOC is emphasizing—offshore wind power in the case of CNOOC and green hydrogen in the case of Sinopec, for example.

The NOCs are increasingly having to balance their mandates to supply China with oil and natural gas now while taking steps to prepare for a lower-carbon future. This balancing act is similar to the one that China as a whole is doing, in which China’s leaders are trying to make sure that China’s energy supply is adequate for growing its economy right now, but at the same time making sure that China is taking the steps needed to meet its carbon peaking and neutrality goals.

Where might investors expect to find growth in the Chinese market and overall economy?

John Lin, Chief Investment Officer—China Equities, AllianceBernstein: A long-term–minded investor is able to find, we think, a lot of opportunities as China embarks on the green transition, spanning from areas like sustainable transportation, the most prominent of which is really the electric vehicle and its supply chain. Also, alternative energy areas as China looks to generate more of its energy needs using solar and wind and other renewable resources and moving away from coal.

And then, of course, to link everything together, you need more infrastructure, you need to upgrade the grid, you need to upgrade charging stations, you need to build hydrogen stations, refuel the trucks, etc. And that infrastructure investment itself will also generate a lot of demand for certain industries and a lot of potential return for the investors who are placed in the appropriate part of the value chain.

"China’s energy mix will be turned upside down in less than four decades," Kevin Tu, Columbia University’s Center on Global Energy Policy.

Examining Global Food Security Through the Climate Change Lens

Since food insecurity is an urgent problem, what’s the drawback to addressing it aggressively?

Dr. Michael Puma, Senior Research Scientist and Director—Center for Climate Systems Research, Columbia University’s Earth Institute: We have to recognize that there are always unintended consequences that can be major concerns for our food system. We need to be aware of this as we’re deciding how we want to move forward. Also, if we intervene in our food system in an uninformed way, we can end up causing more harm than good. I think this is an important perspective when we think about grandiose plans for the food system—we need to understand that we can in fact cause more harm than good. We have to be careful about any changes or any transformations we make, and we do have to be careful about making them rapidly.

Looking at our food system with a systemic lens—and making the most of the current tools that we have in network science and dynamic systems analysis—can help us test out a lot of new innovations that are coming to the market. As an investor, if you want to consider scaling up a particular technology, there are avenues to understand how these changes could potentially impact the food system.

And so, if we do this in a measured way, in a careful way, I think we can really make important changes and improve lives around the world and reduce hunger. So, rigorous analysis and thoughtful implementation, which require thoughtful and effective policies and governance, can help us move towards a more resilient, sustainable and equitable global food system.

How can technology drive bigger agricultural yields in a sustainable manner?

Joseph Sun, Senior Research Analyst—Sustainable Thematic Equities, AllianceBernstein: Genetics is the first piece—the practice of gene editing and the technologies, tools and diagnostics that enable the practice of gene editing. These costs have fallen precipitously over the last two decades. Back in 2001, it cost a little over $1 million to sequence one genome. Those costs translate to a couple hundred dollars in today’s world. So, you could effectively edit a plant’s DNA to express more positive traits like drought or pest resistance. This would obviously help with reduction in water consumption and could also potentially eliminate the use of harmful pesticides.

It’s also about the environment. If your soil is dry and lacks nutrients, your crops will have an inherently difficult time growing. When we think of the ways that we can address this, regenerative agriculture is a big focus—things like planting cover crops, leveraging no-till farming tools, and even leveraging some bio-based pesticides and fertilizers can actually help overcome some of the challenges of weaker soil conditions.

Then lastly, management. This speaks to the growing trend of precision agriculture, which is mostly about leveraging data analytics and cloud-based tools. This would help deliver technologies like precision fertilizer applications, which could help reduce the amount of waste that’s being generated by using excessive fertilizer and prevent the amount of nutrient pollution in fresh waterways. You also see the growth of soil health sensors and other sensors that can be retrofitted onto existing agricultural equipment, again really allowing farmers to be more precise in managing their farm operations.

"Strategic investments can fuel transformative solutions for global food security," Dr. Michael Puma, Columbia Climate School.

Natural Hazards Index: Dimensioning Physical Risks from Climate Change

How do you define risk when it comes to natural disasters?

Jeffrey Schlegelmilch, Director—National Center for Disaster Preparedness, Columbia University’s Earth Institute: If we really want to understand risk, first we have to understand the hazard. Are you in a floodplain? Are you surrounded by forest that has had longer and drier summers? Are you in an area prone to hurricanes? That’s the hazard. And your exposure is how closely you are situated to that hazard.

Then there’s vulnerability. Just because there is a hazard, and just because it’s near you, it doesn’t necessarily mean that you are incredibly vulnerable to it. It doesn't necessarily equate to high risk. If we’re building with wind-resistant materials, if we’re building in ways that allow water to flow without accumulating in ways that promote flooding, these are things that can reduce the risk. We can control and reduce vulnerability.

And capacity has to do with capacity to cope. Do you have the ability to evacuate? Do you have a car? Do you have a place you can go? To have a higher wind rating, can you afford to replace all the windows in your house? So, capacity starts to get into more of the sociological factors. And risk, of course, is ultimately the aggregation of all this.

What kind of data inform the Natural Hazards Index tool?

Jonathan Sury, Senior Staff Associate—National Center for Disaster Preparedness, Columbia University’s Earth Institute: Looking at all the possible hazards, we landed on 14 different hazards where we could find reasonably good data, as well as available nonproprietary data. These included coastal flood, damaging wind, drought, earthquake, extreme heat, floods, hail, hurricanes, landslides, tornado, tsunami, volcano, wildfire and winter storms. So, the end result is a nonranked, summative index with individual hazard scores.

There are four main buckets in which the data are classified: historical data, based on prior event data; probabilistic or predictive data, providing some percent likelihood; deterministic data—given some set of conditions, what the expected outcome might be; and a model data set, which uses multiple explanatory variables to approximate some outcome of interest.

Version 2.0 of the Natural Hazards Index was released in 2023 as a [US] census-track version, and the data are also kept by AB at the county level and the census-track level. The Natural Hazards Index is not a risk index. It tells us the presence of a hazard and how severe that hazard might be on a scale of one to five for each individual hazard and in summative form. But the tool does not tell us damage or loss estimates, or potential population impact. That’s the next part of the risk equation that AB is going to help fill in.

How can investors use the Natural Hazards Index as a tool?

Patrick O’Connell, Director—Fixed Income Responsible Investing Research, AllianceBernstein: When we think of measuring exposure, vulnerability and capacity, we’ve looked back over historical time frames and asked, What is the damage from these different perils over time? This is data that we’re mining from the National Oceanic and Atmospheric Administration, from universities that have data on all these major perils and the costs to clean them up, to mitigate them, to ameliorate them over time.

A few perils stand out as being higher risk than the rest: tropical cyclones, severe storms, droughts, floods. We wanted to create a framework that homes in on these most costly perils, because we think that they could do more damage to municipalities—cities, states, governments—or properties like hotels, warehouses, whatnot. Because there are different levels of materiality, we wanted to calculate that in a quantitative form looking backward, and then apply that to our logic to create a risk score.

What we’ve built is an approach to measure US counties by what we call adjusted investment risk. This is a combination of the hazards, using Columbia’s Natural Hazards Index, times exposure, vulnerability and capacity.

"We learned that climate change may have surprising impacts on many different kinds of hazards," Jonathan Sury, Columbia University’s National Center for Disaster Preparedness.

Evolution of Carbon Markets—Corporate and Investor Perspectives

Can companies use carbon markets to reach net zero? What does a credible net zero program look like?

Paul DeNoon, Senior Advisor, Columbia Climate School: Companies can’t offset their way to net zero. First, a company must commit to reducing emissions across its value chain, consistent with a 1.5-degree pathway. Second, a credible net zero program has to create both a near-term target and a long-term target. Third, the plan should include a quantified decarbonization strategy outlining the capex required to realize the transition. Developed countries and more advanced companies that can hit net zero before 2050 would give flexibility to developing countries to hitting net zero after 2050.

There are certain industries whose residual emissions will be extremely difficult to abate, in which case, high-quality removal credits may be used for those hardest-to-abate emissions as part of a credible net zero strategy.

What role can carbon markets play in investor portfolios?

Vinod Chathlani, Portfolio Manager—Multi-Asset Solutions, AllianceBernstein: We see three primary roles for carbon markets. One is to express a view on the price of carbon. Most transition pathways that are reasonable require a higher carbon price compared to what we have today, and to the extent investors want to express a view on the carbon markets, they could potentially participate in the carbon allowance market—the larger, more liquid market—as a way to express that view.

The second is diversification. The drivers of the carbon markets are sufficiently different from financial assets, and also different across the various emissions trading systems, for there to be meaningful diversification from these instruments. And finally, as a means to hedge the risk of a faster or more disruptive transition pathway than what is discounted by the financial markets at a given point in time.

"Companies can’t offset their way to net zero," Paul DeNoon, Columbia Climate School.

Biodiversity: Exploring Systemic Risks and Investable Opportunities

What are the key solutions to mitigate the challenges of biodiversity loss and to protect biodiversity? Why is this important for investors?

Dr. Caroline Flammer, Professor of International and Public Affairs and of Climate, Columbia University: The first solution is intergovernmental measures, which include, for example, COP15 “30×30” goals or the Convention on Biological Diversity. Second, we have government measures that aim to regulate the quantity of natural capital through, for example, the establishment of protected areas, technology standards or cap-and-trade programs, and measures that aim to regulate the price of natural capital through, for example, incentives and subsidies.

While these intergovernmental and governmental measures are very important, their effective implementation proves to be challenging, so this puts the spotlight on the third potential channel: biodiversity finance. The typical monetization mechanism of natural capital includes the transformation of natural capital—think about, for example, logging and mining—but how do you achieve a financial return when, instead of transforming natural capital, we protect it? While this seems puzzling at first, it’s actually feasible. The key lies in the bundling of the public good with the private good, where the public good increases the value of the private good.

Let’s look at agriculture. By engaging in regenerative agriculture, this improves the soil quality, which could optimize the harvest and the quality of the produce, allowing the farmers to potentially increase the price—especially if this produce is certified. When we look at forests, by protecting forests this can enhance ecotourism, which allows hotels to increase the prices of the hotel nights and increases demand for tour guide services, etc. Another example is that, by conserving urban parks, it increases the value of the real estate around these parks.

Besides the financial and biodiversity returns of such investments, protecting biodiversity also helps decrease investors’ exposure to systemic risks. That is, investors need to realize that over 50% of the world’s GDP is dependent on nature and the services it provides. Moreover, the biodiversity crisis is deeply intertwined with the climate crisis. In order to address the climate crisis, we need to address the biodiversity crisis.

As biodiversity loss is increasingly seen as a global issue to solve alongside climate change, what should investors keep in mind?

Max Lulavy, Environmental Research Associate, AllianceBernstein: It’s important to emphasize how much work there is in aligning our economic activity to a more nature-positive economy, with an estimated financing gap of just under $1 trillion annually. While this might seem like a lot, the collapse of ecosystem services could result in a global GDP decline of $2.7 trillion annually.

In order to enable this flow of capital, new financing mechanisms need to be supported, such as blended finance or other nature-related monetization mechanisms. Private capital will also be an essential component of this capital flow journey. A three-dimensional consideration of risk, financial return and biodiversity return will have to be used by investors to ensure financial goals and biodiversity goals are met. Effective public policy is also essential to both facilitate and complement this flow of capital.

Lastly, this systemic issue is essential for asset managers and investors alike to consider in their practices, from both a risk and an opportunities perspective. From a risk perspective, transition and physical risks should be evaluated to ensure the longevity of portfolio companies that are dependent on ecosystem services or that may be affected by changing regulations or consumer behavior. The opportunities are also vast. As World Economic Forum research has shown, $10 trillion worth of opportunities are available by 2030.

"Biodiversity finance is a relatively recent phenomena that is gaining momentum in practice, but investors often feel underinformed about the risks and opportunities that are involved," Dr. Caroline Flammer, Columbia University.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

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