SPEAKERS

Paul, Jeremy, Anna Moss

Paul 00:06

Hello and welcome to macro bytes the economics and politics podcast from abrdn. My name is Paul Diggle Deputy Chief Economist at abrdn, and today we are talking about the energy transition. It's a topic we have tackled a couple of times before on the podcast. But we're specifically going to focus on the energy transition in the Asia Pacific region in this episode. And that's because the region is a crucial battleground in the world's fight to decarbonize with many large emitters base there. And it's also a region replete with opportunities and challenges as part of that transition. So joining me in this discussion are Jeremy Lawson, our chief economist, and Anna Moss, our climate change scenario, analyst. And Jeremy and Anna have recently authored a paper on exactly this topic, so it's going to be great to get into it with them. So Jeremy, let's start with you. Perhaps you could start by laying out why the Asia Pacific region matters so much in the fight against climate change and the transition to clean energy. So I

Jeremy 01:10

think the simplest way to put it is that in the last 20 years, almost all of the net increase in global emissions has come from the Asia Pacific region. That's because you have reductions in emissions in the United States. Here are some other advanced economies, and modest increases in places like Latin America, Middle East and Africa. But they're broadly offsetting service, all of the aggregate increase, and you've got to the three world's largest emitters are based in the region, China and India. And then, as I say, other very large emitters, like Indonesia, and so there can be no energy transition, unless there's an energy transition in the APAC region, any chances of holding temperature increases to one and a half degrees above pre industrial levels, the rest on rapid decarbonisation in the Asia Pacific. And in fact, one of the really important reasons why we don't think that that type of pathway is likely, and even a blue two degree pathway is going to be hard to achieve is because the Asia Pacific region in aggregate, and almost all of the major countries within it are not on net zero trajectories themselves.

Paul 02:29

Brilliant. And AIPAC is, of course, a very big region very heterogeneous in terms of the stage of development climate policy in individual countries. Could you give us a sense of some of that heterogeneity that difference across countries?

Jeremy 02:45

Well, exactly. So think about it through the prism of net zero targets themselves. So we have everything from net 02 1015 targets in places like Australia, Japan, South Korea, then you have a number of countries on China has got a net zero 2060, objective, India's is net 02 1070. So governments very clearly signaling different different policy pathways. You have some of the wealthiest countries in the world in the region. And still some of the poorest, particularly of us sort of expand to include the Pacific Islands, but also parts of Southeast Asia, and parts of southern parts of southern Asia. The credibility of policy very significantly, funnily enough, China is actually the only country that really has a national carbon pricing regime in place through its emissions trading scheme, whereas actually, the advanced economies who look like they have more aggressive climate targets, have actually not managed to put those types of instruments in place. So actually, the credibility of their objectives is even more under question. And so it becomes very, very important to take these types of variation into account, manufacturing shares of GDP, renewable energy, intensity of the energy system, all these sort of things into account when sort of considering the nature of the risks and opportunities that are going to be facing investors looking to get exposure within the region.

Paul 04:18

So I know you're very closely involved in the climate scenario modelling work that you and Jeremy have undertaken. And this is a quantitative framework that we've applied to AIPAC, but also globally to understand different paths for climate change the energy transition, the fortunes of individual sectors and companies. Can you tell us a bit more about the modelling framework? How does it work? What have we done with the modelling?

Anna Moss 04:42

Yeah, so we're about to commence what will be our third year of climate scenario analysis. And I'd say that that really reflects the importance that we place on the potential insights that this type of analysis really can provide to us. And I'd say that also our unique approach Ah chi, that analysis also emphasises that commitment, because rather than relying on publicly available tools, and simply relying on off the shelf scenarios, which can typically have more simplistic assumptions that are built into, that they're built upon. And instead, we've created our own bespoke scenarios. And this allows us to input our sectoral and critically here our regional insights and research. And this means that we can create is more plausible scenarios, where regions and sectors are able to vary within a global pathway. So, as Jeremy has illustrated in his outlining of the importance of the APAC region, there are distinct and important characteristics between regions and between countries in those regions. And it's important for scenario analysis to be able to reflect these. So our approach means, for example, we can reflect China's that China's expanded policy commitments mean, it's likely to decarbonize more quickly than the average across emerging markets, or how the policy ambition and the timescales of that ambition for countries like Japan or Australia, for example, are significantly different to those of Thailand and India, for example. But as Jeremy pointed out, because we need to also the credibility of all those targets. It says right, in terms of the simple off the shelf approaches, these tend to focus on, if you like, the stress testing, approach to climate scenario analysis. So that means that they're concentrating on more the tail risks. And this will flag up the major risks and potential opportunities, but it doesn't allow you to consider what would be the more likely impacts of climate change. So instead, we've, we have a large suite of scenarios and that we apply probabilities. And that then provides us with a really good depth as well as the breadth. So this allows us to explore the differing impact impacts of, for example, limiting warming to the degree two degrees, more ambitious scenarios that are critically aiming for the 1.5 degrees, the hothouse world use of a continuation of work where basically current policy fails to scale up. And also the varying degrees in between, including our current view. That is that the likely figure is around 2.2 degrees in terms of global warming.

Paul 08:01

Brilliant. So we've got this set of bespoke climate scenarios. And our model takes into account alternative paths for climate change the energy transition emissions, the global temperature rise, and gives us impairments of individual sectors and companies that we might invest in. Jeremy, could you bring to life a little bit what the average scenario looks like? So there's the 2.2 degree temperature rise, but what else do we have in terms of technological path or regulatory path bring this to life for us?

Jeremy 08:34

Sure. So I think it's very important for the listing to understand how this framework is built. We have a baseline scenario, which really reflects what we think is priced into assets today across geographies and sectors. And this is a really important starting point for investing, because any investor always has to begin with the question of what is in the price of assets. Then what we do, as I said, we build this array of scenarios, which we think are more likely more plausible, because they build in technology and variation across technology and policy variation across sectors and geographies. And then the mean the probability weighted mean that we generate as a result, then that dictates the extent of the impairment that different securities are exposed to. And this is going to generate very different results than what a standard scenario analytical framework will sort of generate. So they give a couple of examples. We're able to build in the fact that for example, the European Palace sector is decarbonizing more quickly than the power sector in the typical emerging Asian economy. And it's going to matter a lot, because implicitly that means that the carbon price trajectory in Europe in the power sector is going to be higher than it is going to be in emerging Asia. That's also therefore going to significantly influence the after tax. Earning streams of companies differently. So all these things are going to matter quite a lot in terms of what is the demand for products look like? What is the carbon price sort of trajectory look like? How was the ability of companies to pass on changes in carbon prices. So effectively in this model, carbon pricing closes the system, it effectively generates a pathway that ensures that emissions drop in line with the overall sort of temperature, or emission sort of trajectory. And again, if we think about some of the key inputs around, for example, electrical vehicle penetration, or when does global oil demand peak, or how much coal is used in the future, each of these things is going to look a lot different in our main scenario than they do in those extreme tail scenarios. So there's gonna be a lot more fossil fuels use in our main scenario than in one and a half degree or below two degree Well, however, there's going to be a lot less used than in the current policy world says, say most investors, when they gauge a scenario analysis, they're going to get these types of risks that vary widely available, they're commonly used by just kind of precise enough. Ultimately, assets will be dictated by what happens in the real world, not in highly stylized scenarios that reflects the tail probabilities that are very unlikely. And so our The unique part of our framework is the ability to build that in as a feature. And so we're looking for example, for how is BHP Billiton affected by the energy transition, our framework will generate a very different impact than what are the frameworks will.

Paul 11:36

Brilliant and one of the findings of the modelling, Jeremy is that the typical aggregate equity market impairment from the transition is often quite small. There are lots of winners and losers. But you find the aggregate they largely net out at a global level. But that's not the case in a pack, is it especially not for some specific countries, say like India, where you find pretty large aggregate impairments to tell us what it is about Asia Pacific equity markets, that mean that you actually get some pretty big aggregate impairments from the energy transition, you're envisaging.

Jeremy 12:14

I think the simplest way to explain it is that if you look at, say, equity indices across the Asia Pacific region, for the most part, they had larger concentrations in the sectors that are negatively affected under the transition scenario we have in mind. So for example, energy materials, consumer discretionary, each of these sectors that on average, is negatively impaired in our main scenario. And so naturally, if those sectors have got a larger weight in the indices, that will drag the aggregate down in India's case, for example, in very significant weight to materials, but materials that are in some sense, brown rather than green materials. And so that has a negative effect on the aggregate results. But it is still very important to recognise that even though it's true, that the index level effects are a little bit larger, on average, across Asia, and across emerging economies than in the major advanced economies. That it's still the case that dispersion of the impacts of fair valuation impacts is predominantly a security level phenomenon. Right? So So knowing what country the firm is, in knowing what sector even a firm is, is in tells you relatively little about the true exposures, the different types of climate risk and opportunity.

Paul 13:37

And that's the great insight, of course, or of the framework you've built. It allows you to think about individual companies and their exposure to the energy transition, which as you say, Jeremy, varies considerably. And Anna, so a potentially surprising result of your modelling work within a PAC specifically is that Chinese indices actually have quite a low negative exposure to the energy transition. Could you explain why that is? Yeah, so

Anna Moss 14:07

as you say, it is quite a surprising result, given the carbon intensity of the Chinese economy. One of the reasons for this is that some of the country's most fossil fuel intensive firms are actually non listed state owned enterprises and that means that the energy sector which is the most negatively impacted sector, and she has a very small weight in the in the aggregate index, as Jamie pointed out, is quite critical that the weight of these sectors within their indices and that results in therefore a smaller set tall drag on valuation for China in comparison to some these other markets. But also, as Jeremy pointed out, this importance of the dispersion within a sector and whilst the the overall whilst overall the energy sector is very negatively exposed. There's still many firms which do show significant uplift in valuation in our mean scenario. And some of these are actually coal producers based in China, which again, is perhaps surprising to people. And that's because coal remains a dominant fuel type in China, under continuation of current policy, and even in the most stricter and early action scenarios, the projected role for coal actually remains a dominant figure for the dominant figure in terms of few types of much longer in China can compared to other regions. And if you add to that, the issue around carbon pricing so as Jeremy pointed out in although they do have this carbon price pricing scheme in place, it is projected the prices still projected remain pretty low in China across our scenario sweet. So those coal producers in the region have the potential to benefit from the continuing demand, whilst at the same time, their regional peers are potentially going to be hit by higher carbon prices. And along with this dwindling demand that they would face that would see them exiting, exiting the market sooner. So although this car, these coal producers do see a large downturn in net zero scenarios, the uplift from these other scenarios is enough to pull through a positive result in the mean scenario.

Jeremy 16:43

And it's just a Can I just pulled this out a couple of things to that that are probably work, you will help people sort of understand even more in any sort of asset pricing framework, you will have a discounting mechanism taking place, right, and so the further out, the change in earnings occurs generally will, the less weight it has in the valuation, because in emerging economies, including in China, a lot of the policy action, the most aggressive policy actions projected to take place, say after 2030, the biggest negative effects on fossil fuel usage are occurring in periods that are going to be more heavily discounted within the framework. So another way of thinking about that is if we rolled this all forward 10 years and we were doing the analysis, then those same companies might look quite poorly, they still had the same structure reliance on coal. The other one there's a sector element as well is that the Chinese power sector is definitely on a decarbonisation pathway that a lot of coal is used in the industry sector in China, and industry is the sector, it was one of the sectors that we think is going to decarbonize much more slowly, in part because alternative technologies aren't available didn't, then the sheer growth rate of China can sort of create sort of still healthy demand for coal through that particular channel. So again, it's the real importance of taking these nuances into account rather than sort of, say, coal bed renewables good. It's much more complex than that in terms of modelling.

Paul 18:14

Right. And and Or another nuance then is that individual firms can actually take measures to limit their impairment through the energy transition, can't they? So they can they can move to net zero, they can set carbon targets, can you tell us about the sort of measures firms might take that would mean, they they can do well, through the energy transition?

Anna Moss 18:39

Yeah, so I guess the the measures really fall into two broad categories. So limiting rising costs from their emissions, and also reducing the risk of, of losing market share as demand for their products and services declined. So sort of changing how they're the products changing the actual products that they're producing. And so the most common measures fall into that first category with companies announcing commitments to reduce emissions. So basically, as the carbon prices rise, they can improve their position relative to competitors by by basically reducing their costs. But also, there are companies that are announcing targets to adjust their revenue splits to move away from their high carbon products, and increased production of low carbon products. So they're not disadvantaged by these these changing demand dynamics

Paul 19:37

in the auto industry might be an example of that.

Anna Moss 19:41

Yeah, yeah. I'd say definitely the the auto industry is a important one to bring in there. And really, that's so if you consider in terms of the changing in the revenue split, particularly there, you're seeing auto companies announcing In their commitment to change their their split much more favourably towards electric vehicles. And I'd say a lot of the time the devil can really be in the detail. So there can be considerable variation between companies, not just in terms of addition, but also in terms of the the type of permissions that they're including within those targets. And also in terms of whether they're considering the milestones that they'll need to achieve, achieve those those targets. So if we look back at consider our analysis. So climate scenario analysis, although the the policy and technology pathways that underpin it are forward looking, we are working now to introduce a way to incorporate the kind of dynamic responses that individual companies are also likely to make. So we're exploring how to integrate those company level targets into the modelling. But we really do need to consider this this credibility issue. So just as we consider the credibility of targets at country levels, we also need to consider the credibility of these targets being announced by companies. So for that reason, we're also developing a credibility framework in house that can consider the track record in terms of decarbonisation of these companies, how detailed the targets are, and whether these they have these milestones to transition, whether they're operating in jurisdictions where the policy and the regulations, or perhaps like the hinder their plans. And also really crucially, this this issue that the Jeremy touched on earlier about the viability of the technologies that are actually needed to aid their transition, because a lot, a lot of the technological developments that are going to be needed to achieve net zero. In across, most sectors are yet to actually be proven at scale. And in many cases, they've not even made it to market yet. So if you consider going back to your question about the autos, so that's a sector where even where we have proven technology, we're already seeing companies falling short of the targets that that they've set, and majority of the world's car makers already lagging behind with regard to the necessary switch to electric vehicles,

Paul 22:50

right. So credibility is absolutely key when assessing individual again,

Jeremy 22:54

and again, to emphasise how unique this is because it's already the case in our standard work, we're able to take into account policy variation across sectors and geographies and technology variation way but other frameworks don't. But now our ability to take into account dynamic corporate strategies with a layer of credibility will take this work to the next stage in the next level. So it really needs to be thought of as an innovation that makes it even more relevant to investment decision making. And the framework already was and takes a long way beyond this, the standard risk based assessments that are that are mostly sort of prevailing in the industry.

Paul 23:33

And Jeremy, tell us how how we're incorporating this into investment decision making, ultimately, how are our portfolio managers changing their decisions, using this research, this great modelling framework that you and Anna have developed.

Jeremy 23:49

So it's very important to emphasise that the modelling the analysis does not dictate any investment decision. It's a model poll, you're very familiar with the strengths and weaknesses of different model their representation of the world, but never a perfect one. And we want to really emphasise that there are things that are going to be influencing asset prices over different frameworks, including the energy transition, you can never sort of fully capture in a single framework. But what it is being used for in large parts of the businesses is like a think of it as a as a screen as an input into decision making helps people sort of understand well, okay, so how exposed might this firm be? How does that weigh against other things that might be influencing you know, the company, how should I think about long term value compared to short term value? Maybe it can be used in the way where it's being used in the way we engage with companies. So a lot of corporates themselves do scenario analysis, but some of them cherry pick those scenarios to represent favourable futures and say, Hey, we're already on the right track. We don't need to do anything. But when we're armed with our own analysis, we can say, Oh, actually, when you look at it this way you're exposed Asia looks a bit different. How are you? You know, how are you counteracting that? So it's sort of it's, I sort of see it as, like any sort of good model as a way to make better decisions to influence the not dictate and make sure that we've just got a better way of capturing of avoiding risk capturing opportunity. Alongside the other things, they're gearing towards the value of companies and, and the way that we make investment decisions over short, medium and long term timeframes.

Paul 25:29

Anna Jeremy, thank you both for a fascinating set of insights. The full report on the energy transition in Asia Pacific and how we are using it in our in our modelling in our stock selection, portfolio construction, and company engagement can be found on abrdns website and we'll link to it in the show notes as well. Thank you to you for listening to macro bites, we'd love you to give a like or subscribe to the podcast on your platform of choice. But until next time, Goodbye and good luck out there.

26:08

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for informational purposes only and should not be considered as an offer investment, recommendation or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The companies discussed in this podcast have been selected for illustrative purposes only, or to demonstrate our investment management style and not as an investment recommendation or indication of their future performance. The value of investments and the income from them can go down as well as up and investors make it back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provide no guarantee of future results.

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