What's the story: Should investors flip the script regarding the energy transition? (Part 1)

This is part of a 3-article series. You’re reading Part 1. Here is Part 2 and Part 3.

“Sometimes reality is too complex. Stories give it form.” Jean-Luc Godard

“The value of challenging narratives is not simply to find the best explanation of what is going on. It is to test the weakness of proposed plans of action, and to secure robustness and resilience.” John Kay and Mervyn King, Radical Uncertainty

Introduction

This is the first in a series of three articles about climate change and the energy transition. And about ‘reference narratives’, or stories. The stories that we often, unwittingly, have in the back of our mind as we try to work out how to assess the impacts of climate change, or what we can do about it. The articles are based mostly on my experiences working with investors, but I believe these insights have much wider applicability – the reference narrative used by many investors is often very similar to, if not the same as, those used by policymakers, the general public or climate activists, for that matter.

In this first article, I’ll explain what a ‘reference narrative’ is, and I’ll discuss the first common narrative: the market-led transition narrative. In the second article, I’ll discuss the second common narrative: the policy-led transition narrative. In the third article, I’ll contrast the two narratives and will determine which one is most aligned with ‘the facts’. 

The facts, as I see them, are taken from a set of books about climate change – about solutions to climate change in particular – by experts on public policy, economics and energy systems. And one moral philosopher. Note that this doesn’t include any climate scientists – all of these authors take the climate change problem as a given and discuss mostly how we should solve it, something I find climate scientists tend not to dwell on in detail, though of course they are very good at describing the problem. The books that I would most recommend from this larger collection are listed at the bottom of this article.

Kay & King to the rescue

Over the past ten years, I’ve had many opportunities to work with institutional investors (both asset managers and asset owners) on the issue of climate change, and I was confronted with the many uncertainties investors are facing in this area – this often makes it difficult to know what the best course of action is. I also noticed that people often draw very different conclusions about climate-related investment risks, or about solutions to climate change, even when looking at the same set of facts and circumstances, and wondered why that was. 

Then, some five years ago, I picked up a copy of the book Radical Uncertainty by the well-known economist John Kay and Mervyn King, former governor of the Bank of England. The book is essentially about decision-making under uncertainty, and one of the concepts they introduce and keep coming back to throughout the book is that of the ‘reference narrative’:

“We believe the best way to understand attitudes to risk is through the concept of a reference narrative, a story which is an expression of our realistic expectations. (…) Since different people start with different reference narratives, the same risk may be assessed by different people in different ways."

This immediately struck me as insightful and very true, but also as applicable to my climate-investment work. In my own words, when investors make decisions about climate-related investment risk or how to contribute to solutions, their starting point is often a certain expectation as to how we as society will fix the climate problem, or a certain story about how this will unfold, and the actions we need to undertake. And more importantly, which actors need to be leading in taking these actions. In that sense, it is quite similar to the concept of ‘theory of change’ that many investors have started using, for example, in relation to their stewardship programs.

And this story that investors have in mind, typically subconsciously, determines how they assess risk and which actions they take to manage these risks or contribute to solutions.

Even if the story is wrong.

Because another thing that Kay and King point out in their book is that we should continuously test our reference narratives as we learn new facts – they should not be static; instead should evolve to reflect reality as we know it. But this, they say, is something we’re not very good at: “We change the reference narrative in response to disconfirming events, but infrequently and discontinuously.”

The main purpose of these articles, therefore, is to make readers aware of the energy transition reference narrative they have in mind, and give them an opportunity to test if it’s the ‘correct’ one. 

Market-led narrative

Effectively, there are two reference narratives around climate change and the energy transition: the market-led narrative and the policy-led narrative. What they have in common is that they both tell a story about the ‘why’ of the transition: we need to address climate change and will do this by engineering an energy transition – switching the global economy from fossil-based energy sources (coal, oil, gas) to renewable sources (wind, solar, nuclear, hydro). 

In simple terms: problem – climate change. Solution – energy transition.

But that’s where the similarities end – where these narratives differ is the what, how and, most notably, who of the energy transition. In the first narrative, market forces, consumer preferences and voluntary corporate and investor action are decisive. In the second narrative, policymakers, public investments and rules and regulations are decisive.

Market-led transition – the transition will be shaped mostly by market forces and voluntary corporate and investor action

This is the market-led transition narrative in a nutshell:

• Companies, also through encouragement by investors, will reduce emissions, e.g. by switching to less carbon-intensive energy sources. Anticipating the transition, they will invest in technologies that will also accelerate it. Companies need to have transition plans outlining how they will do this with a view to aligning with the Paris goals. 

• Investors play a key role through the allocation of capital and the demands they make of companies. By diverting funds away from dirty industries to clean ones, they can cause the former to shrink and the latter to grow. Investors need to decarbonize their portfolios and engage with companies to encourage them to adopt and implement transition plans.

• Companies and investors need to set targets for these actions.

• For both companies and investors, and for broader society, this is a win-win: this will result in reducing or eliminating emissions but also in new profitable business activities for corporations and attractive investment opportunities for investors.

• Over time, this will add up to an energy transition and will make the global economy net zero. Apart from energy sources, there will not have to be much change in the makeup of the global economy.

• There is significant focus on suppliers of fossil fuels – they caused the problem of climate change, so they will also have to steward us out of it. They are the winners in today’s energy sources and should choose to be winners in tomorrow’s sources, and therefore switch to low-carbon technologies; as they change the type of energy supplied, the demand for these types of energy will then also adapt. Or, if they refuse, investors should starve these companies of capital – this will limit the supply of fossil fuels and force energy users to switch to renewables.

• Investment risk is determined by the carbon intensity of companies, which requires an understanding of scope 1, 2 and 3 emissions. This can also be translated into ‘temperature alignment’. Risk mitigation is then achieved through portfolio decarbonization – removing or underweighting carbon-intensive or ‘high temperature’ companies.

• The key constraint in this narrative is transparency: investors and other stakeholders need to know which companies are responsible for which emissions; they also need to understand their transition plans (and progress against plans), so that they can be targeted with engagement or other sustainable finance practices to keep the transition on track. Lack of information is a critical issue that is holding back progress. This is why disclosures and disclosure-based approaches are central in this narrative.

• In sum, in this narrative, the dynamism and innovation of the market can substantially solve the problem without government intervention. Indeed, in some versions of this narrative, government intervention could even get in the way because of the inability of governments to “pick winners” or direct economic activity through industrial strategy.

Sounds pretty persuasive, no? 

In the next article, I’ll describe the policy-led transition narrative in more detail. I hope you’ll stay tuned as the story unfolds…

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Sources

Of the various books I’ve read about climate change and the energy transition, I’ve found these to be most accessible and insightful, and together I feel they offer a fact- and science-based narrative on how we as society should engineer the energy transition:

• Climate Matters, John Broome (University of Oxford)
• Making Climate Policy Work, Danny Cullenward (University of Pennsylvania, American University) and David G. Victor (UC San Diego)
• How to Avoid a Climate Disaster, Bill Gates
• The Entrepreneurial State, Mariana Mazzucato (University College London)
• Carbon Captured, Matto Mildenberger (UC Santa Barbara)
• More and More and More, Jean-Baptiste Fressoz (Imperial College, Centre National de la Recherche Scientifique)
• Short Circuiting Policy, Leah Stokes (UC Santa Barbara)
• Sustainable Energy – without the hot air, David JC MacKay (Cambridge University, Fellow of the Royal Society, Chief Scientific Advisor to the Department of Energy and Climate Change, UK)
• The Green Frontier – Assessing the Economic Implications of Climate Change, Jean Pisani-Ferry (Sciences Po, Paris; Bruegel Institute; Peterson Institute for International Economics) & Adam Posen (Peterson Institute for International Economics)

Acknowledgements

I’d like to thank Tom Gosling at the London School of Economics and Political Science (LSE), who was a valuable sparring partner in fleshing out the ideas set out here. Also, I’d like to thank Royal London, who made it possible for me to do the thinking and allocate the time needed to write these articles.