What’s the story: Should investors flip the script regarding the energy transition? (Part 2)

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

In the first article, I explained what a ‘reference narrative’ is, and I discussed the first common narrative: the market-led transition narrative. In this second article, I’ll provide a very brief recap of this and will describe the second common narrative: the policy-led transition narrative. In the final article, I’ll contrast the two narratives and will try to conclude 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. The books that I would most recommend from this larger collection are listed at the bottom of this article.

What are reference narratives? What’s the market-led narrative?

In article 1, I discussed these concepts in detail, which I’m happy to refer you to, but if you’re eager to get to the policy-led narrative below, a quick recap here:

Reference narratives are the stories that we hold in the back of our mind – stories about how we expect things will unfold, in this case, about how we as society will address climate change. Often, we’re not very conscious of what specific narratives we’ve adopted and are referencing, and we do not proactively test or regularly update them. Yet they inform our views on who we expect to act on climate and on how they should act, and they inform how we assess climate-related risks.

The first common transition-related reference narrative is the market-led narrative, which holds that the dynamism and innovation of companies and investors can substantially solve the climate problem without government intervention. Central to this narrative are transition plans, where companies detail how they will decarbonize their operations. Fossil fuel providers are a particular focus – they need to be encouraged to switch to renewable energy sources. Investors also play a key role because, through the allocation of capital, they can enable green technologies and shrink dirty industries, and through engagement, can hold companies to account on their transition plans. Adding up all this activity will make the global economy net zero over time. Investment risk is determined by assessing companies’ or investment portfolios’ “Paris-alignment,” and a major constraint in this narrative is the availability of data on transition plans, and on who is responsible for emissions, which leads to the need for disclosures.

Policy-led transition – the transition will be shaped mostly by government policy

So then, in contrast, consider the policy-led transition narrative:

• The speed and nature of the transition depend mostly on government policy, political will, and the wishes of the polity. This is out of recognition that the transition requires a substantial transformation of most industries, which involves switching to technologies that are not yet economically viable, and that goes against the interests of many incumbents.

• Recognizing that commercial entities will not make these necessary (uneconomic) investments, this transformation requires laws, regulations, taxes, subsidies, and government-sponsored investment and R&D: to create the right economic incentives to switch to other technologies; to internalize the carbon externality; to stimulate innovation in and deployment of emerging low-carbon technologies; and to change the nature of energy demand. Once the incentives are correctly set, markets will act as a powerful force multiplier and can help to organize resources in a way that enables the transition.

• The key constraint in this narrative is the political power of carbon-dependent interests, who have proven able to weaken or even block climate policies in virtually all developed economies. This goes far beyond corporate lobbying – carbon interests are well-organized, wealthy, and firmly embedded in political processes, on both sides of the political spectrum, e.g., through unions in carbon-dependent industries or representatives from coal-dependent regions. At the same time, low-carbon actors are nascent, fragmented, and politically weak. Losers from the transition are politically salient, coherent, and, importantly, know who they are. Winners from the transition are dispersed, not politically organized, and, as yet, may not even know they are winners.

• Investment risk and opportunity are mainly driven by (the likelihood of) government action: how will companies and industries be affected by emissions caps, laws, (carbon) taxes, or subsidies? The market responds to the policy framing. The most carbon-intensive companies may not be the riskiest, in financial terms, in the absence of (clarity on) policy measures; also, whether the economy as a whole is Paris-aligned is more important than whether individual companies are Paris-aligned. Therefore, to assess risks and opportunities, investors require clear policy signals from governments.

• Governments are also crucial in developing new technologies and markets. The innovations required to address climate change in a timely fashion will not emerge without governments actively nurturing markets through R&D support, subsidies, and mandates for future technology transition. 

• Voluntary corporate and investor action doesn’t play an important role in this narrative – they cannot meaningfully influence the desired climate outcomes at a systemic level. Indeed, voluntary corporate action can even distract from or even stymie public policy if governments get the impression that a lot of heavy lifting is being done by the private sector and government policy is not that necessary. However, the operation of the private sector in pursuit of commercial objectives is the vector by which the transition is implemented, once the correct incentives are set.

In the previous article, I concluded the market-led narrative sounds pretty persuasive, but I hope you’ll agree this narrative isn’t unconvincing either.

In the final article in the series, I’ll do some ‘compare and contrast’ to reach conclusions on which narrative is most aligned with the facts, and what the implications are for investors.

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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)

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.