Having considered the various potential drivers of an IPR, this paper further considers when the IPR could occur, what policy and technology pathways it might take, and how these pathways would affect the macroeconomy and risk-returns of financial assets.

It forms the basis for further work on an IPR intended research programme.

The PRI is supporting its signatories to encourage governments and policy-makers to close the gap to the Paris Agreement with the urgency that is required. However, the PRI also recognises that the full impact of a delayed, but forceful policy response, such as an IPR outcome, has not been widely debated or understood by many in the institutional investment community. In that context, the goal of this technical paper is to build a better understanding of how the low-carbon transition will impact financial markets in response to an IPR by considering:

  • The timing and key stages of an IPR outcome.
  • What an IPR would entail, to get the world from the current trajectory to 1.5-1.75°C with 50–66% probability, and the multiple permutations of potential policy and technology pathways that will get us there. This includes proven and feasible mitigation policies, as well as policies that facilitate and encourage ‘negative emissions’ technologies.
  • The financial outcomes of the policy and technology scenarios, and the potential implications for SAA and portfolio construction.

The outputs from this analysis will provide the basis for understanding what an IPR pathway will consist of, and how it will impact institutional investment portfolios, as further examined in the companion technical papers, ‘Implications for Strategic Asset Allocation and Portfolio Construction’ and ‘Investors Actions’, including the management of stranded assets.

Timing of an IPR

In light of the triggers described above, a significant IPR is possible at almost any time in the near to medium term. Anchoring around the major global policy intention – the Paris Agreement – there will be an assumed IPR by 2025.

  • The Paris Agreement already sets the policy framework and process that could trigger a global response to limit global warming to well below 2°C (B2D).
  • Under the agreement, countries must submit NDCs every five years, starting in 2020.
  • Current pledges are not on track to meet the stated goals of the Agreement.
  • However, each round of pledging will be accompanied by five-year collective reviews – called ‘global stocktakes’ – starting in 2023, with the stated aim of ratcheting-up commitments to achieve B2D.
  • If countries are to meet the goals of the Paris Agreement, they will need to begin ratcheting-up their pledges before 2025.
  • In addition to the political momentum achieved through the Paris Agreement itself, increasing awareness of the costs of asset stranding, major technology improvements, and extreme weather events and their impact on public opinion are all credible and compounding triggers to action by, or before, 2025.
  • More so than in the past, these triggers could sway the breadth of actors – citizens, consumers, businesses and government – whose alignment makes an IPR more likely. These triggers could also intensify over time, making a stronger case for action in the run-up to the global stocktakes and ratcheting-up of pledges.
  • Moreover, even though the ideal IPR would take place through fully coordinated international climate action, this is not the only credible route to an IPR.
  • Instead, the leaders of key countries and regions, such as the EU, China, Canada and progressive US states, who consider action to be urgent, could drive an IPR more widely through their inordinate weight in a globally interconnected political and economic system. This means that only a certain critical mass of countries need to ratchet-up their policies to B2D to trigger the equivalent of a global IPR.
  • Finally, it is important to recognise than an IPR does not need to be fully formed and adopted for it to change market expectations and drive a major shift in the value of financial assets. This change will take place the moment the IPR is seen as the most likely future trajectory based on a sufficiently credible commitment. This depends on the response of the most active investors who price at the margin. As such, the increasing awareness built through the Paris Agreement, and the pattern of increasing commitments established by 2025, might be enough to trigger the IPR impact on financial markets.

Policy pathways to the Paris Agreement

Combinations of policies are needed to limit global warming to well below 2°C. These are best understood through scenario analysis, due to a lack of historical evidence and considerable uncertainty in future climate policy and technology developments.

  • Policies to reduce emissions differ in their impact on financial markets, even when the broad technology pathway might look similar.
  • Delayed action means foregoing well-understood and cheaper emissions reductions today (e.g., through energy efficiency) for more costly and uncertain reduction measures tomorrow (e.g., negative emissions technologies).
  • This makes the exploration of future technology scenarios even more important, as the importance of unproven levels of scale-up, and unproven technological solutions, will be even greater.
  • At the same time, the level of coordination across jurisdictions (which remains uncertain) can significantly affect the impact of asset values across regions and sectors.

As stated in the technical paper Strategic asset allocation and portfolio construction,scenario analysis is of vital importance, due to a lack of historical evidence and considerable uncertainty in future climate policy and technology developments. While a policy response is inevitable, the severity, timing and global coordination of the IPR remain sources of uncertainty that investors will have to assess. The process of building climate scenarios of investor relevance will involve a greater level of detail than policymaker scenarios reported in the literature, such as the IEA’s Energy Transition Policy scenarios.

Figure 6: Scenario-building identifies important sources of uncertainty and establishes likely levels of variation

Figure 6: Scenario-building identifies important sources of uncertainty and establishes likely levels of variation

Building blocks of policy pathways

Policies are split across those that either restrict the demand  (through impacts on key sectors in the economy, such as power, transport and industry) or supply  (e.g., fossil fuels) of carbon-intensive inputs or products (e.g., beef). Importantly, the intended research programme will look at the most efficient ways of implementing believable and impactful policies, examine more precisely the likely stringency of these policies (e.g., the level of carbon prices) and it will assess how delay affects the likely forms of those policies.

  • Demand-side policies: By far the most predominant and important demand side policies are those that seek to restrict demand for emissions intensive inputs (especially fossil fuels) – carbon pricing (domestic and internationally coordinated) and regulation and standards.
    • Divergence in policy response could lead (perversely) to lagging regions and associated assets achieving short-term gains.
    • Any coalition acting as a ‘carbon club’ will likely employ punitive measures to entice other countries to join the policy response, while running some risk of broader disruption to trade and global supply chains.
    • Sticks will likely be accompanied by the carrot of climate finance and international assistance (including support for a just climate transition), with potential implications for global capital flows.

Carbon pricing

  • There is widespread consensus that carbon pricing – encompassing emissions trading schemes, carbon taxes and other price-based instruments – will be indispensable for limiting global warming to 1.5-2°C. These are based on different regulatory approaches.
  • There are currently 51 carbon pricing initiatives around the world with prices ranging from <$1/ tCO2e through to $139/tCO2e. However, only 13 of the current carbon pricing schemes have prices above $10/tCO2e.
  • The carbon price to reach well below 2°C needs to be high and it needs to increase steeply over time. On average, studies estimate a carbon price of $39- 62/tCO2e during the 2020s, $54-190/tCO2e during the 2030s and $139-423/tCO2e by 2050.
  • A lowest-cost policy response will require international coordination, and ideally the linkage of carbon pricing instruments. However, an IPR could imply a breakdown in full international coordination, with potentially far-reaching implications.

Regulation and standards

  • Widespread regulations and standards will need to be implemented to complement carbon pricing initiatives.
  • For example, vehicle fuel emission standards play a key role in reducing global emissions.
  • Across demand side policies, delay means a more sudden rise in the stringency of these policies, and more stringent overall level by the 2030s and beyond.
  • This would be expected to have a similar sudden and large impact on financial valuations across a large swath of major sectors, with effects propagating throughout supply chains.
  • Supply-side policies: These aim to reduce the supply of carbon-intensive inputs or products and increase the provision of low-carbon alternatives (e.g., renewable energy).
    • Policies targeting the supply of fossil fuels and other carbon-intensive inputs are suitable for a more specific set of sectors than demand side policies, but where relevant, they offer a suite of economic and political benefits
    • The supply of fossil fuels and other carbon-intensive inputs could be directly priced upstream at the point of extraction (well-head taxes) or production to make their supply costlier (rather than their end-use, as for carbon pricing).
    • In some instances, supply side policies include the phase-out of subsidies, such as those for fossil fuels or fertilizers.
    • As part of an IPR, the level of taxation or pricing would need to be significantly higher than today to induce the desired outcome, particularly if pricing were to reduce or completely prevent the exploration and development of new fossil fuel resources. This works in tandem with demand-side policies.
    • Previous analysis and experience also suggest that these policies could be implemented very suddenly, with quite immediate impact, as in the case of removing fossil-fuel subsidies.
  • Sequestration supportive policies: While there is considerable scepticism, most low-carbon scenarios assume that carbon capture and storage (CCS) would need to increase significantly past 2025, encouraged by either pricing policies (carbon pricing or subsidies) or by direct regulation.
    • Net-negative emissions are required in many B2D scenarios in the second half of the century. Negative emissions technologies (NETs) may hence be essential, unless significant emissions reductions are achieved before 2050.
    • However, NETs are not currently capable of commercial deployment on large scales.
    • Bio-Energy with CCS (BECCS) remains the most widely considered NET, but direct air capture and other emerging technologies might eventually be more easily deployed at scale, although they currently remain in the early stages of development.
    • Carbon pricing, or more direct forms of revenue enhancement and risk reduction, would provide the necessary incentive for CCS, as a step towards negative emissions through BECCS. Later, this could apply to direct air capture NETs.
    • Governments could directly finance the creation of negative emissions facilities.
    • Regulations could establish standard practices that require the use of CCS and/or NETs, such as regulations on cement, steel and other heavy industries, and a mandatory BECCS target for power generation (akin to the renewable energy standards used today).
    • Significantly enhanced mechanisms for enabling and ensuring sustainable biomass at scale would be required for BECCS, with large current uncertainty being its potential viability.
    • Subsidisation and research and development funding could be used to develop promising approaches that are technologically immature.
    • Under an IPR, there would likely be a much more intense and rapid push to make NETs viable. In some areas, this could create risks (e.g., in relation to food security) and opportunities (e.g., in emerging NETs) not currently considered in financial valuations.

Figure 7: Negative emissions technologies must be adopted much more widely for a below 2 degrees (B2DS) scenario

Figure 7: Negative emissions technologies must be adopted much more widely for a below 2 degrees (B2DS) scenario

Source: Data based on IEA Energy Technology Perspectives 2017

  • Scenarios for an IPR: A range of scenarios will be considered that are consistent with a forceful policy response to limit global warming to well below 2°C with 50–66% probability.
    • The response to reach either 1.75°C or 1.5°C at 50–66% probability (a range will be explored) will rely on some fundamental, necessary policies.
    • The creation of all scenarios will account for the full range of uncertainty in likely future technology and policy implementation pathways.
    • The intended work programme will draw upon IPR scenarios in comparison to a ‘committed policy’ scenario, such as the IEA New Policies Scenario (NPS) and an ‘orderly 2°C transition’ scenario, where the NPS is based on the publicly available NDCs.
    • Keeping to a well-below 2°C budget would require a radical shift in existing climate and energy policies.
    • However, the sweeping changes required for the well-below 2°C budget would involve instant reform of all energy sectors and the wider economy, and are therefore unlikely to materialise.
    • The work will draw together which policy pathways are part of the IPR, in order to estimate their impacts, in the following section.

Keeping to a well-below 2°C budget would require a radical shift in existing climate and energy policies

Based on the preceding analysis, this would include:

  • Escalating carbon prices, starting at 54–190 $/ tCO2e. These could be based on different regulatory frameworks with best efforts to harmonise them.
  • Strong performance standards in power and transport in particular.
  • New building codes for all new buildings to be carbon neutral or negative.
  • Policies to phase-out and prematurely retire the existing stock of fossil-fuel infrastructure that is incompatible with the carbon budget.
  • Significant state-sponsored research and development into low-emissions aviation technology, low-carbon high-grade process heat technologies, such as plasma arc welding, and high-density batteries for the electrification of heavy vehicles.
  • Subsidisation of electric vehicle charging stations, along with tax and congestion charge exemptions for electric vehicles.
  • Implementation of feed-in tariffs in many countries for solar photovoltaics, offshore and onshore wind and solar thermal.
  • A widespread roll-out of energy efficiency and consumer appliance standards, in particular for electric motors.
  • Behavioural change policies to encourage dietary change away from animal products and energy inefficient lifestyles.
  • Energy intensity targets for iron, steel and cement.


  • Estimating the Financial Impacts of an IPR: Forward-looking measures represent the best approach for estimating the financial implications of IPR, feeding into SAA and portfolio construction. The paper sets out a framework and toolkit for assessing the exposure of financial assets to the climate transition in a way that directly informs portfolio construction decisions by investors.
    • Impacts will be quantified using a layered approach.
    • The approach combines macroeconomic sector- and microeconomic company-level modelling to estimate the impacts on portfolio construction.
    • The modelling will produce two layers of internally consistent data that can be used for strategic asset allocation decisions and portfolio construction.
    • The first layer will consist of macroeconomic outcomes under different climate-action scenarios over time.
    • The second layer of value analysis will feed into asset-class performance, which will not only vary with climate ambition level, technology cost and policy timing, but also based on the specific characteristics of individual assets as they map up into companies and sectors.
    • Combining the two layers of outputs allows a comprehensive estimate of mean returns and risks for key asset sub(classes) across climate scenarios.

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    The inevitable policy response: when, what and how

    September 2018

The inevitable policy response to climate change