Winners and losers from the transition to a more sustainable production world

• The transition means that sectors have to adapt to new ways of producing and often to increasing costs. This requires massive investment.
• The recent UN COP26 summit delivered commitments that will affect industries both positively and negatively.
• Transition for the oil and gas and power sectors will not be smooth.
• The agrifood sector, previously sidelined in climate targets and strategies, is drawing increasing attention.
• Transition in the steel sector will be slow and costly.

Climate change is well underway and affecting companies in numerous respects. Natural disasters can directly translate into temporary or more definitive changes or destroy production capacities, possibly resulting in supply chain problems that will then impact other companies across different sectors. For example, this cascading impact across the supply chain was visible last summer when drought hit Brazil, affecting food crops and creating bottlenecks in the transport of iron ore by waterways, or when water scarcity in Taiwan last spring affected semiconductor manufacturers, exacerbating the supply deficit of this critical component.

While exposure to climate risk can directly impact a company’s survival and will mainly depend on its geographical location and those of its suppliers and clients, climate risk can be monitored at sector level by assessing the geographical concentration of both the sector and the entire supply chain. While this assessment concerns the direct risk of climate change on businesses, the transition to sustainable production presents an additional risk, worth considering in any credit risk analysis. Transition may be imposed by national/international regulations or motivated at a corporate level, which means that sectors have to adapt to new ways of producing and often to increasing costs. In turn, this will have an impact on their level of default risk.

This publication aims to provide some insight into the risks and opportunities, inherent in this transition phase, which are faced by various carbon-intensive sectors. They could be of short- or medium-/long-term duration, depending on the industry. In particular, it will assess how some industries will cope with and adapt to the decisions made in the framework of the UN COP26 summit held last November in Glasgow, or to measures included in more general national or international roadmaps for climate change mitigation. COP26 reaffirmed the collective global goal to keep the rise in global temperatures within reach, up to 1.5°C above pre-industrial levels and in accordance with the target laid out in the Paris Agreement in 2015, and to reach net-zero emissions by 2050.

Oil and gas

A few agreements and pledges were taken at the COP26 summit that affected the oil and gas sector directly. Among others, all countries agreed to accelerate the phase-out of “inefficient” fossil fuel subsidies (i.e. encouraging wasteful consumption), though without any fixed end date. In addition, over 20 countries (including Belgium) signed an agreement to end new direct public financing for international unabated fossil fuels by the end of 2022.

The new global methane pledge (to reduce methane emissions by 30% by 2030, based on 2020 levels) will also have a direct impact. Besides agriculture, the oil and gas sector is one of the largest methane emitters. Fortunately, abatement solutions are already available for the sector, but investment will be needed in this regard.

COP26 also reinforced the carbon pricing policy system through Article 6, and more pricing schemes should progressively be put in place across the world. Carbon pricing schemes are often excluded from investment decisions for oil and gas projects, as the industry is not covered, because of the low carbon pricing or since it involves long-term assets. Therefore, companies that have underestimated carbon pricing risks and avoided taking this into account expose themselves to weakened financial economic performances, deteriorating balance sheets and lower environmental financing.

These aspects will all result in more capital investment needs in the context of a more difficult financing appetite by private and public partners for the sector. The industry will also be one of those most affected by spillovers from emission reduction targets in other sectors, as all scenarios of climate change mitigation indirectly involve quite a significant reduction in oil and gas demand in the energy mix. Energy majors that plan to switch to and invest massively in renewable energy infrastructure plants while continuing to operate oil and gas assets will have to be agile enough to compete with “pure play” renewables’ companies.

Power

A global agreement was reached at the COP26 summit to reduce the role of coal in power generation, although the language was softened to ‘phasing down’ rather than ‘phasing out’, which left room for the sector to continue operating. Certain big coal users, namely the USA, China, Russia, India and Australia, have all avoided or opposed the announcement of an end date for coal. The transition also means that financing and insurance tools and conditions will become more restrictive towards the coal sector.

On the other hand, renewables received a further push with the announcement of the Breakthrough Agenda, seeking to establish renewable power generation as the cheapest and most reliable option for all markets by 2030 and a commitment to working together internationally this decade in order to accelerate their deployment. China, a signatory of the agenda, will be key.

Regarding Europe in particular, in addition to the COP26 pledge, the EU’s Fit for 55 decarbonisation plan under the European Green Deal will prompt a massive investment cycle for European utilities in order to expand renewables generation infrastructure and upgrade energy networks. The transition will not be smooth, given that greener technologies, which still need to develop further to push down costs and boost efficiency, will only replace conventional thermal and nuclear generation gradually. Therefore, utilities face a number of rising risks: managing a fragile supply-demand balance in the European energy system at least until 2025; maintaining affordability to minimise social and political risks while remaining profitable; and overcoming hurdles in the delivery of new projects, including permits, feedstock inflation and supply chain disruptions.

Agrifood

The agrifood sector, previously sidelined in climate targets and strategies due to significant difficulties in reducing sector emissions and conflict with other goals (e.g. food security), has drawn increasing attention during this COP summit. It is indeed a large GHG emitter, estimated to account for 20-30% of global GHG emissions.

Two specific pledges taken at COP26 will affect the sector. First, the methane pledge (see the paragraph on the oil and gas sector) is of direct concern in terms of agrifood as the sector represents about half of global methane emissions (mainly from ruminant livestock and rice production). The global pledge focuses on technical measures such as animal feed supplements which, according to the UN, can cut emissions in the sector by 20% a year until 2030. Science and technology can help in this aim by supporting innovative feed ingredients that minimise methane emissions from enteric fermentation. However, actions to reduce emissions will continue to be voluntary for the sector for now. New Zealand is one of the rare countries to already have a roadmap in place to reduce methane emissions from agriculture, and this will require high investment in helping farmers to reach the goals.

Second, the deforestation pledge, signed by more than 100 world leaders, intends to halt and reverse forest loss and land degradation by 2030. Large agricultural producers that are driving deforestation are signatories, including Brazil and Indonesia. However, significant challenges and a lack of credibility cast doubt on the execution of this pledge, since similar commitments have had limited results in the past and key countries have failed to take action.
 
There has also been a growing focus on imported emissions and deforestation, reflected at the COP26 summit through two agreements: ‘Forests, Agriculture and Commodity Trade – A Roadmap for Action’ and the ‘Agricultural Commodity Companies Corporate Statement of Purpose’. The former is a roadmap for action based on four areas of work which are central to achieving the overall objectives of promoting sustainable development and trade of agricultural commodities while protecting and sustainably managing forests and other critical ecosystems: trade and market development; smallholder support; traceability and transparency; and research, development and innovation. The second announcement was made by ten global companies with a major global market share in key commodities such as soy, palm oil, cocoa and cattle, sharing a commitment to halt forest loss associated with agricultural commodity production and trade.

In that context, two weeks after the summit, the EU outlined a draft law requiring companies to prove that agricultural commodities destined for the bloc were not linked to deforestation having taken place after 31 December 2020. Those failing to provide accurate information to national authorities via satellite images could face fines of up to 4% of their annual turnover. Beef, wood, palm oil, soy, coffee and cocoa are covered by the proposal. Furthermore, a few major European agrifood retailers have decided to stop sourcing Brazilian meat. Others have decided to study the supply chain in depth to identify cases of illegal deforestation. However, as European imports represent only 3% of Brazilian meat exports (all types included), the impact for Brazilian meat producers should not be systemic.

Transport

In terms of electric vehicles (EVs), the COP26 declaration on accelerating the transition to 100% zero-emission new car and van sales in leading markets by 2035 is not legally binding, and key large automobile markets (including China, the USA, Japan, Brazil and Russia) are missing, which means that there will be no change to the forecast trajectory for countries adopting electric vehicles. However, it must be acknowledged that the automotive sector has shown significant improvement in the last two years, implementing plans to shift away from traditional combustion engine vehicles thanks to a combination of higher alternative-fuel vehicle production and improved prospects for complying with emissions regulations.

On the other hand, the deforestation pledge could well exacerbate EV supply chain risks by increasing delays, red tape and costs in the development of new mines for critical raw materials for the automotive sector and manufacturing infrastructure. For example, the application of the deforestation pledge for cobalt mines in the Democratic Republic of the Congo, which backed the deforestation plan, would increase the cost of batteries and therefore EVs as a whole.

The shipping sector, which was not covered by the 2015 Paris Agreement on climate change, is viewed as one of the hardest sectors to decarbonise, given that most of the world’s container ships travel huge distances between ports and so electric batteries are not a realistic solution. Still, the COP26 summit made some progress for the sector: 22 countries, including the USA and the UK, agreed to define six zero-emission shipping corridors by 2025. These ‘green maritime routes’ would form channels that are decarbonised from end to end, for all vessels as well as land-based infrastructure, and would be scaled up as of 2025.

Since the launch of the ‘IMO2020’ measure in January 2020 to reduce the sulphur levels in maritime fuel, there has been no action by the International Maritime Organisation (IMO) to achieve any significant ship emission reductions before 2030, and therefore ship emissions are expected to continue to rise to 2030. The summit could therefore serve as a wake-up call, prompting the IMO to react and impose stricter measures to the sector.

As for the airline industry, responsible for about 3% of global CO2 emissions in 2019, an industry-wide net-zero carbon emission pledge was announced in the run-up to COP26 and 23 countries, collectively responsible for more than 40% of global aviation emissions, have signed a new commitment to reduce CO2 emissions from aviation in order to meet global emissions targets. However, five of the top ten countries contributing to passenger CO2 emissions (China, Germany, India, the United Arab Emirates and Australia) have not signed this declaration. Sustainable fuel will play a major role in this transition, which requires the right incentives from governments for production to be ramped up.

Metals (steel, aluminium) and cement

Under the Industrial Deep Decarbonisation Initiative (IDDI) launched last year to decarbonise heavy industries, five countries (the UK, India, Germany, the United Arab Emirates and Canada) signed a pledge to set emission targets for 2030 by the middle of this year for eligible steel and cement under public procurement. The hope is that other countries will join them. Currently, the public procurement of steel and cement in those five countries represents 25-40% of the domestic market for such products. Together, these two materials account for 14-16% of global energy-related CO2 emissions, making them some of the most carbon-intensive industrial materials.

In addition, major steel producers and steel-producing countries (the USA, China, Japan and South Korea) have recently adopted net-zero emissions goals to be achieved by the middle of the century. The challenge now is to translate this target into action, as it would require radical changes in the way that steel is produced. Most low-carbon steel production pathways are not yet at technological maturity and it is not yet clear which process will dominate steel production in the future. Ambitious investments in pilot plants are necessary today to enable rapid deployment. In 2019, the European Steel Association (EUROFER) estimated that total production costs will rise by 35-100% per tonne of steel by 2050 as a result of the costs of using new technologies and more energy to produce green steel. This difference mainly results from higher operational costs, in particular for the low CO2 energy and feedstock supply (electricity and hydrogen). If the full additional cost of green steel is supported by the steel producer, it will be unable to compete on price with conventional steel. If the cost is passed through to the end-consumer product, the extra cost could be quite prohibitive.

As for the aluminium sector, limiting the rise in global temperatures to 1.5°C above pre-industrial levels would involve a huge effort and drastically cutting GHG emissions by 95% by 2050. On the plus side, technological research is promising. At COP26, two giant aluminium companies in Quebec (Alcoa and Rio Tinto) officially announced that they had managed to produce a zero-emission aluminium which will be tested at industrial level in 2023. However, no estimate of the additional cost has been publicly communicated.

Analyst: Florence Thiéry – f.thiery@credendo.com