Decarbonisation is at the top of the agenda for many governments and corporates, and the pandemic has accelerated global efforts. A world with significantly lower carbon intensity will upend global macro dynamics, particularly in global exchange rates and commodity prices, and impact how geopolitical risk is priced. Investors are not yet fully considering these consequences in their thinking on environmental, social and governance issues.
In macro dynamic terms, a lower-carbon economy will lead to a gradual reshaping of global imbalances. Since the end of the Bretton Woods regime and the introduction of floating exchange rates in the 1970s, the world has experienced an accumulation of excess balance-of-payments surpluses, either through commodity sales, exchange rate policies or inadequate domestic demand.
As we reduce our hydrocarbon usage, energy exporter surpluses will shrink and big energy importers could see an improved trade balance and a boost to their sovereign credit. It is frequently forgotten that commodity exporters tend to accumulate their surpluses in the dollar and recycle them into dollar financial assets. Therefore, the shifts in the current and financial accounts will have dramatic effects on global exchange rates and remove one source of structural demand for dollar assets, with the potential for a weaker dollar over time.
A parallel development is likely to occur in other parts of financial markets. Most of the critical commodities are largely priced in dollars. This has led to clear correlations between commodity and foreign exchange markets, with big oil rallies coinciding with dollar bear markets and vice versa. In addition to these correlations, the linkage between these markets has meant that each operates as a channel for transmitting volatility across asset classes. In a lower-carbon future, both correlations and volatility should structurally decline.
Could this herald a stronger reliance on other commodities such as precious metals? Not to the same extent. First, in contrast to oil and gas, most of the precious metals required (such as battery components) have greater substitution options with technological alternatives to certain metals.
Second, the macroeconomic reliance is different as oil and gas operate on a ‘flow’ principle, with economies needing to burn through them on a constant basis. In contrast, most metals will be in high demand during the energy transition period. But once a ‘stock’ of renewable infrastructure is in place, only a small amount of new metal consumption is needed for maintenance and upgrading. All in all, this should lead to smaller commodity cycles and fewer spill-over effects.
Finally, the geopolitical risk premium will be completely transformed. The 1970s oil crisis was ignited by an Arab-Israeli war and led to global recession. Regional politics could affect the supply of a critical economic input and therefore the risk premium was baked into global energy prices or sovereign spreads. Back then, the US required more than one barrel of oil to generate $1,000 of gross domestic product. Adjusting for inflation, that oil intensity has dropped significantly and is less than half a barrel today. Coupled with rising US oil production, the US has consequently retreated from global security hotspots.
Investors will follow suit as border conflicts, civil strife and revolutions in hydrocarbon producers will matter less as the risk premium wanders off geographically and into other arenas. The contested areas of the lower-carbon economy will not be over natural resources in the ground – not even about rare earths or certain metals. Instead, the battle will be over economic supremacy in future technologies.
This is where the climate transition intersects with the US-China standoff, as technological leadership will also help shape economic competitiveness in a lower-carbon world. Geopolitical risk will apply more to intermediate and advanced goods producers, especially those countries supplying the critical inputs to make wind turbines and solar cells run efficiently.
These industries are heavily concentrated in Northeast Asia, and particularly Taiwan. However, the geopolitics of the future means the battle is not only over physical control but also economic competitiveness, which means the arena of confrontation will reside more in the domains of trade, regulation and economic policy. Donald Trump’s trade wars were a taster of a more sophisticated struggle to come. The key message for investors is that this can imply both a negative or positive premium, with certain companies, sectors and regions generating excess returns on the back of policy intervention.
All of the above processes are slow moving and complex. Nevertheless, investors should prepare to expand their approach to ESG investing, designing their portfolios to move in tandem with the greening of the global economy as well as incorporate the spill-over effects arising from the energy revolution.
Elliot Hentov is Head of Policy Research at State Street Global Advisors.