COP26 and carbon reduction: Lessons from the market

Ask someone if the 2021 United Nations Climate Change Conference (COP26) was a success or a failure and you’ll likely get different answers. While the commitments made at the conference have brought us closer to net zero, the promise of keeping global temperatures below 1.5 degrees Celsius remains some way off, with current commitments estimated to put us on course for 2.4 degrees¹.

When it comes to the energy sector, the glass half-full camp will point to the positive shift whereby fossil fuels have, for the first time, been directly named as contributing to climate change. Those on the pessimistic side will point to the eleventh-hour watering down of the communique changing “phasing out” for “phasing down” coal production.

But how are markets responding to COP26 and will the economics, rather than the politics, ultimately be more decisive?

While it’s still early days, initial evidence of how coal and fossil fuel indices have performed over the period would indicate that markets are increasingly alive to the risks inherent in financing companies in these sectors, compared with clean energy companies that have outperformed the market. The EU’s carbon price also hit an all-time high of well over $60/tonne², signalling that the market may be expecting tighter regulation going forward.

It is worth comparing how markets performed in response to COP26 with how markets performed after the Paris Agreement was adopted in December 2015.

A Bank of England (BoE) analysis from 2016 found that “these events had a negative but statistically insignificant effect on the abnormal returns for oil and gas companies, but a positive and significant effect for renewable energy companies”.³ This stands in contrast to COP26, where the effect on oil and gas companies seems to have been stronger than for renewable energy.

What might explain this effect?

Policy levers to address climate change can broadly be divided into two types: carrots, that support green activities; or sticks, that punish polluting ones.

A simple read would suggest that the market post-Paris Agreement believed that policymakers would come bearing carrots rather than sticks, and therefore saw opportunities for clean technologies, but was slower to price in additional downside risk for fossil fuel companies. The BoE, for example, considered that one reason was “that investors may be uncertain about both the future course of climate-related policies and their impact on the value of fossil fuel companies”.

However, the new narrative around net zero and increasing policy action, such as the EU’s Fit for 55 package⁴, seems to underscore that policymakers are increasingly willing to use sticks to help to achieve their carbon reduction goals, making the transition risks for holding polluting companies more palpable for investors.

Of course, there are a myriad of other factors that influence market dynamics, and it would be simplistic to suggest that expectations around future policy action are the sole or even determinant factor at play.

However, it is clear that COP26 is the latest stop on this long journey to achieving the goals of the Paris Agreement, and reinforces the overall trend of shrinking cost of equity for green stocks and the growing cost of equity for brown stocks.

To further this momentum, we think it is essential that governments quickly turn promises made at COP26 into action.