Carbon pricing is coming, but watch out for “greenflation”

October 27, 2021

By Terry Raven, Director, European Equities, Fidelity International; Gita Bal, Global Head of Research, Fixed Income, Fidelity International; and Amber Stevenson, Investment Writer, Fidelity International

Carbon pricing is an inescapable tool in the race to net zero, according to Fidelity’s latest Analyst Survey [1]. But a higher carbon price could fuel inflationary pressures, especially when combined with the capital expenditure (capex) required to go green.

Companies expect carbon pricing.

Over a third of companies will adapt their business models in anticipation of a future carbon price over the next three years, according to a survey of Fidelity analysts. In high-emitting industries such as energy and materials, the analysts believe the proportion is closer to two-thirds (see Chart 1). This suggests many companies are acting to get ahead of the financial and regulatory effects of carbon pricing, especially in those sectors where a carbon price will make new technologies more viable.

Chart 1: Some companies anticipate a future carbon price and are seeking to adapt.

Question: “Over the next three years, what proportion of your companies do you expect will adapt their businesses in anticipation of a future carbon price?” Chart shows the average response. Source: Fidelity International, September 2021.

Some form of carbon pricing is likely to be on the table at the U.N. climate conference in Glasgow. A global regime would push companies to adapt, but could be inflationary if implemented too aggressively. Keeping the carbon price too low, however, would slow the transition and make companies more vulnerable to sharper price hikes in the future.

Analysts have put hard numbers on the effect a carbon price could have. “A carbon tax or carbon cost above $100 a ton [up from $3 today] would have a dramatic impact. Capex plans would be adjusted quickly,” argues an analyst covering North American and European chemicals companies.

Companies are beginning to adapt

The good news is that the analysts believe over half of companies globally have begun to adapt their business models for a pathway to net zero by 2030 – far sooner than the Paris Agreement deadline of 2050. However, only 7% are taking far-reaching action, fewer than may need to in order to achieve that target (see Chart 2). Government policy may be required to fill the gap. Fidelity analysts have identified incentives and regulation as the most effective measures to help firms get to net zero, with carbon pricing being the top policy choice for the energy sector.

Chart 2: Companies are starting to adapt their business models.

Question: “What proportion of your companies are acting today to change their business models for a pathway to net zero by 2030?” Chart shows the average response. Source: Fidelity International, September 2021.

The transition will fuel “greenflation.”

Policy interventions will, however, have consequences. Fidelity analysts expect that around a quarter of their companies will incur higher costs due to carbon pricing over the next three years, with the energy, materials and industrials sectors most exposed. “European airlines are required to purchase carbon credits under the E.U. cap and trade system. Prices are rising as allowances reduce,” reports one analyst covering European industrials.

Many companies will face other types of costs from going green. Just over half the analysts expect the low-carbon transition to increase operating costs for their companies over the next three years, while 60% believe it will push up capital expenditure (see Chart 3).

Chart 3: The transition will drive up costs for many

Questions: “How, if at all, do you expect the low-carbon transition to impact your companies’ operating costs?” and “How, if at all, do you expect the low-carbon transition to impact your companies’ capex?” Source: Fidelity International, September 2021.

But that investment could pay off. Firms that increase transition-related capex today could lower their operating costs sooner. The utilities industry is one example. “Utility companies are moving toward renewable generation,” reports one analyst covering utilities in emerging Europe, the Middle East and Latin America. “This requires significant upfront capex, but the marginal cost of production then falls to zero. This is compared with traditional generation methods that require a commodity input.”

Paying for it all

Nonetheless, the transition is likely to increase upfront costs for most companies. The analysts expect companies will fund these costs predominantly from internal resources such as cash (see Chart 4). But a growing proportion of analysts expect companies to raise prices for consumers, which could further fuel greenflation.

Not all companies have the pricing power to do this, however. Some will need government subsidies, while others will rely on debt. “As my companies are price takers, they can’t pass prices onto consumers, so they will need fiscal incentives to continue investment,” says an analyst covering European materials companies.

Chart 4: Companies will need to fund the transition.

Question: “How do you expect your companies to fund the low-carbon transition over the following periods? Tick all that apply.” Source: Fidelity International, September 2021.

Conclusion

We are carbon-based organisms in a carbon-fuelled economy. Making the transition to a lower-carbon world will require new policies to break energy-usage habits that have become entrenched over centuries. Even if new technologies ultimately lower costs, the policies needed to get there could pour greenflation fuel on the post-pandemic price fire already underway. But Fidelity’s analysts suggest that, for some companies, the costs of delaying policy action, even by a few years, will be many times higher.

Disclosure

This article has been provided by Fidelity Investments Canada ULC (Fidelity) and is for information purposes only. It may be comprised of, among other things, examples of sustainable investing activities which are reflective of the approaches used across Fidelity and FIL Limited (Fidelity International) only, current as at the date of the article. The article may refer to ESG considerations that Fidelity and Fidelity International may take into account as part of their research or investment process, and is not reflective of the approach of any other Fidelity Investments company or sub-advisers’, such as Fidelity Management & Research Company LLC, FIAM LLC, Geode Capital Management, LLC and State Street Global Advisors Ltd., to ESG research, stewardship and sustainable investing, either specifically or generally.

Fidelity has a dedicated Sustainable Investing Team within its Asset Management division to further support the integration of ESG considerations into its investing practices. The Sustainable Investing Team is responsible for supporting engagement and proxy voting activities on behalf of funds and applicable accounts managed or advised by Fidelity and Fidelity International.

Fidelity International refers to the group of companies which form the global investment management organization that provides information on products and services in designated jurisdictions outside of North America. This communication is not directed at, and must not be acted upon by persons inside the United States.

Commissions, trailing commissions, management fees, brokerage fees and expenses may be associated with investments in mutual funds and ETFs. Please read the mutual fund or ETF’s prospectus, which contains detailed investment information, before investing. Mutual funds and ETFs are not guaranteed. Their values change frequently, and investors may experience a gain or a loss. Past performance may not be repeated.

The statements contained herein are based on information believed to be reliable and are provided for information purposes only. Where such information is based in whole or in part on information provided by third parties, we cannot guarantee that it is accurate, complete or current at all times. It does not provide investment, tax or legal advice, and is not an offer or solicitation to buy. Graphs and charts are used for illustrative purposes only and do not reflect future values or returns on investment of any fund or portfolio. Particular investment strategies should be evaluated according to an investor's investment objectives and tolerance for risk. Fidelity Investments Canada ULC and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered.

From time to time a manager, analyst or other Fidelity employee may express views regarding a particular company, security, and industry or market sector. The views expressed by any such person are the views of only that individual as of the time expressed and do not necessarily represent the views of Fidelity or any other person in the Fidelity organization. Any such views are subject to change at any time, based upon markets and other conditions, and Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity Fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity Fund.

Certain Statements in this commentary may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and assuming no changes to applicable tax or other laws or government regulation. Expectations and projections about future events are inherently subject to, among other things, risks and uncertainties, some of which may be unforeseeable and, accordingly, may prove to be incorrect at a future date. FLS are not guarantees of future performance, and actual events could differ materially from those expressed or implied in any FLS. A number of important factors can contribute to these digressions, including, but Fidelity Confidential Information 31 not limited to, general economic, political and market factors in North America and internationally, interest and foreign exchange rates, global equity and capital markets, business competition and catastrophic events. You should avoid placing any undue reliance on FLS. Further, there is no specific intentional of updating any FLS whether as a result of new information, future events or otherwise.

© 2021 Fidelity Investments Canada ULC. All rights reserved. Fidelity Investments is a registered trademark of Fidelity Investments Canada ULC.

[1] The Fidelity Analyst survey, which is administered by FIL Limited (Fidelity International), Fidelity Canada’s research and trading affiliate, provides the views of analysts across the global Fidelity International and Fidelity Canada investment management teams.