Reflections On Transitioning The World Towards Net-Zero

As we continue towards the net-zero path, it is important to understand the scale of investments required and the challenges ahead. Although commitments have risen over the past years, there are two challenges with where we stand today. Despite all the commitments made by countries and companies in accelerating their transition efforts, we are still behind in the path towards reducing global warming to 1.5°C, which is the threshold that climate scientists indicate would reduce the odds of the most catastrophic impacts from climate change. Commitments made publicly are very different from actions on the ground. Therefore, according to the analysis of McKinsey & Company, this has called for “greater action, greater urgency, and greater resolve”.

Inevitably, economic shifts are needed to meet the net-zero objectives by 2050. For example, these shifts include the demand, capital allocation, costs, and jobs in sectors that emit 83% of the world’s emissions as indicated on Exhibit 1. According to the data provided by McKinsey & Company, there are six characteristics of an economic transition towards net-zero, such as “universal, significant, front-loaded, uneven, exposed to risks, and rich with opportunity”. These six characteristics entail the nature and magnitude of transition shifts that are required for this transition, followed by the nature and magnitude of the responses needed across all stakeholders.

Exhibit 1

MCkinsey1

Source: The net-zero transition report by McKinsey Global Institute (2022)

The net-zero transition will only be achieved if all seven energy and land-use sectors (i.e., power, industry, mobility, buildings, agriculture, forestry, and waste) substantially reduce their emissions. The net-zero goals will not be met if any of these sectors does not decarbonize and transform, there should be a collaborative effort among sectors, from the producers down to the consumers at the end of the value chain. Under every sector, there are sets of countries that contribute to the emissions produced and participate in these sectors directly or indirectly. Thus, the urgency for transition should be a universal agenda for every country, sector, and stakeholder.

Exhibit 2

2

Source: The net-zero transition report by McKinsey Global Institute (2022)

The scale of the transition requires a significant amount of capital that needs to be deployed for these energy and land-use sectors on physical assets. As can be seen on Exhibit 3, as of today, around $5.7 trillion are being spent on physical assets, while the transition stage requires about $9.2 trillion on average to be spent annually for the next 30 years, which is a scale-up of $3.5 trillion of spending every year. Despite government policies in place and an alternate scenario of spending that was affected by income and population growth, substantial capital would still need to be deployed for financing this transition. Additionally, the nature of spending will change as well, capital will need to be reallocated from high-emission assets to low-emission assets. To date, 70% of the current spending is allocated on high-emission assets, meanwhile it should be the contrary.

Exhibit 3

3

Source: The net-zero transition report by McKinsey Global Institute (2022)

Currently, about 6.8% of GDP is spent on physical assets across the seven sectors. That number would need to rise to 9% of GDP by 2025-2030 before receding. The world will experience an unevenly spread-out transition within the timeframe, an exceptional number of investments, resources, speed, and scale will be needed to be deployed forefront. Actions taken within the next decade will determine whether the world can reach a pivotal point to the net-zero path.

Exhibit 4

4

Source: The net-zero transition report by McKinsey Global Institute (2022)

Transition efforts made will be uneven across the world, as fossil-fuel-reliant countries and developing countries will be more exposed to the transition. As shown on Exhibit 5, McKinsey & Company has created a measurement called the transition exposure score which calculates the average GDP in the most exposed part of the economy (e.g., sectors that have high emissions because of their operations, products that have high emissions when used, or their supply chain emits high emissions). The chart presents three key insights as follows:

  1. Every country is exposed in some shape or form. No country has a transition exposure score of 0 (100 being fully exposed). This implies that there is some degree of economic shift that each country will need to undertake.
  2. The exposure itself is not evenly spread; some countries will be more exposed than other countries.
  3. Some countries will need to deploy more capital towards the transition, undergo economic diversification, and experience a country-wide reallocation of jobs across sectors and geographies. They will need to spend more of their respective GDP on investments compared to other advanced economies.

Exhibit 5

5

Source: The net-zero transition report by McKinsey Global Institute (2022)

Although transitioning will bring countless benefits, the transition exposes us to multiple short-term inherent risks that should not be ignored. It requires a holistic approach to ensure that it would not lead to a disorderly transition and create a whole range of substantial negative impacts. For example, supply constraints and price volatility, the standing of high-emissions assets, acceleration of physical climate risks, and labour market disruption. All stakeholders should consider these adverse risks to minimize the effects of the transition.

Exhibit 6

6

Source: The net-zero transition report by McKinsey Global Institute (2022)

However, the shift to net-zero emissions will also create unprecedented opportunities for both businesses and countries. Within this timeframe, new decarbonizing processes and products will be developed, which companies can benefit from lower operating costs and gain access to a new market as consumer demand rises for relatively low-emissions products. This will lead to the replacement of products with high-emission process to the low-emissions ones. Companies can scale their existing products and develop new and emerging technologies to capture growth in demand for low-emissions goods. Globally, we would see an expansion of supply chain infrastructure and support services as new technologies emerge, such as risk management services and financing services. Thus, new offerings to aid decarbonization will be more accessible for companies and countries.

Channelling financing for the net-zero transition

In effect, to meet transitioning infrastructure needs, financial institutions (FIs) will play an essential role in international financial architecture. A new structural approach will need to be placed to gather all forms of financing, whether public, private or blended that is aligned with the transition to net-zero. This requires massive public and private reimagining of how clean energy and a sustainable future can raise the aspirations of 81 developing and emerging countries globally, which over time will constitute the majority of global emissions. In reality, such financing has yet to become a reality despite public commitments made in Glasgow and elsewhere. This raises the urgency of forming public and private alliances that can finance these programs.

In time, many private financing have embarked on this journey and participated in financing this transition. Private financing is expected to contribute by almost up to 70% of the total financing capital available, however, this significantly depends on the countries in which it is financing. Building on the competitiveness, the private sector put into action their commitments because this type of capital flow will change the basis of competition across many industries, as many believes this is an offensive opportunity rather than a defence one. Furthermore, the establishment of the voluntary carbon market (VCM) reflects the strong push by the corporate sector. However, this leaves the question of how the world will be able to scale up the supply to meet the demands of the market. VCM is one of many ways of moving the capital from high-carbon emitters to carbon removal and helping investments flow across the world. This will subsequently stimulate the development of the compliance market.

The journey to net-zero has forged a race among countries, setting a geopolitical competition across the world, which can drive to fill the gaps in the vision the world has launched towards net-zero. This can be seen from how China is embarking on a country-wide initiative, with this type of competitive threat, we can anticipate more countries to follow in their footstep and launch their own initiatives. In other parts of the world, South Africa has announced that they have invested $8.5 billion to decommissioning coal and expanding its renewable energy.

Transition to net-zero in the private sector

It is undeniable that the transition will occur, where companies will need to re-examine the stakeholder ecosystem, starting from the company itself, environment, customer, and vendors, to baseline their carbon to net-zero. On the downside, a huge job transition would take place as a consequence. There is a strong need to have skilled human resources who understand the complexity of the transition and will drive such transition and business forward, which is oftentimes a constraint. Companies need to have the right people in the right number and at the right time of the curve for the company to move forward.

It is impossible for the private sector to not move in this direction because many FIs and banks are aligning to net-zero, as anything lent to a private company, lenders will also own the emissions produced. In addition, many large asset managers, banks, and FIs are looking to invest in net-zero-aligned assets in developing countries.

Many private sectors are already factoring in carbon prices to make their decisions, which has an impact on the duration of the assets depending on the carbon intensity that they are willing to invest in. Over time, this will be a prequel to the compliance market, which will be required to decarbonize intensive carbon-intensive industries such as steel, cement, aluminium, etc. However, even in the absence of compliance markets, the world is already seeing capital beginning to move towards this transition. To stay competitive and sustain their business, CEOs must have a clear view of where the market is headed, have a full potential analysis on their portfolios, determine what are the risks and opportunities it confronts and start to make investment decisions on where technology is headed in the future.

Capital flow in the net-zero transition is oftentimes measured just from carbon pricing, but it is important to note that carbon pricing is one of the many tools that can be used. Although it creates demand signals and the right incentives, it is not by any means the only form of the tool in this transition, it extends beyond carbon pricing in the corporate world. In-lieu, the offset market only has a complementary role to play, where it is not the core of the net-zero goal as it is only to support the scaling up capital from high-emission companies to low-emissions companies.

Based on the data provided, McKinsey & Company has brought a comprehensive outlook on the journey of transitioning to net-zero on a global scale. Taking on a holistic view and identifying the key elements on the scale of capital, resources, and actions needed to be deployed if we are to meet the 1.5°C thresholds. Again, the upcoming decade will reflect what the world would look like in the future. Lastly, advancing this agenda will require more cooperation amongst all stakeholders across the world to ensure that there is an equitable transition across all geographies.

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