Net Zero: A Framework for Investors

Climate change is driven by an imbalance in Earth’s energy system. Earth’s surface temperature rises when the energy entering the planet exceeds the energy escaping back into space. Human activities, particularly the burning of fossil fuels, have significantly increased greenhouse gas (GHG) levels in the atmosphere. These gases, including carbon dioxide (CO₂), methane, and nitrous oxide, trap heat that would otherwise escape into space, creating a warming effect.

While the planet will likely survive these changes, the risks to human civilization are immense. Climate change introduces long-term risks—events that might occur far in the future but could have catastrophic consequences. These include excessive heat, flooding, wildfires, and rising seas. The uncertainty surrounding the timing, location, and severity of these events complicates efforts to mitigate them. Furthermore, humanity faces transition risks tied to policies aimed at reducing emissions. For example, a rapid shift away from fossil fuels could disrupt industries, causing economic volatility while creating opportunities for renewable energy businesses.

In “Net Zero: A Framework for Investors,” Robert F. Engle highlights the financial and investment implications of climate risks. Companies with higher climate risks tend to have lower stock prices but higher returns, reflecting their risk exposure, he explains, noting that climate hedge portfolios are emerging as tools for reducing exposure to climate-related financial risks. These portfolios invest in firms better prepared for climate risks while underweighting those vulnerable to them, he asserts.

Physical and Transition Risks

The paper explains that climate change risks are divided into physical risks (e.g., heat waves, droughts, floods) and transition risks (challenges linked to policies aimed at reducing emissions). Policies to mitigate climate change include carbon taxes, renewable energy subsidies, regulations, and voluntary actions by businesses and individuals. The author cautions, however, that achieving the global goal of net-zero emissions by 2050 requires collective efforts from nations, sectors, and firms.

Physical risks are the direct consequences of climate change, such as extreme weather events. Transition risks arise when policies and market forces attempt to reduce emissions. If governments decide to phase out fossil fuels, energy companies relying on coal, oil, and gas may struggle to adapt. Meanwhile, firms that invest in renewable energy and low-carbon technologies may thrive. This creates a dual risk–reward dynamic: Industries failing to transition to greener practices may lose value, while those embracing change can attract investment and capital.

The paper points out that these risks can counterbalance each other. Policies that successfully reduce emissions can lower physical risks while increasing transition risks for industries dependent on fossil fuels.

Reducing Climate Risk

Efforts to combat climate change focus on reaching net-zero emissions by 2050, as outlined in the 2015 Paris Agreement. This agreement emphasizes cutting emissions and offsetting any remaining ones through such strategies as carbon capture and reforestation.

The paper suggests that governments can reduce emissions through the following approaches:

• Taxing carbon: Carbon taxes or cap-and-trade systems, such as the EU Emissions Trading System, charge polluters for emissions, encouraging reductions.
• Subsidizing renewables: Supporting renewable energy (e.g., solar, wind) and such technologies as electric vehicles (EVs) fosters cleaner energy transitions.
• Regulating emissions: Standards for vehicles, buildings, and industries ensure compliance with decarbonization goals.
• Voluntary actions: Businesses and individuals can adopt greener practices, but this depends on collective goodwill.

Termination Risk and Global Climate Solutions

Countries dependent on fossil fuels face significant termination risks. For example, Middle Eastern nations, such as Saudi Arabia, are diversifying their economies by investing in tourism, education, and renewable energy to prepare for a future without fossil fuels. In contrast, Russia and Iran are pursuing geopolitical strategies to secure power as fossil fuel demand declines. Russia’s invasion of Ukraine and Iran’s disruptive policies illustrate attempts to maintain influence but often worsen global instability.

Looking forward, global collaboration is essential for addressing these challenges. The Paris Agreement provides a roadmap for decarbonization, emphasizing cooperation to overcome “free rider” problems, in which some nations benefit from global efforts without contributing. The United States and China, as major emitters, must lead by example to drive global progress. China, a leader in producing green technologies, such as solar panels and EVs, and the United States, with such initiatives as the Inflation Reduction Act, can create a model for other nations.

Investors and risk managers also play a key role. Climate hedge portfolios help manage financial risks by reducing exposure to companies vulnerable to climate change. Such tools as marginal CRISK (a financial metric used to measure how much capital a financial institution is likely to lose under stress caused by climate-related risks) allow regulators to monitor financial institutions’ climate risk.

Ultimately, humanity must act collectively to reduce climate risks, ensuring a sustainable future through innovation, cooperation, and equitable policies.

Six Key Takeaways

1. Greenhouse gas imbalance: Human activities, particularly fossil fuel combustion, are causing a rise in GHGs, which traps heat and leads to global warming.
2. Risks of climate change: Physical risks (e.g., extreme weather) and transition risks (e.g., economic shifts due to decarbonization policies) pose significant challenges.
3. Global net-zero goal: Achieving net-zero emissions by 2050 is critical to avoid severe climate impacts. This requires a combination of taxation, subsidies, regulation, and voluntary actions.
4. Financial implications: Companies with high emissions face greater financial risks, while climate hedge portfolios offer investors a way to manage these risks and support sustainable practices.
5. Termination risks: Industries and countries reliant on fossil fuels must prepare for long-term declines in demand by diversifying and transitioning to greener economies.
6. Call for cooperation: International collaboration, especially between major powers, such as the United States and China, is essential to tackling climate change and ensuring a sustainable future for all.

The Paper’s Author

Robert F. Engle, Professor Emeritus of Finance, Co-Director, Volatility and Risk Institute, Leonard N. Stern School of Business, New York University, New York City