The “prisoner’s dilemma” in economic game theory offers an explanation as to why the world is doing far less than needed to be aligned with the Paris Agreement goals as nations are prioritizing self-interest over the shared-goal of achieving net zero. For nations that are heavily reliant on fossil-fuels and carbon intensive revenues, they will be finding it difficult to fill the revenue gap left behind when they transition away from these revenues. Furthermore, due to the discrepancies in regulations and ESG standards in nations, this has created an opportunity for carbon-intensive companies that operate in a more lax environment to expand their capacities in carbon-intensive activities. The road to meeting the Paris Agreement will likely remain an uphill task in the absence of a trigger event that significantly tilts the risk-reward climate change equation.

Prisoner’s dilemma. In economic game theory, the “prisoner’s dilemma” describes a scenario where rational individuals who prioritize their own self-interest may choose not to cooperate even though it is in their best interests to do so. By choosing not to cooperate, the individuals will achieve the worst outcome possible (see Figure #1 for illustration). The current climate change conundrum is a classic case of prisoner’s dilemma (see Figure #2).

Paris Agreement – a gentleman’s agreement? As of Nov 2021, 194 states (including Malaysia) and the EU have signed the Paris Agreement, which sets the goal to keep the rise in global temperature to well below 2°C above pre-industrial levels, and preferably limit the increase to 1.5°C. The Paris Agreement has been touted as a “legally binding international treaty on climate change”, yet the treaty itself does not impose penalties, such as fees or embargos, for parties that violate its terms, and there is no international court or governing body ready to enforce compliance. According to the recent IPCC report released on 28 Feb 2022, the world is now on track to warm by more than 3°C (twice the Paris Agreement target), indicating a lack of progress and failure thus far to achieving the Paris Agreement goals.

Are countries ready to give up their fossil fuel assets? A 2015 study in Nature suggested that, globally, a third of oil reserves, half of gas reserves an d over 80% of current coal reserves should not be extracted from 2010 to 2050 if the world is to meet the Paris Agreement target of limiting any temperature increase to below 2°C. For countries that have already taken on large amount of debt with the expectation that the debt will be funded by fossil fuel revenues, these countries will be finding it difficult to fill the revenue gap left behind if they were to transition away from relying on fossil fuel as their revenues.

Opportunity for ESG arbitrage. As such, while the regulations are still relatively lenient and the consequences of not abiding to the Paris Agreement are still not punitive enough, fossil-fuel reliant nations are likely to continue (or even expedite) tapping in to their fossil fuel reserves as the reward to the nation are perceived to far outweigh the risks for doing so. This is especially true in developing nations where some of these countries have yet to develop a framework and roadmap in achieving net zero and there are no regulations (e.g. carbon pricing) in place that create disincentive for carbon-intensive companies to decarbonize. The lack of shareholders scrutiny and the lack of stringent loan financing standards allow these companies to continue to invest and expand their capacities capitalizing on the regulatory and ESG standard shortfall.

Case study: Thungela. As an example, we look at Thungela Resources, which is a South African coal mining company. Since its listing in June 2021, the stock has soared >900% in share price (see Figure #3). Thungela’s CEO said that it is now free of an owner that had questioned further investment in mining and is now planning to expand its capacities in new coal resources. The colossal rise in the price of the stock was driven by a c.260% increase in coal futures over the past year as well as rising demand especially from the Europe. The rise in demand in Europe was due to (i) the Russian-Ukraine war (Europe imports around half of its coal from Russia in 2019), and (ii) the ongoing pressure to shut down coal companies in the Europe. The case of Thungela highlighted an investment opportunity that emerges due to discrepancies in regulation and ESG practices among nations.

Who is the next Thungela? Prior to the Russia-Ukraine war, crude oil price was already on an ascending trend as demand was supported by post-Covid reopening, while supply was constrained by (i) US shale producer bankruptcies, (ii) carbon pricing and other climate-driven regulations, (iii) under-investment in expanding oil capacities, and (iv) ESG mandates to decarbonize. The protracted Russian-Ukraine war further escalated oil price. The geopolitical tension and its lingering effects (including elevated oil price) are likely to outlast the war itself (as how the global shipping container disruption persisted long after the post-Covid reopening). With sustained elevated oil price, it is not far-fetched to imagine that another similar ESG arbitrage opportunity may be on the horizon as upstream oil companies, especially in the developing nations are incentivized to expand their capacities to capitalize on the lucrative oil revenues.

In need of a wakeup call. As the recent IPCC report highlighted, the world is now grossly misaligned with the Paris Agreement goals. It is an uphill and almost impossible task to coordinate a global effort to achieve the Paris Agreement goals as nations continue to prioritize self-interest over the greater good. Much of the climate change impacts warned by the scientists (no matter how grim and dire the picture is painted) are perceived as distant risks that when discounted to the present, are risks that underweigh the reward of pursuing economic gains from carbon intensive activities. Where then is the tipping point that would finally trigger the world in for joint action? To delve in to this, we draw parallel similarities to the global pandemic Covid- 19. As the saying goes, “necessity is the mother of invention” – in under a year since the outbreak of Covid-19, a vaccine was developed, which would typically take up to 10-15 years under normal circumstances. Today we are finally getting a preview of climate change impacts through the increased frequency and severity of extreme weather events, including floods, drought, wildfires, heat waves and more. What we are experiencing today is a result of what has already been “baked-in” to the climate system and it will only get worse from here onwards. Perhaps a global scale of extreme weather event (or series of events) similar to the scale and magnitude of Covid-19 is the “necessity” that it takes to move the needle in the risk-reward equation of climate change for an urgency in global action.

Source: Hong Leong Investment Bank Research - 10 May 2022