(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2024--collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2024.)

While climate change remains recognized as a key global risk, any acceleration to decarbonize might face challenges--from higher costs, geopolitical disruptions, and environmental policy backlash--that divert climate mitigation priorities. Credit risk is higher in an abrupt transition, and the disruption potential for carbon-intensive sectors remains both high and difficult to predict.

How This Will Shape 2024

Higher-for-longer interest rates and input-cost inflation could slow the energy transition.  As funding and the economic environment dramatically change after a decade of supportive monetary policy, the cost of the energy transition has also increased and will continue to tighten in 2024. Higher funding costs affect renewables investments more so than for fossil fuels, given the upfront capital needs. Additionally, supply-chain bottlenecks and the resulting inflationary effects on critical materials for the energy transition remain key issues as demand for clean technologies increases globally, especially for wind and battery storage. Governments and companies will navigate these risks as they progress on decarbonization.

Tighter budget constraints put pressure on environmental policies.  Even though heat pumps, energy-efficiency retrofits, and electric vehicles (EVs) are becoming more cost-competitive in relation to their fossil-fuel alternatives, higher borrowing costs are likely to slow the uptake among households--especially as households' real disposable incomes are only just recovering from the recent inflation surge. Looking to 2024, consumers may be confronted with difficult choices between what is most cost-effective for their families, or what is better for the planet. Companies confronting credit headwinds may also take into account new considerations when it comes to their plans for energy reliance and resilience. At the policy level, tighter resources can give rise to a growing backlash from certain political constituencies to slow climate action. This translates into climate policy back-and-forth, and results in a more uncertain business environment as governments and companies face pressures on both sides.

Innovation could support faster decarbonization, while slower economic growth in 2024 reduces the need to add more fossil-fuel capacity.  Rapid technological change could also surprise on the upside as initiatives to decarbonize the economy spread, especially in the context of broader government subsidies and support. After the passage of the Inflation Reduction Act in the U.S., the likely upcoming response from the EU, and China's 14th five-year plan, we will be watching for the next climate policy shifts in 2024. At the same time slower growth, in part driven by global manufacturing weakness, reduces the need to compensate so-far insufficient renewable-capacity additions with fossil fuels.

What We Think And Why

With slower economic growth and higher financing costs, priorities might shift away from tackling climate change.  While climate change is likely to remain a top risk for many governments and corporates, more short-term pressures--such as lower growth prospects, rising pressures to tighten spending and related social tensions, or access to liquidity--could divert their attention away from investing in decarbonization and preparing for climate change. This means some countries and businesses are more likely to fall behind in their transition if they reduce their climate-mitigation efforts.

Credit risk is higher in an abrupt transition.  Implementing comprehensive and coordinated climate policies and strategies remains a challenge for governments and companies. As climate actions progress faster for a given sector or a region, this could reshuffle sector-specific competitiveness, potentially leading to negative side effects across local supply chains. This could, for instance, result in weakened business positions or profitability for certain players, or ongoing regulatory adjustments that reduce stability and visibility and jeopardize investment decisions.

However, the higher carbon-emitting sectors are not yet feeling a lot of credit pressure.  Carbon pricing remains relatively low worldwide. The oil and gas sector has not faced any notable deterioration in its financing conditions so far, even though the IEA projects that demand for fossil fuels will have peaked by 2025. Sectors such as cement, airlines, and chemicals currently do not face very binding climate policies. As scalable technology alternatives remain scarce, we believe policymakers might still avoid stricter environmental policies for hard-to-abate sectors.

What Could Go Wrong

Markets might not be sufficiently prepared for disruption.  Failure to comply with fast-changing climate policies and regulations in some markets could pose significant business risks and future liabilities. Market dynamics might also evolve rapidly, with new and disruptive competitors growing their market shares. We could see this in the automotive sector, for example, with new EV players. But lack of preparedness could also stem from weak resilience to climate physical risks and unaddressed adaptation needs. Such risks are still largely unaddressed by many governments and companies, when looking at the adaptation gap.

More radical climate policies would increase transition risks.  Most economies lag both their intermediary pledges (2030) and the well-below 2°C pathway set by the Paris Agreement. While these gaps will be hard to close, more constraining climate regulations on certain sectors, including stricter industry norms or sanctions, could be considered by policymakers. The visibility and materiality of such risks remain challenging to foresee, however.

Geopolitical uncertainty could prevent necessary global coordination.  Ongoing conflicts, such as the Russia-Ukraine and the Israel-Hamas wars, might make it harder to attain the global coordination required to truly mitigate climate change. In addition, trade disputes in the clean technology space could become more prominent (including with China in relation to EV subsidies) and add to the collective action problem. Additional pressure points include the unresolved funding of the transition for countries in the Global South, which would need to increase investments by more than five times to meet the IEA's net-zero scenario.

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Related Research

• China's IPPs Can Speed Energy Transition As Power Demand Tapers, Nov. 7, 2023
• Will Oil and Gas Producers Lose Access to External Financing as Lenders Decarbonize? Nov. 16, 2023
• Economic Research: Climate Change Will Heighten Output Volatility, Jan. 5, 2023