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2022 - Q1

Renaissance - Redefining Research

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How climate change can impact return expectations and what this means for multi-asset investors

Alex Funk
Chief Investment Officer, Schroder Investment Solutions

schroders logoClimate change affects the long-term asset class return assumptions that underpin portfolio construction and multi-asset investors need to consider its implications carefully.

Climate change impacts potential future asset class returns in in three main ways:

  • The first concerns physical costs, considering the risks to physical assets and infrastructure from rising temperatures and changing weather patterns.
  • The second concerns transition costs, considering the high level of investment required from governments and businesses to align with more sustainable, carbon neutral outcomes to reduce climate change.
  • The third concerns stranded assets, considering the impact on economic growth and on individual businesses of leaving fossil fuels in the ground in order to limit climate change.

Together these have an impact on inflation and the factors that help drive asset returns, in particular productivity, which collectively feed through to determine GDP growth.

From a portfolio construction perspective, what is interesting is how governments and businesses respond to rising temperatures. Here it is worth noting that while a warming earth is bad news from an environmental perspective and no-one stands to benefit from higher temperatures on a longer-term horizon, they are not universally bad for growth. The economies of countries in yellow, green and blue in the chart below should be less severely affected by increased temperatures than those shown in red, for example.

Higher temperatures are not always bad for growth

world map showing change in temperature
Source: Burke and Tanutama (2019).

The reason for this relate to productivity, which is one of the most important drivers of asset class returns. The chart below shows the impact of climate change on the productivity of economies of cooler and warmer countries and regions in two scenarios; the first where no climate action is taken and the second where some action is taken to partially mitigate climate change.

Impact of climate change on productivity % p.a. 2021-2050

chart 1
Source: Burke and Tanutama, Cambridge Econometrics, Schroders Economics Group. January 2021.

The chart shows the impact of higher temperatures measured as the difference in productivity of the partial mitigation and No Action scenarios relative to the No climate change scenario, in which there are no transition and physical costs.

In the ‘no action’ scenario you can see that the productivity of cooler countries actually increases because as temperatures start to rise, productivity can improve in areas such as manufacturing, which can be curtailed when temperatures are low. In warmer countries however, as temperatures rise and conditions become more humid, productivity in some sectors can decline. ‘Partial mitigation’ decreases the productivity benefits in cooler countries but also decreases the negative impact in warmer countries.

Further factors that need to be considered include the likely introduction of carbon taxes by governments. Carbon taxes involve taxing industries that are emitting high levels of carbon into the atmosphere, such as oil and gas, more aggressively. Carbon taxes will push up the price of the products of high carbon emitters to the end consumer, which should curtail demand and lead people to seek out alternatives. Money raised through carbon taxes will provide governments with funds to invest in alternative energy sources and improved energy infrastructure which should help to speed up the move to a greener economy.

The cost to businesses and economies of aligning to the targets set out in the Paris Climate Agreement should also be taken into account. Then there is the effect on productivity in different sectors and industries to consider as we move away from traditional fossil fuel consumption towards cleaner energy.

Stranded assets are another key issue.

The chart below shows the carbon emissions in reserve of listed companies in major economies around the world.

Carbon emissions in reserves in billion tonnes of carbon of listed companies

chart 2
Source: MSCI, Refinitiv Datastream, Schroders. January 2021.

As we move towards a carbon neutral or a net zero world, this is effectively the amount of coal, oil and gas that will have to be left in the ground. You would expect this to have the biggest negative impact on export heavy emerging economies that are currently most dependent on oil and gas and mining to drive growth. The chart below shows the reduction in equity returns that we could see across major economies from stranded assets, with the biggest hit seen in emerging markets.

Reduction in equity returns from stranded assets in a partial mitigation scenario (% p.a. 2021-50)

chart 3
Source: Refinitiv Datastream, Fossil Free Indexes, Schroders Economics Group. January 2021. We use the Nifty Index for India and the Shanghai Stock Exchange Composite Index for China since we have data for companies listed on their domestic stock exchange.

To construct portfolios that account for the impact of climate change all of these factors must be considered. Clearly there is still a large amount of uncertainty relating to the decarbonisation of the global economy when forecasting long-term returns from asset classes, but as we progress towards a greener economy more information is constantly becoming available, helping us to refine our understanding of these issues further.

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