Limiting global warming to 1.5°C above pre-industrial levels by 2100 to meet the Paris Agreement requires major reductions in greenhouse gas emissions to make the world carbon neutral by 2050. As the world attempts to reach net zero, investors need to know what the energy transition pathway will look like, and how it will affect asset prices.
Traditional assets such as stocks and bonds can be valued using discounted cashflow analysis according to the following equation:
…where E refers to expectations, and expected cashflows are discounted using the appropriate rate that reflects the (systematic) risk the asset is exposed to. The discount rate is sometimes also referred to as the cost of capital of a firm, and it equals the expected return on the asset.
The impact of, for example, the introduction of a higher carbon tax would affect the cashflows of companies differently. In the case of fossil fuel companies, estimates of future cashflows must incorporate the possibility of stranded assets, such as oil reserves that have to remain unused.
At present, there is considerable uncertainty about future climate policies, such as carbon taxes. Therefore, investors may discount expected cashflows that are more sensitive to climate policies at a higher rate than cashflows that are less sensitive. This means that the same expected cashflows may be worth less today if the discount rate is increased to reflect the carbon risk.
Such an increase in the discount rate is called the carbon risk premium, and it is equal to the additional return investors earn from investing in risky companies. A negative premium would mean that companies involving higher carbon risk would be worth more today, and would consequently earn lower returns in the future.
Measuring carbon intensity
An important way to look at the impact of carbon risk on portfolios is through the carbon intensity of the investee companies and their sectors. The table below shows that unsurprisingly, the materials, utilities and energy sectors have the highest carbon intensities in developed markets, ranging from 258 to 503 tonnes of CO2 per million dollars of enterprise value.
The carbon intensity of sectors in developed and emerging markets
Robeco, Refinitiv Datastream, MSCI, TruCost, June 2021.
This table also shows that equities from emerging markets are much more carbon intensive, with 160.8 at the index level compared to 49.1 for developed markets. This is partially due to the higher carbon intensity the most sectors, but also a higher index weight of the three most polluting sectors.
It’s a similar story when we look at corporate bonds. The table below shows that a developed market investment grade corporate bond index has a carbon intensity of 72.2, while the high yield corporate bond index’s intensity is 164.5. The fixed income sectors that contribute most to these scores are again electric, energy and basic materials.
The carbon intensities of developed market corporate bond sectors
Source: Robeco, Barclays, TruCost, June 2021.
Consequences for asset class returns
From a wider macroeconomic perspective, the economic cost of climate change will be enormous if the Paris Agreement targets are not met. A 2021 study by the reinsurer Swiss Re puts such a ‘business as usual’ decline in global real GDP as high as 18% by 2050 if no action is taken now. Financial markets could therefore reflect the prevailing uncertainty about climate change as a systematic risk factor.
The question for investors is to what extent climate risk is already priced in across asset classes. The answer will vary by asset class given differences in market structures, liquidity, investor bases, active versus passive money flows, shares of price-insensitive buyers (such as central banks) and cash flow vulnerability to climate change.
Let us now look at the outlook for the three main asset classes:
Government bonds: Projected declines in GDP per capita growth caused by climate change should translate into lower real yields for sovereign bonds. Historically, real bond yields are around 80% of real GDP growth. Taking into account this capture rate and Swiss Re’s projection of an 18% drop in GDP if nothing is done, our calculations suggest that investors should expect bond returns to be 0.4% lower in geometrically annualized terms between now and 2050.
In the medium term, the story looks more complex. A positive relationship can be shown between bond yields and climate vulnerability, which has a bigger impact on yields than climate resilience. This creates a vicious circle: countries that are more vulnerable to climate risk face higher borrowing costs to create the resilience that they wish to achieve, thereby lowering investment activity and leaving them even more vulnerable to climate risk.
Equities: The key question is how climate change will affect the cashflow generation abilities and the discount rate of the typical firm in investors’ assessments of net present value. In the long run, one should expect earnings growth to equal long-run economic output growth. If GDP per capita growth is structurally impaired by climate change, there should also be repercussions for the long-term earnings growth potential of companies.
Assuming a worst-case scenario, resulting in temperatures rising to as much as 3.2°C above pre-industrial levels, the 18% decline in global GDP growth predicted by Swiss Re would imply global corporate earnings growth falls by around 0.5% per year between now and 2050. Earnings growth in emerging markets is expected to fall by more than this global average.
Commodities: Climate change seems to be a double-edged sword for commodities. On the one hand, demand for commodities might fall as global economic activity slows. On the other, demand is soaring for certain commodities used in climate change solutions such as electric vehicles, which use on average 83 kg of copper compared to just 23 kg for a petrol-driven car.
The impact on expected commodity returns under a business-as-usual scenario could be neutral. However, in the scenario of progress towards the Paris climate targets and the green energy transition, the commodity intensity of economic activity could increase. On balance, we expect commodity returns to be higher than average in the coming five years.
An uncertain future
The exact magnitude of climate change over the next decade is uncertain, and its impact – and those of the policies and regulations to combat it – on asset prices is even more unclear. However, this does not absolve asset allocators from the task of considering the long-run impact of climate change on asset class returns. The nature of the path from the current situation to the long-run equilibrium is likely to have big implications for most investors’ decisions.