There is growing appetite among investors to allocate their portfolios in a more climate-aligned way. In some cases, this is driven primarily by concerns about the financial risks associated with climate change. For example, some investors report under Task Force for Climate-Related Financial Disclosures (TCFD) guidelines. Others wish to align their portfolios with 2050 net-zero objectives as outlined in the recently launched Net Zero Investment Framework. 1
The financial impact of the climate transition
The world is almost certainly not on course to achieve the Paris Agreement goal of "well-below 2C." But it is starting to move in the right direction. Stronger government policies and improvements in low-carbon technologies mean large-scale change is very likely in several important business sectors. These include energy, transport, heavy industry, mining, real estate, infrastructure, farming and forests.
Charts 1 and 2 show a base-case forecast for growth in electric vehicles, and solar and wind power in the coming decade.
Chart 1: Electric vehicle sales by region
Chart 2: Electric power generation by source
Source: BNEF – central scenario, 2020.
The predicted trends may translate into very high rates of earnings growth for companies in these sectors. Analysts have estimated that aggregate earnings from renewable-power generation will rise from around $50 billion today to $1 trillion by 2050.2 Conversely, demand for coal and, further into the future, oil and gas will eventually start to fall, suggesting low or negative earnings growth for these sectors.
High growth is even more valuable in the current secular economic environment because it’s harder to find. Also, the risk-free component of discount rates is extremely low. The risk-free rate is used in the standard discounting equation. Valuation is an inverse function of interest rates, so the lower interest rates go, the higher the valuation. The combination of low interest rates and high growth rates justifies high prices (Table 1).
Table 1: Interest rates and growth rates determine an asset’s fair value
Source: Aberdeen Standard Investments, December 2020.
High "green" valuations are scenario-dependent
High growth rates for renewable energy and electric vehicles are likely but not inevitable. If governments were to backslide on their stated climate ambitions, growth will be significantly lower. Similarly, interest rates may not remain at today’s historically low levels. For example, they may rise in a more inflationary macroeconomic environment. This would reduce fair valuations, particularly for high-growth stocks.
To deal with this uncertainty, we believe it’s important to be able to assess the effect on returns of a range of different climate scenarios. In addition, return assumptions must be regularly retested as market prices and climate policies shift.
For some sectors (e.g., financials, healthcare, communications) the climate transition has little impact on valuations. For the energy sector (oil & gas) the impact is much more material, and predominantly negative. For industrials, the impact is predominantly positive. This sector includes many companies that will benefit from the growth in new technologies (e.g., wind turbines, solar panels, batteries, electric motors). In the utility and materials sectors there are winners and losers. Coal miners and coal-powered generators may "lose"; copper and lithium miners and renewable-energy generators may "win."
It is important to emphasize that these scenarios are long-term in nature. The performance of these sectors may differ in the short-term – for example, oil stocks often do particularly well during recoveries from recessions; but may face challenges when demand for their products eventually starts to fall.
Overall, at the level of the aggregate stock market index, the "winners" and "losers" cancel out, and the net effect is very small. This means that, when forecasting expected returns for standard equity indices, there is very little impact under our mean climate scenario. Some regions (e.g., Europe and Japan) have more winners than losers, so they might outperform. Others (e.g., emerging markets) have more losers than winners. But the differences are statistically insignificant, adding or subtracting only 10-30 basis points per year. Return implications are much more varied for individual sectors and securities. This may create opportunities for active investors.
Revising fair value
This is only a snapshot based on running climate scenarios at a point in time. The real value of climate scenarios is that we will be able to re-assess them on a regular basis. We can change their specification to take account of climate policy changes, and adjust the probabilities of different outcomes accordingly. This approach also allows us to reflect changes to market prices.
It is possible that, over time, a "green bubble" might emerge, where market prices rise above the lofty valuation multiples justified by high growth and low interest rates. While bubbles deliver high returns for early investors, those who buy close to the peak experience disappointment. Our climate scenario tool allows us to regularly assess the scale of the investment opportunity, and to modify our strategic asset allocation appropriately.
1 IIGCC Net Zero Investment Framework 2020.
2 UBS ref
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.