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
At ASI, we’ve been working to address investors’ demands by exploring how the transition to net-zero emissions might affect long-term portfolio returns. We’ve developed a state-of-the-art climate scenario tool kit to allow us to estimate the effect of different climate scenarios on investment returns. We’re able to look at both generic asset classes (e.g. US equities, UK equities) and also innovative strategies such as climate-aligned index trackers and products focused on climate solutions.
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 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 US$50 billion today to US$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.
When forecasting long-term equity returns in our strategic asset allocation, we use a simple discounted cashflow approach of the kind used widely by fundamental equity investors. In this model, long-term investment returns are highly sensitive to growth rates. In the simplest discounting equation3, the higher the growth rate, the higher the company’s value. So, if the winners of the climate transition have the kind of growth rates implied by Charts 1 and 2, they will merit high valuations.
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 (see Table 1).
Table 1: Interest rates and growth rates determine an asset’s fair value
Source: Aberdeen Standard Investments, Dec 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. This is what our climate tools seek to do.
We have been working with Vivid Economics, a leading provider of economic climate scenario modelling, to build a set of climate scenarios. These scenarios allow us to estimate the impact of a range of policy and technology pathways on the earnings growth of companies. The model also helps us assess the corresponding return and valuation implications for different sectors and regional equity indices.
Using these modelling tools, we have generated 14 different climate scenarios illustrating various climate-change temperature outcomes. These range from +1.5C above 19th century levels under the most ambitious climate policies to above +3C in a world where governments renege on their climate commitments. The climate scenario models provide us with a distribution of potential earnings growth and valuation outcomes for individual companies and aggregate indices.
As with our standard approach to generating expected returns for asset classes, we have assigned probabilities to each scenario. We base these probabilities on discussions with external climate experts and internal teams. This allows us to generate probability-weighted mean ‘expected’ returns at various levels of aggregation.
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 lose; copper and lithium miners and renewable-energy generators win.
It is important to emphasise 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 creates opportunities for active investors. It also offers opportunities to investors willing to make strategic allocations to thematic climate-solution portfolios.
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.
Read the next Global Outlook article Oil, electric vehicles and the environment.
1 IIGCC Net Zero Investment Framework 2020.
2 UBS ref
3 P = D/(r-g) where P is fair value price, D is dividend in year 1, r is discount rate (comprised of the risk free interest rate and the equity risk premium), and g is the earnings growth rate. Low risk rates and high earning growth justify high valuations.