Climate scenario analysis – looking to the long term for investors

Climate change is one of the biggest issues facing the world today. Many governments, countries and industries have recognised the threat and are taking measures to try to counter it. Much depends on their success or failure. As asset managers, however, our primary interest is in the investment implications. Our recent White Paper uses a scenario-based approach to examining the subject in depth. You can also read a series of other short articles on related topics here.

Below, we take a brief look at how the output from our analysis has influenced our long-term forecasts for asset classes.

When we decide how to construct portfolios over the long-term, we use a structured framework. We call this strategic asset allocation (SAA). When we carry out SAA, we look at what we expect a large variety of asset classes to do over given periods. Then we consider how to combine them into portfolios in order to meet investors’ long-term objectives. Our understanding of the likely impacts of climate change means it is imperative for us to consider how it might affect portfolio performance.

Building on our existing economic scenarios

Generally, we base our asset-class forecasts on developing a range of economic scenarios. For each of these, we make a set of different assumptions. These are likely to include prevailing rates of economic growth, inflation and interest. We then consider the probability of each scenario. From there we decide our probability-weighted mean ‘expected’ returns. These are behind the SAA advice that we give to our clients.

Since scenarios have long played an active role in our process, it is natural for us to use them when we consider the long-term effects of climate change on investment returns. Our approach is very similar to the one we use for other aspects of SAA, and we can in fact combine the two effectively. We can look at the mean expected return of our standard economic scenarios along with the mean impairment generated by our climate scenarios.

What are the financial effects of climate change?

Currently, as we described in Climate scenario analysis – our rigorous framework gives vital insights into the future of energy we think it’s likely that the world will fall short of the ‘well below 2 degrees’ goal set out in the Paris agreement. But our central scenarios suggest that a major energy transition is underway. Both stronger government policies and improving low-carbon technologies suggest that this will prove durable. It seems that significant change is almost inevitable. And there will be implications for a number of business sectors.

It seems that significant change is almost inevitable. And there will be implications for a number of business sectors

Rapid growth is expected in renewable energy generation - electric power generation by source

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Source: Bloomberg News Energy Finance, December 2020.

This could translate into high earnings growth for the companies driving the transition in these areas. Conversely, demand for coal, eventually oil and potentially gas will start to fall, suggesting low or negative growth rates in earnings for these sectors.

When forecasting long-term equity returns in SAA, we use a simple discounted-cash-flow (DCF) approach of the kind used widely by fundamental equity investors. In this model, long-term investment returns are highly sensitive to earnings growth rates. In the simplest DCF equation1, all else equal, the higher the earnings growth rate, the higher the company value. If the winners of the climate transition have the kind of growth rates implied by the charts above, they will have high justified valuations – particularly if interest rates remain structurally low2.

Scenarios are invaluable modelling tools

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 would be significantly lower. Similarly, interest rates may not remain at today’s historically low levels. For example, they may rise in a more sustained inflationary environment – reducing valuations, particularly for high-growth stocks.

Climate scenarios are invaluable tools that allow us to model this uncertainty. We think it is important to be able to assess the impact on returns across a range of different climate scenarios and to regularly retest assumptions on returns as market prices and climate policies shift. This is what our climate tools aim to enable.

The effect on our forecasts

As we show in our White Paper, our 15 climate-scenarios provide us with a distribution of potential earnings growth and valuation outcomes for individual companies and aggregate indices. In short, the impact of the mean climate scenario is very small at the level of aggregate equity market indices such as the MSCI World. The climate ‘winners’ are offset by the climate ‘losers’ and on average this impact is small. Between and within individual sectors, it is much larger – fossil fuel companies lose, renewables and electric vehicles win.

The story is the same for corporate bond indices, though here time is more of a factor. The biggest impact of the climate transition on credit risk will be in the 2030s and beyond – for example, as oil demand falls. Bonds that will be redeemed within 10 years are little affected by this risk. It is only the small minority of very long-dated bonds (e.g. an oil company’s 20-year bond) that are severely affected.

From an SAA perspective, this means that climate scenarios change our standard forecasts for equity and bond indices only a little. The story is very different across and within individual sectors. Sector valuation impacts are over 10% in some sectors (e.g. oil & gas and utilities) and well over 50% for some individual companies. These impacts are big enough to make a substantial difference to SAA forecasts, and to subsequent asset-allocation decisions. This creates significant potential for long-term investors to focus strategically on shifting allocations to investment themes and sectors that are particularly strong at mitigating climate risk or exploiting new climate-related opportunities.

DOWNLOAD THE WHITE PAPER pdf

1 3 P = D/(r-g) where P is fair-value price, D is dividend in year 1, r is discount rate (comprising the risk-free interest rate and the equity risk premium) and g is the earnings-growth rate.

2 Low interest rates mean lower discount rates in the DCF equation.

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

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