Climate scenario analysis – dispersion is king, underscoring the value of active management

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 focus on the dispersion of (climate change-related) outcomes for sectors and companies.

Tackling climate change is rightly gaining prominence on the agenda of both companies and investors. In this context, perhaps surprisingly to some, our analysis found that the impact of climate change on returns for aggregate global equities (MSCI World Index) could actually be quite modest. We estimate a +/- 2% impact on aggregate valuations in most scenarios. The main reason for this is that indices are well diversified by definition. Accordingly, the negative impacts for some companies tend to be largely cancelled out by positive impacts for others.

The generally small index-level impacts might lead some to conclude that climate risks are not so material. However, this would be the wrong conclusion. In fact, our estimated ‘world-level’ or aggregate effects mask much larger variations between sectors, subsectors, and especially individual firms. On a high level, this largely reflects different sectoral and company exposures to projected demand changes and carbon costs. As such, far from being immaterial, we think the wide potential dispersion in climate-related outcomes should be of great interest to active investors.

Sizeable sectoral variation…

When we drill down to the 11 sectors of the MSCI World Index, significant variation in their exposures to different climate scenarios becomes apparent. The biggest negative impact of our probability-weighted mean scenario was on the energy sector (see Figure 1). The biggest positive impact was on the utilities sector. The intuition for this is fairly straightforward. Currently, the energy sector is heavily fossil fuel-reliant. As such, any significant policy and technology-driven rotation towards renewable sources implies significant demand destruction and/or much higher carbon costs. On the other hand, utilities is the biggest winner on the whole. This is because of the sector’s generally higher exposure to renewables and the ability to pass on higher carbon costs to customers.

Figure 1: Asset price impairment is concentrated in a small number of sectors

insert_chart
 

Comparison of sector level impact or impairment (%) (means weighted by market cap; relative to what is priced into the Baseline) under three scenarios. Bracketed percentage shows the sector weight within the aggregate index. Data source: Planetrics and ASI analytics January 2021

While sectoral-level effects are most concentrated in the energy and utility sectors, other sectors also see significant impacts. This is particularly evident at the sub-sectoral level. Our analysis uncovers a group of ‘resilient winners’, which see positive uplifts in most scenarios. Two examples of this are electrical component and equipment manufacturers, and semiconductor manufacturers. These subsectors do well as they are a key part of the low carbon energy supply chain – for example, as producers of solar panels and chips used in electric vehicles.

…but dispersion is greatest at company level

While dispersion under different climate scenarios is greater among sectors than at the index level, it is much greater at the individual company level.

While dispersion under different climate scenarios is greater among sectors than at the at the index level, it is much greater at the individual company level. This point, which is depicted below, is well encapsulated by the utilities sector. Here, an 18% average positive effect masks negative impairments as high as 65%, and positive impairments in some cases exceeding 100%. This wide variation reflects the fact that within the broad utilities sector, individual business models differ hugely. For example, on one extreme there are more traditional utilities that are still essentially fossil fuel-reliant. At the other extreme, there are ‘renewable energy’ firms, which benefit from demand growth rather than demand destruction.

Figure 2: Within aggregate sectors, climate impairment effects are highly dispersed

insert_chart
 

Dispersion of total impact across all companies in the MSCI World index for each sector (Probability weighted mean scenario). Outliers beyond 200% are not shown. Data source: MSCI*, Planetrics and ASI analytics, January 2021

No substitute for company-level analysis

Scenario-based analysis can certainly play a part in gaining a fuller appreciation of climate-related risks and opportunities at the company level. However, the large variation in company-level outcomes really underscores the potential value of understanding specific business models and how they adapt to avoiding material climate-related risks and opportunities. This includes the extent to which companies are credibly preparing for the zero carbon energy transition in their business strategies. By definition, active investing approaches that consider all the factors relevant to the investment case for a company are the only way to do this properly. That said, there are also some systematic-type opportunities for investment strategies that tilt towards climate-transition winners and for thematic climate-solutions portfolios. We look at these in more detail in our next article.

DOWNLOAD THE WHITE PAPER pdf

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.

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

Any data contained herein which is attributed to a third party ("Third Party Data") is the property of (a) third party supplier(s) (the "Owner") and is licensed for use by Standard Life Aberdeen**. Third Party Data may not be copied or distributed. Third Party Data is provided "as is" and is not warranted to be accurate, complete or timely.

To the extent permitted by applicable law, none of the Owner, Standard Life Aberdeen** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates.

**Standard Life Aberdeen means the relevant member of Standard Life Aberdeen group, being Standard Life Aberdeen plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time.