Each day starts with a choice. Do you get up? From there, it only gets more complicated.
You live in a world of growing social cleavages, shifting geopolitical sands and binary opinion, fed by a culture with few positive visions of the future. As the world’s politicians assemble in Glasgow, you will hear some say this is their last chance to save humanity from environmental meltdown. A version of this claim has been made many times before, but the doomsayers need only be right once. Some think we have already run out of time.
Amid the din, one choice asserts itself ever more loudly: how do you respond to climate change? From there, it only gets more complicated.
This is especially true for investors. In recent years, soothsayers in the financial world have told savers they can help slow a heating planet and make a profit in the process. Last year, as the pandemic forced a rethink about the fragility of our economies and societies, one powerful narrative suggested allocation to companies aligned to the Paris climate goals could even help investors to beat the market.
In some corners of the financial market, this story gave way to bubble-like conditions. One electric vehicle company was briefly valued at $23bn (£17bn), despite having neither a prototype nor sales forecasts. Shares in Danish wind energy firm Ørsted (ORSTED) entered 2021 on 57 times forward earnings. After billions of investor dollars rushed into BlackRock’s flagship renewable energy product iShares Global Clean Energy (INRG), the fund was hit by liquidity issues, prompting an overhaul of its holdings.
Meanwhile, executives of asset managers, pension funds, banks and corporates fell over themselves to proclaim their green credentials and promise net zero carbon emissions by 2050. This was often done without a concrete plan, and in the near-certain knowledge they will have retired or left their current jobs in 30 years’ time.
This hyperbole has started to readjust, along with hopes for the COP26 UN Climate Summit, which starts on Sunday. Much hinges on the cooperation of China, the world’s largest polluter. But after a four-year hiatus, the US is at least engaged in the crisis once again. Globalisation may be fraying, the optimists admit, but the nature of global warming behoves a multilateral approach.
As the political drama unfolds or fizzles out, investors are still left with choices. Unfortunately, these choices are a lot more complicated and wide-ranging than they first appear. If the implications of climate science are to be confronted, investors face much more than a dilemma about whether to divest from fossil fuels. For anyone who plans and thinks in decades, what is required is a more radical macro view of the climate change century.
It’s not easy being green, as Kermit says. Nor is it going to be easy to invest in the years ahead.
An inflationary climate?
In April 2019, Bloomberg ran an opinion article piece entitled ‘Did Capitalism Kill Inflation?’ Its author, the economics writer Peter Coy, reflected on a decade of central banks’ unsuccessful attempts to reignite inflation in the wake of the financial crisis, and quoted Fed chair Jerome Powell, who called low inflation “one of the major challenges of our time”.
Two and a half years on, clients of UBS are worrying about stimulus-induced hyperinflation. After the disaster of Covid-19 came stasis, recovery and then – just as fast – dislocation and supply chain turmoil.
That’s what happens with massive crises: shocks beget shocks. Economies print money to repay the damage, the equilibrium between supply and demand collapses, and GDP growth data plots veer wildly from the smooth forecast lines.
Climate science states clearly that rising temperatures will act as a Pandora’s box of crises which will quickly matter to financial markets, as policymakers, central banks, and economies each grapple with the increasing regularity and severity of natural disasters. As with the aftershocks of Covid-19, this could be inflationary, as the cost of doing business climbs and fresh sources of friction are added to companies’ supply chains.
Then there is the cost of addressing climate change. To take just one example, the UK government this month announced plans to subsidise the installation of heat pumps in homes, which it sees as a viable solution to individuals’ efforts to reduce their own carbon footprints. Although the technology reduces emissions and can lead to lower energy bills, a 2020 report by the Carbon Trust found the capital required for refitting would result in higher lifetime costs over a 30-year time horizon.
Until – and if – society puts a price on carbon, it will be up to individuals and companies to internalise the cost of doing business in a greener, less carbon-intensive way. Historically, both business and the field of economics have treated emissions as an externality. Changing that requires new solutions, which come at a cost.
One of those who believes this cost will ultimately heap inflation on the economy is Larry Fink, the chief executive of the world’s largest investor, passive fund giant BlackRock. “If our solution is entirely just to get a green world, we’re going to have much higher inflation, because we do not have the technology to do all this yet,” he said earlier this year.
To others, greening the world too slowly risks kicking the inflationary can down the road. In a speech in June, Bank of England governor Andrew Bailey said: “A disorderly transition, where more severe policies are introduced later in the horizon to compensate, could result in both lower growth and higher inflation from rising energy and materials costs in the economy.”
In part, this reflects two different ways of seeing the world. As an investor, Fink sees events through the lens of markets and efficient capital allocation; as a central banker, Bailey’s outlook is more concerned with political economy and financial risk. Both are valid positions. But, together, they suggest climate change poses inflationary challenges to long-term investors however fast we move.
Simon Webber, portfolio manager of Schroders’ Global Climate Change Fund (LU0302446132), believes both that disruptions brought about by climate change will prove “almost certainly inflationary in many circumstances”, and that building a low carbon economy “will also likely have inflationary consequences for some materials”.
He also points to recent oil and gas spikes as a sign that inflation is a threat even if the pace of change is much slower than the one Larry Fink worries about. “Even in a normal recovery, unless the build out of the low carbon economy is fast and creates spare capacity, there will be periods of shortage that can drive up prices.”
At the same time, Webber believes de-carbonisation could bring some deflationary forces. “Weaning ourselves off fossil fuels is, at the end of the day, going to be very negative for the pricing of those fossil fuels when we successfully make that transition,” he says.
Others paint a more bullish picture of the pivot from our incumbent energy system.
“Because renewables are cheaper than fossil fuels in around 90 per cent of the world, these deflationary costs will actually flow through to benefit the consumer and industry,” says Mark Campanale, founder of climate finance research group Carbon Tracker. “We expect the cost of energy overall to drop, which will be a special dividend to society.”
But even if we assume our energy system is now under the sway of unstoppable declining cost curves, investors need to think about the physical effects of climate change.
Climate stress tests
Swiss bank UBS recently launched an ad campaign pictures a series of parents standing in woodland settings, each holding their child, while staring pensively past the shared moment. “Will she always be happy?” one poster asks. “Live a good life on a healthy planet? Can sustainable investing protect her future?”
Although UBS promises that “together we can find an answer” to these questions, it doesn’t say if this will be a good, or straightforward answer.
It is also telling that such palpable concern is now sufficiently mainstream for a wealth manager to build its marketing strategy around. Then again, by this point, anyone who thinks carefully about their financial futures will have considered what the scientists’ warnings might mean for their wealth and investment returns.
To some investors, the locus of climate stress on the real economy – and the determinant of whether future generations can expect “a good life on a healthy planet” – is food. GMO’s Jeremy Grantham has described threats to agriculture as “the real underlying problem produced by climate change”.
The Intergovernmental Panel on Climate Change, the United Nations body that studies global warming and its effects on planetary and human systems, has warned that as temperatures rise, we are likely to see “severe and large risks to global and regional food security”. The increased incidence and severity of droughts and floods will hit agricultural yields and increase soil erosion. In many parts of the world, growing food or working outdoors will become impossible.
“Particularly on the food side, I don't think you can overestimate the scale of the challenge we're facing,” says Isabella Harvey-Bathurst, who manages the Schroders climate change fund with Webber. “Feeding a growing population, when the demand for protein is rising even faster than demand for calories, and doing all of this in a world where extreme weather events are becoming more frequent; in that business-as-usual scenario, agriculture would use up the whole carbon budget by 2050.”
Climate change-induced natural disasters will also act as multiplier effects on economies and global markets. This month, the World Health Organisation described climate change as the biggest health challenge facing humanity. Extreme weather events both take lives and impair healthcare systems. Crises, particularly in fragile states, have the potential to compound conflict: last week, a report by the US government’s top spies and scientists concluded that climate change will “exacerbate cross-border geopolitical flashpoints as states take steps to secure their interests”.
What this means for societies and economies is hard to say, but it is unlikely to be positive. The National Intelligence Council, which penned the US government study on geopolitical risk, said it only had low to moderate confidence in its predictions, given the “complex dimensions of human and state decision-making”. What it means for financial markets is an even tougher call.
One place to start with is economic growth projections. Several closely followed forecasters peg global annual GDP growth at around 3 per cent until 2050, where it has hovered for much of the past half-century. This would imply a 136 per cent increase in the size of the world economy over the period, and – with some important caveats – is generally viewed as a lead indicator for corporate earnings and shareholder profits.
Such forecasts form the basis of long-term asset allocation. But factoring in the effects of climate change is dicey. Swiss Re estimates that a 2.0°C increase in global temperatures by 2050 relative to pre-industrial levels will lead to an 11 per cent loss in world GDP, relative to a world free of climate change. Accounting for the compounding effects of global growth, the reinsurer’s models still expect the size of the global economy to more than double.
Equally, economists at the asset manager Schroders have calculated that over the next 30 years, returns from cash, bonds and equities are all likely to be lower because of climate change. That seems a sensible assumption, but what should concern investors is where global economic stress will be most acute.
In its most severe scenario, in which temperatures rise 3.2°C and the as-yet unknown effects of climate change are magnified 10-fold, Swiss Re believes the global economy could be 18 per cent smaller by mid-century. Forecasts for India and south east Asian nations – where dents to economic output are predicted to range from 35 to 46 per cent over the period – are particularly frightening.
These are countries whose populations are expected to grow considerably. The risk of resource scarcity and social calamity are non-trivial. Such pockets of acute climate change-induced stress, rather than generalised drags on economic output, are most likely to spark widespread crises.
If the world is to avoid climate change’s worst threats, then at some point carbon will need to be properly priced. There is debate over whether this would be inflationary or deflationary, although the broad idea of adding a tax to emissions is to incentivise consumer and producer switches to less carbon-intensive forms of economic activity. In effect, a carbon price acts as a massive behavioural nudge to shift supply and demand patterns.
That could serve to propel industries such as electric vehicles, renewables, energy efficiency, plant-based meat, and recycling, and further underline their investment cases.
Unfortunately for investors, beginning to price carbon properly would have huge impacts on the earnings of companies as currently configured. One estimate suggests half of listed global companies would face a rise or fall of more than 20 per cent in earnings if carbon prices rose to $100 a tonne.
The most obvious casualty of a properly enforced carbon tax would be those companies that depend most on the legacy energy system. Depending on the region, Swiss Re pegs the hit to earnings for energy producers at between 40 and 80 per cent, with even steeper average falls in the materials and utilities sectors. Some 14 per cent of the MSCI World Index’s earnings would be at risk, says Schroders.
Such warnings are getting louder. The hedge fund giant Bridgewater recently urged investors to start treating carbon prices seriously, arguing that “the carbon price will over time become an essential input to economic activity…just as oil, gas, coal, and other commodities are common input costs today that reflect how growth and inflation are evolving”.
Right now, there is little incentive for companies or investors to incorporate this philosophy. Few expect COP26 to change that.
Even in Sweden, which has the highest carbon tax in the world at €114 (£96) a tonne, exemptions mean less than half of the country’s emissions are covered. And even then, this price may fall short: the International Energy Agency reckons it needs to hit $140 in order to meet the goals set out in the Paris agreement, while researchers at the University of California San Diego say $417 is required to properly account for the economic damage one tonne of carbon dioxide leads to. At current emissions levels, that would mean $14 trillion a year.
How any of this might be enforced is perhaps the biggest policy debate in climate change politics, and a huge question for asset owners and financial markets. But even the energy sector now acknowledges that business as usual could prove much more costly in the long run. Its critics smell blood. “I'm a big fan of putting the price of carbon not at the point of use, but at the point of production – at the wellhead, or the mine head,” says Campanale. “Suppliers would have to acquire a permit to sell the fossil fuels they produce.”
For investors, a carbon price would at least pass the job of environmental concern onto board directors. But that still leaves a lot to think about: a nimble approach to regulation, a reappraisal of long-term asset returns and an appetite to back the world-changing innovation needed to get us through this epochal challenge will all be required.
It’s not easy being green. But like Kermit, you don’t have any other choice.