Launching climate-aware return assumptions

Capital at risk. The value of investments and the income from them can fall as well as rise and is not guaranteed. Investors may not get back the amount originally invested.

Avoiding damages from climate change

The popular notion that tackling climate change comes at a net cost to the global economy is wrong, we believe. Avoiding climate-related damages will help prevent economic deterioration and improve risk-asset returns, in our view. We see the “green” transition to a carbon-neutral world rewarding companies, sectors and countries that adjust and penalizing others.

That is why our capital market assumptions (CMAs) – long-run estimates of risk and return – now reflect the impact of climate change.

Estimates in this area are highly uncertain, yet our framework is designed to account for this. We will refine this framework as we monitor the evolution of the “green” transition.

We focus on climate because we believe a broad consensus around its impact and measurement suggests that climate change is fast becoming a key driver of asset pricing. Our updated CMAs are driven by sectoral views, with exposure to climate risks and opportunities a key determinant.

We see technology and healthcare benefiting the most from that perspective, and carbon-intensive sectors such as energy and utilities lagging. This in turn increases our strategic preference for developed market (DM) equities, at the expense of high yield and some emerging market (EM) debt.

Why? The composition of DM equity indexes better aligns with the climate transition, with large weights of technology and healthcare companies, less vulnerability to transition risks and lower carbon intensity. Equities also can better capture potential opportunities of the green transition, as bonds are capped in their capital appreciation. Sectors that face structural challenges due to rising climate awareness, such as energy and utilities, are more prevalent in high yield and EM debt indexes.

Climate risks and opportunities

Climate change and efforts to curb it will have major economic outcomes, we believe, not just far into the future but in the next five years. Economic projections that ignore climate change are widely relied upon – yet are based on an unrealistic future scenario, in our view. We instead focus on two scenarios, see the chart below.

The green transition

The two scenarios to compare from this perspective: a transition to a low-carbon economy in which policies to fight climate change are enacted, and a no-climate-action scenario with no actions to limit damages.

A commonly held notion is that tackling climate change has to come at an economic cost. We think that’s wrong. We assume the global economy transitions to a lower carbon path consistent with Paris Agreement goals.

The positive effect of this transition rests on a gradual phasing in of carbon taxes, green infrastructure spending consistent with the IMF’s recommendation, and subsidies on renewable energy. If none of these actions are taken to mitigate climate change, we estimate a cumulative loss in global output of nearly 25% in the next two decades. The stylized Accounting for climate change chart illustrates the potential difference between the two paths.

We focus on the "E" (environmental) of ESG in our updated CMAs. Why? First, there is wide recognition of the importance of climate change on economic and social outcomes. Second, there is consensus on the measurement of an entity’s contribution to climate change: carbon emissions. Carbon emissions have become a widely enough adopted indicator of sustainability for investors to be a driver of repricing at the broad market level.

We see insights into S (social) and G (governance) as key sources of potential returns through security selection, rather than as systematic drivers of returns. We will consider incorporating them in our framework once consensus around their impact and availability of consistent data improve in coming years.