Climate change – turning investment risk into opportunity

Most ignore the effects of climate change in their financial projections. We believe this is not right.

Climate change is real and cannot be ignored by investors. Climate risk is investment risk, and we see it is as a historic investment opportunity. Our capital market assumptions (CMAs) – a core input to building portfolios – for the first time, explicitly reflect the impact of climate change on the investment landscape. This is one of a set of actions we are taking to prepare investors for the global transition to a net zero emissions economy by 2050 or sooner.

We’ve been saying for a few years that climate risk is investment risk.

And by that we mean is companies, sectors will be affected by climate change and as a result, there will be winners and losers in the transition and that’s what we need to capture in portfolios.

A few forecasters have started introducing some aspect of climate change but very few if any incorporate all the aspects and channels by which we think climate change is affecting our return expectations across asset classes.

The first channel is the macro backdrop. The growth that we expect to see over the next 5, 10, 20 years. Growth will be different; inflation will be different in a green transition.

The second is the fact that we are seeing a premium being reflected now for companies or sectors that are better aligned with the transition. That can be measured by the carbon intensity of the sectors and companies as a proxy for how these companies are likely to fare going forward.

We see technology and healthcare as being among the beneficiaries given that producing the healthcare services or the technology requires a less carbon intensive production process. That would be different than it is for energy, utilities and materials.

And the third channel is profitability of companies and earnings, that expectations will be different in a world where you see a climate transition versus a business as usual

The bottom line is the climate transition is a historic investment opportunity. We see climate change and the transition driving capital reallocation and returns across asset classes over the many years to come and that goes at the heart of how we build portfolios.

Climate change changes investing

On this episode of the BlackRock Bottom Line, Jean Boivin, Head of the BlackRock Investment Institute, explores why we believe the climate transition will boost portfolios. 

Pioneering research

The commonly held notion that tackling climate change has to come at a net cost to the global economy is wrong, in our view. If no action is taken to combat climate change, the considerable physical damages would imply a lower path of economic growth. Our CMAs reflect our view that the green transition to a low-carbon economy, consistent with the Paris Agreement goals, will deliver an improved outlook for growth and risk assets relative to doing nothing.

The chart below shows our estimates of the impact on China – an increasingly important pillar of the global economy and one where the impact of climate change is likely to be significant.

Seeing green

Estimated GDP paths scenario for China, 2020-40

Estimated GDP paths scenario for China, 2020-40

Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, Banque de France, International Energy Agency, OECD, January 2021. Notes: The chart shows our estimated path for China’s GDP over the next 20 years under the two mentioned scenarios. GDP levels are rebased to 100 as of 2020.

Underpinning the climate-aware CMAs is our view of an orderly transition that successfully limits climate-related damage. The tectonic shift toward sustainability has gathered momentum over the past year following a series of major climate change commitments by corporations, governments and investors alike, bolstering our conviction in an orderly transition to a low-carbon world.

Investors are just starting to respond to the structural shift – suggesting it is not yet fully in the price of assets. The BlackRock 2020 Global Sustainability Survey found that respondents plan to double their sustainable assets under management (AUM) in the next five years – rising from 18% of AUM on average today to 37% on average by 2025.

We see climate change and the green transition as persistent drivers of asset returns, and consequently fundamental to making strategic investment decisions. Climate change and policies to combat it flow through our CMAs via three main channels: the macroeconomic impact, the repricing of assets to reflect climate risks and exposures and the impact on corporate fundamentals.

A historic investment opportunity

Climate change and efforts to curb it will have major economic outcomes, not just far into the future but in the next few decades (Dietz et al., 2020). We have updated the long-term macroeconomic framework that underpins our CMAs. Such an outlook rejects the commonly held notion that tackling climate change has to come at a net cost to society.

Globally, we estimate a cumulative loss in economic output of nearly 25% over the next two decades due to the level of GDP being 2.3% lower in 20 years’ time if no climate change mitigation measures were taken. The chart below shows the potential cumulative impact of three factors – avoidance of climate damage, transition costs, and green infrastructure spending – on GDP by 2040.

China’s green opportunity

Estimated cumulative impact as a percentage of GDP scenario for China, 2020-40

 

Estimated cumulative impact as a percentage of GDP scenario for China, 2020-40

Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, Banque de France, International Energy Agency, OECD, January 2021. Notes: The chart shows the cumulative impact on long-term GDP under a green transition relative to a no-climate-action  scenario. The bars show the overall estimated impact of three factors – avoidance of climate damages (positive), green infrastructure spending (positive) and costs associated with the transition (negative). The black line shows the estimated net impact. Our estimates of the impact under a climate-aware scenario are based on expected changes in energy consumption including composition, relative carbon and renewables pricing and on potential losses due to global warming. Energy consumption is estimated as a function of GDP and the relative price of energy per the Banque de France's working paper no. 759 titled the Long-term growth impact of climate change and policies. GDP losses from global warming are calibrated on analysis of Impact Assessment Models per W. Nordhaus and A..Moffat (2017). We assume green infrastructure spending programs of 1% of GDP gradually phased out over the next 10 years.

Getting into the macro

We first incorporate climate damages into our economic projections. The economic losses, associated with rising temperatures, build over time and are more pronounced in some regions than others (Burke et al., 2015). Call this the “no-climate-action” scenario – climate damages occur, but no action is taken to combat it. We then consider a second economic scenario, with policies and innovations that could mitigate climate damages – call this the “green transition” scenario. Specifically, in the green transition we consider the actions needed to ensure the Paris Agreement target of limiting temperature rises to below 2 degrees Celsius is achieved. The green transition is our base case for our updated CMAs and strategic asset class preferences.

Economic loss due to climate damages can be largely avoided, in our view, by proactive climate policy action that keeps the global temperature change within the margins of the Paris Agreement through a combination of gradually rising carbon taxes and clean energy subsidies (Burke et al., 2018).

We acknowledge the risks to the downside in our green transition scenario. Delays in implementing climate policies could result in a “disorderly transition”. Policy execution will be key: any shortfalls could undermine the policy predictability and credibility, making the energy transition more costly.

The “E” in ESG

There is wide recognition of the importance of climate change for economic and social outcomes and second, there is consensus on the measurement of an entity’s contribution to climate change - via carbon emissions. Carbon emissions are a widely enough adopted indicator of sustainability for investors to the extent that it can be a driver of repricing at the broad market level. We see insights into S (social) and G (governance) issues as potential sources of alpha impacting security selection, rather than as systematic drivers of returns and so exclude them from our CMAs.

Macro variables such as GDP would be different in a world that is transitioning to a low carbon future, meaning traditional risk premia for all asset classes will change. The chart below shows our updated CMAs for selected asset class – the green dots show the mean expected returns in our base case of a green transition and the red dots indicate the expected returns in a no-climate-action scenario. For U.S. equities, our expected returns in a no-climate-action scenario would fall outside the band of uncertainty around our mean estimate, highlighting the potentially large impact from climate change.

A meaningful impact

BlackRock capital market assumptions for selected assets, February 2021

BlackRock capital market assumptions for selected assets, February 2021

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Source: BlackRock Investment Institute, February 2021. Data as of 31 December, 2020. Notes: Return assumptions are total nominal returns. U.S. dollar return expectations for all asset classes are shown in unhedged terms,. Our CMAs generate market, or beta, geometric return expectations. Asset return expectations are gross of fees. For representative indices used, see the Assumptions at a glance table. For a full of asset classes we cover, visit our Capital Market Assumptions website at blackrock.com/institutions/en-us/insights/portfolio-design/capital-market-assumptions. There are two sets of bands around our mean return expectation. The darker bands show our estimates of uncertainty in our mean return estimates. The lighter bands are based on the 25th and 75th percentile of expected return outcomes – the interquartile range for more detail read Portfolio perspectives.

Beyond the carbon cost

In addition to the macro impact, we see the effects playing out through two more channels:

  • Repricing: One consequence of shifting societal preferences is that the price investors are willing to pay for assets perceived to be sustainable is changing, driving differentiated returns. Capital flows toward sustainable assets are a symptom of this phenomenon. Our CMAs now directly reflect our estimates of such a premium.
  • Fundamentals: This channel could be seen as an extension of the macro one. Some companies and sectors are better positioned than others for a transition to a low carbon economy. Corporate behavior will likely respond by adapting to policy and regulatory changes brought about to combat climate change. Profitability across sectors will be impacted. There will be sectoral winners and losers – underpinning why we believe a sectoral approach to sustainable investing is additive to a regional one.

The chart below shows the estimated return impact across sectors from both the repricing and fundamental channels. We estimate a 7% annualized return differential over five years between the energy and technology sectors – a significant difference in a world of low expected returns across asset classes.

Total return impact

Estimated 5-year expected return differential for U.S. sectors in green transition vs, no action, February 2021

Estimated 5-year expected return differential for U.S. sectors in green transition vs, no action, February 2021

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream and Bloomberg, February 2021. Notes: The chart shows the difference in five-year U.S. dollar expected returns for the highest sub-category of MSCI USA sectors under two economic scenarios - a green transition and a no-climate-action scenario. The difference in expected return is attributable to repricing – the return impact of changing cost of capital - and fundamentals  – or the return impact of changing earnings per share growth.

Uncertainty is a key element of our framework and is built into our CMAs. No one yet knows what a low-carbon world looks like. The transition may play out over several years, if not decades. We will monitor key trends such as capital flows, policy developments and technological advancements – and the way asset prices respond to them – and look to evolve our framework as new information becomes available. Our portfolio construction approach that explicitly accounts for uncertainty and provides a term structure of returns to capture the time varying impact of climate change lends itself well to the structural transformation we see playing out.

Portfolio implications

Tactical, or shorter-term, investment decisions will not be sufficient, in our view, to position for the fundamental reshaping of the global economy we see playing out. Positioning portfolios appropriately requires expressing views at the strategic asset level. Like any investment view, the ultimate implementation and sizing of climate change-led views in portfolios will vary depending on an investor’s risk appetite, objectives and eligible universe.

Some investors may have to reallocate as much as 10-20% of existing assets. For others, it will be less. See our investor-specific asset allocation breakdowns for more. Our strategic asset preferences for a hypothetical unconstrained, U.S. dollar investor with a 10-year horizon are shown on the chart below and put our asset class views in a portfolio context. They reflect our views on all drivers of long-term asset returns, from the monetary and fiscal policy revolution to structural trends, such as the U.S.-China rivalry and the polarization of global growth. The impact of introducing climate change as an additional driver of returns on asset class views is shown on the right.

Tilting toward sustainability

Hypothetical U.S. dollar 10-year strategic allocation vs. our equilibrium view, February 2021

Hypothetical U.S. dollar 10-year strategic allocation vs. our equilibrium view, February 2021

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream and Bloomberg, February 2021. Notes: The chart shows our asset views on a 10-year view from an unconstrained US dollar perspective against a long-term equilibrium allocation described on our capital market assumptions website. The portfolio is illustrative and the allocation above does not represent any existing portfolio and, as such, is not an investible product. The construction of the hypothetical asset allocation is based on criteria applied with the benefit of hindsight and knowledge of factors that may have positively affected its performance and cannot account for risk factors that may affect the actual portfolio's performance. The actual performance may vary significantly from our modelled CMAs due to transaction costs, liquidity or other market factors. Indexes are unmanaged, do not account for management fees and one cannot invest directly in an index.  See appendix for full list of index proxies.

The most significant impact is a stronger preference for developed market equities at the expense of high yield and emerging market debt. The composition of developed market equity indices better aligns with the climate transition and equities have more ability to capture the upside opportunities from the climate transition. The higher carbon intensity of companies that typically make up high yield and emerging market debt benchmark indices detracts from their expected returns, diminishing their appeal within our overall preferred strategic allocation.

Another impact of incorporating climate change in our CMAs -  granular investing becomes more prominent in portfolio construction. We believe climate change will drive greater dispersion of returns at a sector level than at the asset class level. We see sectors as the relevant unit of investment analysis and if we allow sector granularity in our portfolio construction, buying assets at the sector level rather than at an index-based regional level, the impacts on strategic asset preferences can be material.

We have a strategic preference for inflation–linked government bonds over nominal government bonds. We see the policy revolution driving higher inflation over the medium-term but don’t expect rising inflation expectations to be reflected through higher nominal yields as much as was historically the case. Yet we see a diminished ability of nominal bonds to act as ballast and expect high public debt levels to push yields higher over the strategic horizon. We are strategically underweight credit as we see valuations as expensive on a relative basis relative to equities. Our preference for a strategic overweight to Chinese assets overall is not diminished – and is, in fact, enhanced for Chinese government bonds given the relatively poorer outlook for comparable assets.

Philipp Hildebrand
BlackRock Vice Chairman
Jean Boivin
Head – BlackRock Investment Institute
Jessica Tan
Global Head – Corporate Strategy and Sustainable Investing
Simona Paravani-Mellinghoff
Global CIO of Solutions, Multi-Asset Strategies and Solutions
Ed Fishwick
Global Co-Head of Risk & Quantitative Analysis