Climate-aware return assumptions: an update

We dig into how our assessment of the transition will impact asset returns and how our latest strategic views reflect our latest thinking.

An accelerating transition

We track the transition to lower carbon emissions like we track any other driver of investment risks and opportunities, such as monetary policy. We assess the likely future paths, calibrate their effects at the macro and company level, estimate whether those effects are reflected in market prices today – and then implement these insights into our strategic views and portfolios. That’s precisely why we added climate-related effects to the set of drivers of risk and return for our CMAs in 2021.

To recap our process for incorporating sustainability into portfolio construction: we think investors need to take a view on the likely path of the transition which will be determined by the interplay of three drivers: societal preferences, government policy and technology. These drivers are in constant motion. Right now, enacted policies and available technology aren’t sufficient to achieve the goals of the Paris Agreement to limit global warming to “well below 2°Celsius, preferably to 1.5°C,” compared with pre-industrial levels. See the chart below. Yet we believe there that these drivers will ultimately combine to accelerate the transition from the path implied by current policy.

Possible acceleration ahead

Illustrative transition scenarios, 2022

The transition to a lower-carbon economy entails a massive reallocation of resources. Economies will evolve as carbon emissions are cut, inevitably impacting portfolios, with winners and losers at the sector level. But as with the future path of central bank policy rates, the transition’s path from here is uncertain and evolving. Overall, we see an accelerating transition – boosted by significant policy action in the U.S. and Europe this year.

Why an acceleration? The Russian invasion of Ukraine – and the West’s consequent decision to wean itself off Russian oil and gas – has led to energy shortages and a prioritization of energy security. That has contributed to a sharp outperformance of the traditional energy sector this year – the MSCI World energy index is up 44% vs the 17% decline for the broader MSCI World, according to Refinitiv Data as of Dec 12, 2022. But looking longer term, Europe’s drive for greater energy security has also prompted it to double down on efforts to build clean energy infrastructure. The clearest example of that is the European Commission’s RePowerEU Plan. Further impetus is likely to come from higher energy prices. Tight fossil fuel markets, with sustained high prices, act like a carbon tax on consumers. That surge in prices has shifted the economics decisively in favor of cleaner energy sources. And in the U.S., we see the Inflation Reduction Act cutting clean technology costs, creating incentives for private investment and spurring domestic manufacturing. It could also potentially accelerate state and local policy action. See “Policy steps up”.

Falling short for now

Increase in Europe renewables capacity vs. targets

We have updated our base case scenario to reflect this. This doesn’t change our underlying story and the results of our analysis of the drivers that we tackle further on. This shows how we need to – and will – continuously update our view on the transition to reflect the latest research and policy developments. At the heart of our estimate of the macro impact of the transition – the first of our three transmission channels – is the view that the transition to a decarbonized world involves a huge reallocation of resources. Oil and gas will still be needed to meet future energy demand under any plausible transition. If high-carbon production falls faster than low-carbon alternatives are phased in, shortages could result, driving up prices and disrupting economic activity. We believe that the transition will contribute to higher inflation than we’ve seen in the past, and this year’s developments – including the energy price shock – reinforce that view.

Policy steps up

The Inflation Reduction Act, and other recent infrastructure and science legislation in the U.S., could shape the transition to lower carbon emissions in the country and beyond. We see it as consistent with our view that the transition is likely to be accelerated over time but will be bumpy. The law’s nearly US$400 billion in tax incentives, rebates, grants and loans is likely to trigger changes in transition-linked investment and demand for renewable energy infrastructure and technology. We see the legislation cutting clean technology costs, creating incentives for private investment and spurring domestic manufacturing. It could also potentially accelerate state and local policy action, such as California’s climate and clean energy package, which adds US$54 billion of new spending on climate resilience.

Yet given that more than half of the incentives are uncapped — meaning the credits are available to as many that wish to take advantage — some analyses suggest the true impact could be more than double that. See the chart below. We would note that because the act focuses on incentives and not mandates, the ultimate investment levels will depend on the extent to which two important barriers can be overcome: 1) the requirements for local content and scaling up the supply of materials, and 2) the need for reforms to support securing building sites in a timely way – both for power generation and transmission infrastructure.

Public and private capital on the way

Estimated investment in U.S. energy supply, 2024-2035

The incentives are available to foreign investors without a U.S. tax base, so we also see the potential for a large inflow of foreign capital to the U.S. Whatever the ultimate amount of investment, we expect it to come across a broad range of sectors as the incentives in the legislation are also diverse across many sectors. We see that stimulating demand for a wide variety of low-carbon technologies such as renewable energy, heat pumps in buildings and electrified transport. Yet the biggest investment is likely to be in wind and solar energy, based on REPEAT Project analysis. See the chart below.

Investment targets

Total investment from the Inflation Reduction Act by 2035

The U.S. policy shift will likely diversify the geographic footprint of the clean tech sector now dominated by China. We see it reducing U.S. reliance on China, especially for sourcing materials, batteries and solar panels. The legislation could also influence other countries to adopt similar policies. It comes as the European Union’s drive for energy security spurred its REPowerEU plan for renewable energy investment. But the larger incentives in the Inflation Reduction Act are prompting competition concerns in the EU. Ursula von der Leyen, President of the European Commission, has called for an adjustment of EU rules to make it easier for public investment in clean energy. The recent state visit of French President Emmanuel Macron to Washington helped bring about some agreement on a path forward for the U.S. and EU.

We see the act causing sharp demand shifts in the economy, reinforcing supply constraints and bouts of higher inflation. The transition is one driver of the new regime of greater macro and market volatility. We believe this new regime means inflation will be more persistent longer term, and supports our preference for inflation-linked bonds and infrastructure debt.

An increasing driver of earnings

We expect shifting regulation and policy, changing societal preferences and new technology to influence consumption patterns – and impact the environment that all companies operate in. Companies must navigate this change – by deciding how to reduce emissions, if and how to adapt business models, where to invest and where to cut back. Ultimately, we see the transition as an increasing driver of potential profitability and cashflows for companies, likely becoming more influential over time. Strategic investors need to account for these changes, recognizing that earnings patterns for some industries and sectors could look notably different from the past.

In the fundamentals channel of our climate-aware CMAs, we assess how our base case of an accelerating transition will impact corporate earnings. This drives our expected earnings growth rates by sector – coupled with an assessment of how much of that is reflected in market prices - helps shape our expected returns for both equities and credit. Strategic asset allocation decisions require estimates of the big trends impacting sectors, but we don’t think the sector impact will be evenly felt by companies in a given sector.

We assess the sensitivity of earnings to carbon pricing initiatives. This can be thought of as capturing specific government policies – taxes or subsidies for lower-emission alternatives, technology developments that cut the cost of alternatives, or shifting consumer preferences. We estimate the sensitivity of earnings to these by: 1) direct and indirect carbon emissions; 2) expected emission reductions on current plans, and; 3) the ability of companies to maintain market share if their relative production costs increases. For higher emitting sectors – such as utilities, energy and industrials –  we expect these shifts to be a drag on earnings relative to other sectors. We still expect sectors, such as technology and healthcare, will feature companies better positioned to enable the transition due to their inherent low exposure to carbon emissions and potentially receive an earnings boost as a result.

Our CMAs consider the alignment of sector revenues with the transition. In this update, we see less of an earnings hit to the energy sector than previously assumed. The current pace of the global renewable energy buildout still falls short of what is required to meet energy demand at current climate commitments. More energy will be needed over the next 30 years even as the transition accelerates - see the chart below - partly as the West’s ambitions to weans itself from Russian energy creates additional demand for non-Russian energy supply. That’s one reason why carbon-intensive sectors and companies may potentially outperform others, especially during supply-demand mismatches of low-carbon alternatives.

Global energy demand still growing

Change in energy consumption, 2020-2050

We believe a portfolio that only gets exposure to the transition through low-carbon sectors and companies could miss important investment opportunities. A decarbonized economy will require the transformation of companies across all sectors, including those with a high carbon intensity today like utilities, transportation and cement. And those industries will need sizable investment to transform their operations: estimates from the International Energy Agency (IEA) suggest up to US$32 trillion by 2030 in a fast transition. That capex will in turn increase demand for the materials and inputs needed to retrofit and renew buildings, power and transportation systems. Investors can gain exposure to the transition through the assets of carbon-intensive companies with a credible transition plan or that act as enablers of the transition by supplying key materials, equipment and services. Commodities are a prime example: demand for some critical minerals could grow quickly as the transition progresses, according to the IEA.

Repricing: more to come

Structural shifts are typically underappreciated by financial markets. One example is demographics – the baby boom generation’s impact on the economy and financial markets played out through taste preferences and wealth flows over decades. This means asset prices can be slow to adjust to growth opportunities and risks, creating the potential of higher investment returns for investors who move early. We think the transition to lower carbon emissions could be similar.

We expect changing investor preferences in favor of sustainable assets could increase their value over time relative to assets perceived to be less sustainable. Why? More investable capital flowing toward sustainable assets as preferences shift. We see anecdotal and empirical evidence that this repricing is already at play and has room to run. In our February 2022 paper, we found that less carbon-intensive sectors like IT experienced positive repricing in 2020 – an effect that was negligible in the few years prior. We expect more repricing given shifting investor preferences and historical changes in risk premia for similar long-term transitions like demographic changes. The process of how valuations adjust is likely to be uneven, in our view. Transition-ready companies may not always generate the best financial returns for clients with a short time horizon.

Our long-term CMAs embed the view that ongoing shifts in investor preferences will likely push up the value of sustainable assets over time. These shifts in preferences mean that investors will likely demand greater compensation for holding less sustainable assets and lower compensation for holding more sustainable assets. That’s why during the process of asset prices adjusting, we believe more sustainable assets will have a higher return than they would otherwise during the transition – and less sustainable assets will likely have lower returns.

Academic research from Berk and van Binsbergen (2022) ties the extent of the repricing to three observable drivers: 1) the fraction of wealth owned by investors incorporating sustainability in processes; 2) the fraction of non-sustainable firms in the economy; and 3) the return correlation between sustainable and non-sustainable assets. See the table below to see how changes in these drivers affect the sustainability repricing dynamic and the appendix for more detail. Where our analysis extends the research from the paper above is to assume that we are not yet at a state where the repricing has played out, these variables will evolve between now and when the repricing is over. Rather than look to estimate an overall top-down impact – our previous approach - we take a view on these observable sub-measures and use the study above to derive the overall impact. We still arrive at the same conclusion: We see more asset repricing, with an increased potential return on sustainable assets and a potential discount on others over time.

How will these variables evolve? We believe that capital will keep flowing into sustainable assets. If wealth in the hands of investors favoring sustainable assets grows, we think it would increase the magnitude of the repricing (see the appendix and table to the right for the potential directional impact). The premium that investors will likely demand to hold less-sustainable assets will be greater the more plentiful they are and thus smaller when those assets are scarcer. See the second line of the table. If sustainable assets were perfectly correlated with the rest of the assets in the universe, there would be no return spread between them and the overall asset universe. The more they differ – the smaller the correlation – the greater the required premium. And we expect the risk exposures for sustainable assets to differentiate even further versus others as the transition accelerates. See the third line of table. We do not claim that the calibration we have is perfect or will not evolve further as we continue to learn more. These estimates are uncertain given the wide range of potential outcomes ahead. Yet by tying the overall effect to observable metrics, we can not only monitor these drivers of the repricing dynamic but also take a view on their evolution as the transition takes place. Our return expectations will continually evolve in a manner consistent with this underlying structure..

Portfolio implications

Our latest strategic views – see the table below – incorporate our views on how the transition is likely to unfold. It isn’t the primary driver of our return views – we incorporate the transition along with other drivers of investment risk and return. Yet the transition influences certain strategic investment views more directly than others.

Our overweight in inflation-linked bonds - one of our strongest conviction views – is one example. We believe the transition to lower carbon emissions will become a contributor to the new regime of higher macroeconomic and inflation volatility driven by production constraints – and which is not reflected in market pricing of inflation. We expect investors will demand a higher inflation risk premium because of this, reinforcing the overweight – one of our highest conviction views. Conversely, we are at our maximum underweight on developed market (DM) long-term government bonds.

Our positive view on DM equities relative to emerging markets (EMs) is another example. We prefer low emission sectors such as technology, healthcare and consumer discretionary that have a heavier weighting in DM indices compared to EMs. We believe these sectors may benefit from the transition. EMs are more economically exposed to the transition because of weights in sectors such as energy, utilities, and industrials. We think these sectors are more vulnerable to the massive reallocation of resources that the transition will entail.

Within broad equity indexes, it’s not just about holding companies with lower carbon intensity. Sectors that need the most investments are the ones that are carbon intensive. Investing in the transition also means investing in carbon-intensive companies that have credible transition plans, or supply the materials, services, and equipment needed for the transition. We think there could be continued demand and high prices for Western fossil fuels as the West weans itself off Russian gas.

Investors should also consider how to mitigate the impact on their portfolios from possible supply constraints during the process. If carbon-intensive production falls faster than lower-carbon alternatives are phased in, there could be periods of supply shortages and high prices for the carbon-intensive outputs that economies can’t yet function without. Excluding carbon-intensive exposures could mean portfolios are less resilient to these supply shocks. Investments in carbon-intensive companies with credible transition plans could potentially give investors exposure to the transition and make portfolios more resilient to supply shocks such as the one this year following the Ukraine war that drove up traditional energy prices. We believe exposures to other carbon-intensive companies can still be consistent with the transition. Even with a rapid transition, investment in oil and gas production will still be needed to meet future energy demand. These exposures carry risk - fossil fuel demand could erode faster than expected. Investors need to balance those risks against the benefit of mitigating the effect of supply shocks on portfolios.

More conviction in our strategic views

Hypothetical U.S. dollar 10-year strategic tilts, November 2022

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