Being climate-aware is not simply a matter of applying a single tweak to return assumptions. It will require an evolution of existing valuation approaches, JANA’s Chris Worthington says in this Op-ed
The impact of climate change and the transition to a lower-carbon world will be the defining economic theme of the 21st century. In the face of that change, retrospective methods for projecting the likely risk and return associated with financial assets are inadequate for modelling future outcomes.
Institutional investors have been working to ensure that the return assumptions at the heart of advice are “climate-aware”, reflective of the changes that are coming or already incorporated into financial market activity.
The last decade has already produced meaningful financial impacts for climate-exposed stocks, with the “greenest” stocks outperforming the “brownest” by around 3 per cent per annum.
There are some simple and compelling theories for why this has occurred. Consumer preferences have shifted to wanting less carbon-intensive goods (for example, electric cars). Political drivers – both regulation and carbon-pricing mechanisms – have also favoured green stocks over brown stocks. Investors have been tilting their portfolios in a more climate-friendly direction, pushing green and brown stock prices in different directions through the weight of money.
Investors have been tilting their portfolios in a more climate-friendly direction, pushing green and brown stock prices in different directions through the weight of money
Recent results have been a boon for sustainability-focused investors who received better-than-expected returns while contributing to the transition to a low-carbon world. However, there are strong reasons from financial theory not to expect this performance to persist indefinitely.
A bedrock claim of theory is that in the long run, risk and return are related; climate risk should not be an exception. High-emitting stocks that are more exposed to climate risk should eventually have to offer higher returns to get investors to commit capital to them. Similarly, green stocks will be valued as potential insurance against unpleasant climate scenarios and retain their place in portfolios even if they offer lower returns going forward.
The tricky task for investors is identifying how far this climate-aware financial transition has to go. Put simply, just how cheap do brown assets have to become before they’re fairly priced?
This is not just a question of determining what investors should require to be paid for the differences in risk; climate-exposed stocks can differ in other important ways that matter for valuation. For example, green stocks often have far more “growth” characteristics than brown stocks, arising from the ongoing shift in consumer demand for their products. Generally, we see green industries as likely to grow faster in the immediate future, justifying some valuation differential.
Being “climate-aware” is not simply a matter of applying a single tweak to return assumptions. It is a challenge that is amenable to an evolution of existing valuation approaches. In estimating equity market returns, JANA has incorporated a top-down approach to empirically measuring the climate risk exposure, married with a bottom-up assessment of the market’s growth prospects.
The impact of a “climate-aware” approach compared to a traditional method can be material. For instance, a return assumption for the ASX 300 index which incorporates the browner industry mix (compared to other countries) and greater sensitivity to climate risk falls 0.3 per cent per annum compared to the status quo
The impact of a “climate-aware” approach compared to a traditional method can be material. For instance, a return assumption for the ASX 300 index which incorporates the browner industry mix (compared to other countries) and greater sensitivity to climate risk falls 0.3 per cent per annum compared to the status quo.
Therefore, it is critical to ensure that Australian equity managers themselves have a mature evaluation framework towards climate risk when constructing their portfolios.
A climate-aware assessment of future returns also must wrestle with the macroeconomic impacts of climate change, which naturally filter into all return scenarios and portfolio decisions for investors with long horizons.
Leading climate models agree that global GDP growth will be lower over the current century because of transition costs and increasing physical damages from temperature and weather impacts.
However, even with lower growth, the magic of compounding still means that future incomes will generally be substantially higher than today. Scenario modelling makes it clear that stronger policy action today goes a long way to mitigating distant physical risks, leaving future inhabitants of the planet better off. For that reason, JANA remains a strong advocate of policy actions that put the planet on the pathway to net zero emissions by 2050.
Economic theory normally predicts a linkage between lower growth and lower risk-free rates, but the climate lens suggests we should see dispersion in this area too. Some countries are more advanced on the policy front, and better prepared for the likely location-specific climate risks they face. Evidence suggests that the countries with greater climate exposure are already facing higher borrowing rates for issuing debt.
An inescapable reality of climate change is that it will bring increased risk to all investment strategies. This risk is fundamental and not easily mitigated, and is inherent in how much uncertainty there remains around policy, the degree of warming that will occur and the impacts of that warming. Historical experiences of realised risk may be understating the level of risk for future investments.
The potential for climate policy to escalate current inflationary pressures is another common concern. Central bankers traditionally argue that monetary policy can be used to restore inflation to target in the face of transitory pressures. But faced with the trade-offs from transitioning economies from high-carbon to low-carbon sectors without significant impacts on employment, a higher-than-target inflationary period may be inevitable.
Limiting and adapting to climate change will be one of the greatest challenges society will face in our lifetimes. As investors, we must recognise that climate change materially influences the construction of an investment portfolio.
Chris Worthington is Head of Quant & Risk at asset consultant JANA
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