Weighing the investment implications of climate change policy
- The transition to a low carbon economy could be “sticks-based,” with governments mandating sustainable behavior. Or it could be “carrots-based,” with governments incentivizing green behavior through subsidies.
- During the transition, significant geographical and sector differences will emerge. An active approach to security selection can be valuable.
- Investors can benefit from climate-related opportunities before they are priced in. They should construct their equity portfolios to be “transition ready.”
An orderly transition to a low carbon economy is nothing for investors to fear.
With global temperatures on track to increase by more than three degrees by the end of the century, shifts in public climate policy could begin to accelerate within our 10- to 15-year investment horizon. By moving early, investors can benefit from climate-related opportunities before they are priced in.
As we see it, the transition to a low carbon economy could be “sticks-based,” with governments mandating and enforcing sustainable behavior and private businesses bearing the bulk of the cost of the transition, or it could be “carrots-based,” with governments incentivizing green behavior through subsidies and other forms of fiscal stimulus. At this stage, it’s unclear which path will be chosen. In contrast, the evidence is clear that reducing the energy intensity of GDP (the “fewer fossils” approach) will not be enough to offset the impact of a growing economy and avoid significant increases in temperatures. It will be essential to also generate energy in less carbon-intensive ways (the “more green” approach).
In aggregate, the impact of the transition to a low carbon economy on GDP growth, inflation and interest rates is likely to be limited, although much will depend on whether a sticks-based or carrots-based approach is adopted. But significant geographical and sector differences will emerge, we believe. Countries like Russia, India and South Africa are likely to be hit harder by a shift to a low carbon economy, lacking the fiscal headroom to cushion the blow. In contrast, most European countries seem better positioned.
How might the transition to a low carbon economy impact equity markets? Here we see various countervailing forces at play. Assuming governments take some action to address climate change (our base case scenario), dividend discount models using current discount rates suggest that the drag on corporate profitability may lead to a modest fall in average equity valuations of around 3%. There are a number of plausible counterbalances, however. Insulating economies from exogenous oil price volatility may feed through to lower macroeconomic volatility and thus reduce equity risk premia (supporting equity valuations). Similarly, the level of interest rates and the types of fiscal policy enacted will affect equity valuations over our 10- to 15-year investment horizon.
The impact of the climate transition across and within individual sectors is likely to vary significantly. Sectors that stand to gain include renewable energy and green infrastructure. The sectors likely to be hit the hardest: energy, consumer cyclicals (especially autos), materials and some utilities. A company’s emissions intensity and its capacity to pass on carbon costs to consumers will determine how difficult the climate transition will be.
The nuanced impact of climate change and the transition to a low carbon economy underscores the value of an active approach to security selection. We believe that investors should construct their equity portfolios to be “transition ready.” This can help insulate them from the risks of climate change while seizing the investment opportunities made possible by the transition.