How “Climate-Awareness” changes the financial outlook … for everything

The impact of climate change on our environment, and the transition to a lower-carbon world, will be a dominant financial and economic theme over this century. In the face of that change, backward-looking methods for projecting the likely risk and return associated with financial assets are likely to be inadequate for modelling future outcomes. JANA has been undertaking work to ensure that the return assumptions at the heart of advice are “climate-aware” – that is, reflective of the changes that we believe are coming, or in some cases, are already incorporated into financial market activity.

In this article, we outline growing evidence for climate-change exposure as a driver of financial returns on an asset-by-asset basis. We then reconcile the evidence with financial theory and show how that has influenced our own asset class return estimates. Finally, we consider how climate change will influence the fundamental macroeconomic drivers of investment advice.

The new climate finance facts

There is now a large body of research into the historic performance differential between “green” stocks – typically defined as low in carbon emissions – and “brown” stocks. A recent attempt to unify previous literature found that the greenest stocks outperformed the brownest by around 3%p.a. over the 2010-2021 period.ⁱ

There are some simple, and compelling theories for why this has occurred. Consumer preferences have shifted to wanting less carbon-intensive goods (think electric cars). Political drivers – both regulation and carbon-pricing mechanisms – have favoured green stocks over brown stocks. Investors themselves have been tilting their portfolios in a more climate-friendly direction and have pushed green and brown stock prices in different directions through the weight of money.

In our view, the compelling evidence that this a structural change and not just a fleeting theme comes from research showing that green and brown stocks each move as a group in response to changes in climate concerns (as measured in media stories).ⁱⁱ Climate exposure is a causal factor (like “sector” or “size”) that is now needed to explain the direction and size of one company’s stock returns in relation to those of another.

When facts clash with theory

The last decade has 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 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 parsimonious view of recent history is that investors have shifted from brown assets to green assets, for preference and risk-based reasons. Green asset prices have risen in relative terms, meaning they are becoming more expensive relative to future earnings than brown assets. Consequently, in equilibrium – that is, once short-term and transitory effects subside – expected returns for brown assets will tend to be higher than green assets.

Reconciling theory and evidence in our return assumptions

What is straightforward in theory is not always easy to use in practice. It is not obvious when the transition of demand from brown to green investments will become the new equilibrium. 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 need to be paid to take on the extra risk; green stocks can differ in other important ways that matter for valuation. Green stocks often have far more “growth” characteristics than brown stocks, arising from the ongoing shift in consumer demand for their products. In general, we see green industries as likely to grow faster for the immediate future, justifying some valuation differential.

It is apparent that being “climate-aware” is not a simple tweak to existing models. But it is a challenge that is amenable to an evolution of existing valuation approaches. For instance, in estimating equity market returns, we have incorporated a top-down approach to empirically measuring the climate risk exposure, married with a bottom-up assessment of the market’s growth prospects given the green and brown exposures of the underlying industry mix.

The impact of a “climate-aware” approach compared to a traditional approach can be material. For instance, a return assumption for the ASX 300 index which incorporates the browner (compared to other countries) industry mix and greater sensitivity to climate risk falls 0.3%p.a. compared to the baseline. It is therefore critical to ensure that Australian equity managers themselves have a mature evaluation framework towards climate risk when constructing their portfolios.

The ubiquitous economic impacts of climate change

A climate-aware assessment of future returns also must wrestle with the macroeconomic impacts of climate change, which naturally percolate 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. 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.

Perversely, traditional valuation approaches discount the negative impacts of climate on the distant future heavily and consequently suggest little impact on today’s asset prices, or even prefer a scenario of climate inaction in the short-term even if the long-term consequences appear disastrous. (Which is why many serious economic appraisals of climate change argue the philosophic case for valuing the welfare of the future as highly as the present).

Economic theory would normally predict a linkage between lower growth and lower risk-free rates, on average. 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.ⁱⁱⁱ

Buttressing portfolios for greater climate risk

An inescapable reality of climate change is that it will bring increased risk to all investment strategies, and that risk is fundamental and not easily mitigated. It is inherent in how much uncertainty there remains around the future path for policy, the degree of warming that will occur, and the impacts of that warming. We recognise that there are substantial tail risks around higher temperatures, natural feedback loops, and the unknown level of risk that manifests in disrupting critical eco-systems.

Historical experiences of realised risk may be understating the level of risk for future investments. Research has made this explicit: climate change brings greater uncertainty about the future level of returns, and this can compound over time, making climate change particularly daunting for the long horizon. This is contrary to typical advice that assumes long-horizon investors can be more comfortable taking on market risks that over time should largely balance out.^iv

The potential for climate policy to escalate current inflationary pressures is another common concern. Central bankers traditionally argue that monetary policy can also be used to restore inflation to target in the face of transitory pressures. But faced with the trade-offs from transitioning the economies from high-carbon to low-carbon sectors without significant impacts on employment, a higher-than-target inflationary period may be inevitable.^v

Investors in risky assets face several headwinds, and we expect they will ultimately need to be offered higher returns to maintain their allocation to equities (as is the case now for brown stocks with direct climate exposure).

Conclusion

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. While substantial uncertainty remains, JANA is comfortable that those impacts are directly incorporated into our underlying assumptions about the investment landscape.

ⁱ “Where is the Carbon Premium? Global Performance of Green and Brown Stocks”, Michael D. Bauer, Daniel Huber, Glenn D. Rudebusch, and Ole Wilms, 2023.
ⁱⁱ “Dissecting Green Returns”, Lubos Pastor, Robert F. Stambaugh, and Lucian A. Taylor, 2022
ⁱⁱⁱ This Changes Everything: Climate Shocks and Sovereign Bonds, Serhan Cevik and João Tovar Jalles, IMF Working Paper 20/79, 2020
^iv “Climate Change and Long-Horizon Portfolio Choice: Combining Insights from Theory and Empirics”, Mathijs Cosemans, Xander Hut, and Mathijs van Dijk, 2022
^v “Is the Green Transition Inflationary”, Marco Del Negro, Julian di Giovanni, and Keshav Dogra, Federal Reserve Bank of New York Staff Reports, no. 1053 February 2023

Click here to read the article: Embracing Climate Awareness