Climate change and efforts to curb it will have major economic outcomes, not just far into the future but even over the next five years. Yet climate change is completely ignored in most economic projections or long-term return expectations. As a result, many investors are making asset allocation decisions that are based on unrealistic future scenarios.
Since climate change is real, we believe the two scenarios to compare are: one, a transition to a low-carbon economy and; two, a no-climate-action scenario with no mitigation of damages. This comparison turns on its head the commonly held view that tackling climate change has to come at a net cost to the economy. On the contrary, it should drive significant improvements relative to no mitigation measures being taken.
As our base case, we assume an orderly “green” transition takes place, in line with the IMF’s recommendations, including subsidies for renewable energy. Without those actions, we estimate physical and other climate-related damages could lead to a global cumulative loss in economic output of nearly 25% over the next two decades1. The transition to a more sustainable world has only just started, and we see it as a historic investment opportunity.
A framework for incorporating climate change
Why is it that climate considerations are rarely included? It is challenging to do so. No one knows yet what a low-carbon world will look like and climate change projections are highly uncertain. This is due to the complexity of modelling the dynamics and myriad dependencies between climate and carbon emissions, economic variables and mitigation policies. But the difficulty involved in modelling climate change is no excuse to ignore it altogether.
At the BlackRock Investment Institute, we recently updated our capital market assumptions (CMAs)– our long-run estimates of returns across asset classes – to account for the effects of climate change. While this represents our best assessment, we acknowledge this is an uncertain endeavour and we will work to refine it as we learn more.
The framework we use contemplates the macroeconomic impact of climate change, the repricing of assets to reflect climate risks and exposures, and the effect on corporate fundamentals.
Consider each of these three channels in turn. First, macroeconomic variables will almost certainly be different in a world that is transitioning to a sustainable future. We see changes in so-called risk premia for all asset classes – the compensation investors require for holding them.
Second, the price investors are willing to pay for sustainable assets is changing. A BlackRock survey in September 2020 found 425 institutional investors planned to double their sustainable assets under management in the following five years to 37%. We see changing investor preferences spurring a climate change-led repricing due to the falling cost of capital for sustainable assets. Once this repricing phase has passed, we believe this channel will eventually no longer be a boon for “greener” assets’ expected returns.
Finally, climate change and policies will affect profitability across sectors. This will have knock-on effects for other variables such as credit default and downgrade assumptions. To arrive at corporate profitability estimates, we first assess the sensitivity of earnings to carbon pricing. We then assess the impact of transition risks and physical risks as well as opportunities.
We focus on climate because we believe a broad consensus around its impact and measurement suggests that climate change is fast becoming a key driver of asset pricing.
The investment implications are significant. Broadly, we see developed market equities best positioned to capture potential opportunities at the expense of high-yield and some emerging market debt. The constituents of developed market equity indexes generally have less vulnerability to transition risks and lower carbon intensity. Equities also can better capture potential upside, as bonds are capped in their capital appreciation.
It’s worth looking under the hood, as the relevant unit of investment analysis is really at the sector level. There will be winners and losers – underpinning why we believe a sectoral approach to sustainable investing is more appropriate than a regional one. Likely beneficiaries include technology and healthcare, we believe, while laggards include energy and utilities. We expect the climate effect to result in an annualized return differential of about 7% between the energy and technology sectors over the next five years2. That’s a significant difference in a world of low expected returns across asset classes.
Chart: Return assumption differentials in green transition vs. no-climate-action
For illustrative purposes only. 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 U.S. dollar expected returns over the next five years from now for four sectors of the MSCI USA Index in our base case of a ‘green’ transition (policies and actions taken to mitigate climate change and damages, and to limit temperature rises to no more than 2 degrees Celsius by 2100) vs. a no-climate-action scenario. The estimated sectoral impact is based on expected differences in economic growth, corporates earnings and asset valuations across the two scenarios. Professional investors can access full details in our Portfolio perspectives and CMAs website.
Our three-channel framework – macroeconomics, pricing and fundamentals – allows us to systematically monitor key metrics as the green transition takes shape. We see this as only the beginning: we will monitor, enhance and add to our framework over time as data improves and our thinking evolves. One thing is clear: to exclude climate considerations from asset return expectations would be to ignore reality. It is a vital input for economic projections, return expectations and portfolio construction.
 BlackRock Investment Institute
 BlackRock Investment Institute