Last February, we released our 2020 climate scenario analysis. That study helped us answer many of the questions around the investment implications of climate transition and physical risk. It also established an important new way for us to integrate climate-related risks and opportunities into our investment processes and client solutions. Scenario analysis involves modelling the effect of different climate outcomes – including different climate policies and alternative technology development paths – on asset prices. Each scenario is assigned a probability to help investors make better decisions.

How is our analysis different?

We’re very proud of our climate analysis approach because, unlike those used by many fund managers, it’s not a standard ‘off-the-shelf’ solution.

Instead, we tailor it to make more nuanced assumptions and to review more climate scenarios. It can also be updated to take into account changes in policy, technology and the structure of markets, as well as how companies are adapting.

Time for an update

We see further evidence of the continuing disparity between climate ambition and credible action. The urgency of the climate crisis has helped shape our first updates.

In the third instalment of our climate scenario analysis update, we look at what this may mean for government bond valuations in the post-Covid world.

Why sovereign bonds?

We’ve experienced growing client demand to extend the insights we gleaned from a similar exercise we undertook on listed equity and corporate bonds.

Government bonds account for a big share of assets under management. Asset owners are also under increasing pressure to understand and report the climate risks embedded within portfolios.

Key takeaways

The application of climate scenario analysis to sovereign bond valuations is still in its infancy. A lot more work is therefore needed before existing climate analysis frameworks are ready to be integrated into mainstream developed-market sovereign bond investment processes.

This is for four main reasons:

  1. Existing frameworks focus on climate scenarios that we deem to be highly unlikely. We want to concentrate on the most likely climate policy development paths;
  2. Scenarios with lower probabilities are largely not benchmarked against the climate-policy development paths we think are being priced into the market;
  3. The forecasting models used by central banks to anticipate possible reactions to climate-related shocks are too simplistic;
  4. Important cross-market differences in growth and inflation developments, and hence the outlook for monetary policy and interest rates, are glossed over by forecasting models.

We plan to conduct more research to overcome these deficiencies. In the meantime, we can only do a preliminary qualitative assessment.

That said, we can say: for most of the major sovereign developed bond markets, climate effects are likely to have a relatively modest effect on average yields over the longer term.

Climate effects are likely to have a relatively modest effect on average yields over the longer term

There are, of course, exceptions. For example, economies heavily dependent upon fossil fuels (e.g. oil and gas exporters in the Middle East) will feel a greater impact, while exporters of metals that are a key component of energy-transition technologies (e.g. Chile) will likely benefit.

What the financial industry can do

From a developed-market bond perspective, we believe that asset managers can play a more effective role in encouraging efficient and effective climate-risk mitigation by developing new environmental, social and governance (ESG), as well as climate-related, products.

These products offer asset owners the opportunity to invest in a more impactful way, by not only considering the climate risks, but also understanding the factors that drive climate policies introduced to address those risks.

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