Climate scenario analysis – a unique investment framework

Climate change is one of the defining issues of our age. Its physical manifestations are negatively affecting ecosystems, human health and economic infrastructure. The transition to a zero-carbon economy presents significant challenges, but also opportunities for investors.

To properly account for these risks and opportunities we have developed a unique approach to climate-scenario analysis. Through this, we integrate the macro and micro drivers of climate impacts on asset prices within a probabilistic framework. Our insights are then embedded in our business strategy, investment processes and the development of climate-driven solutions for our clients. In doing so, we believe we can build more resilient portfolios and generate better long-term returns for clients.

You can explore our approach more fully in our White Paper but, to whet your appetite, in the coming weeks we will bring you a series of shorter articles. We hope these will illuminate our thinking and encourage you to read our full paper. The articles fall under the following headings.

  1. Climate scenario analysis – our rigorous framework gives vital insights into the future of energy
  2. Climate scenario analysis –  dispersion is king, underscoring the value of active management
  3. How climate scenario analysis is changing the questions we ask
  4. Climate scenario analysis – looking to the long term for investors

The premise

Driving our approach to climate-scenario analysis is the view that a forward-looking rigorous and transparent methodology is essential for sound investment decision-making. It also helps us encourage positive change in the companies in which we invest. But what makes our approach unique?

To answer that, let’s compare it to the most common approaches in the investment community. In our experience, they typically draw on ‘off-the-shelf’ climate scenarios that do not allow for any real design input from the asset managers themselves. This approach facilitates comparability and can be useful for policy design. However, it usually comes at the expense of unrealistic assumptions like that Europe and China’s climate policies will be identical over the coming decades. This is clearly implausible and weakens the usefulness of scenarios for investment integration and product development.

By contrast, we build bespoke climate scenarios that allow us to make more nuanced assumptions about how different countries apply climate policy, as well as how different technology pathways might shape the future differently. We also draw on a much larger number of scenarios than is common elsewhere. This has the major advantage of allowing us to identify and analyse the consequences of a much larger proportion of the long-term climate-related probability distribution.

Importantly, we believe climate-scenario analysis is a journey rather than a one-off project. We intend to update our analysis annually, taking into account changes in policy, technology, and the structure of markets, as well as how companies themselves are adapting to climate change. This means our insights will continue to evolve, allowing us to identify new risks and opportunities as they emerge.

Our insights will continue to evolve, allowing us to identify new risks and opportunities as they emerge.

How does this look in practice?

Climate scenario analysis – our rigorous framework gives vital insights into the future of energy

Our bespoke approach to climate scenarios helps us generate a detailed picture of what the energy sector might look like in the future. This implies that the zero-carbon energy transition that is already underway it highly likely to continue.

For example, solar photovoltaic is likely the biggest winner from the energy transition. Even in our least favourable scenario, the share of solar in the power sector’s energy mix doubles to 4% by 2050. This increases to 25% in our mean scenario and almost 60% in some strict action scenarios. Onshore and offshore wind are also likely to be large beneficiaries, though to a lesser extent.

The outlook for fossil fuels is naturally more challenged. Coal has the bleakest future because it is the dirtiest fuel and the most sensitive to attempts to rein in emissions in the global power sector. The energy transition also implies weaker long-term demand for oil, particularly if electrical vehicle technologies continue to become more cost competitive. Natural gas likely has a larger role to play in the future of energy, at least as a transition fuel. However, the outlook is very dependent on the extent to which the relative price of renewables continues to fall, as well as developments in carbon capture and storage. We explore more of our scenarios in our next article.

Climate scenario analysis –  dispersion is king, underscoring the value of active management

Of course, we are asset managers and our primary function is to create sustainable returns for our clients. So, armed with our climate scenarios, we next explore their estimated financial impacts. In the main, the impact of climate change on returns for aggregate asset prices, including global equities, is extremely modest. By our measure, it has a +/- 2% impact on aggregate valuation in most scenarios. This is roughly equivalent to losing one quarter of average returns on the S&P 500 over the past 50 years.

Within aggregate sectors, though, there is great dispersion across sub-sectors, firms and regions. The largest risks and opportunities are concentrated in the energy, utilities, industrials, materials and information technology sectors. Renewable-energy-based utilities significantly outperform coal utilities. Meanwhile, copper and lithium miners do much better than coal miners. And oil-equipment manufacturers lose out to battery, wind-turbine and solar-panel manufacturers.

This implies a large opportunity to draw on scenario analysis to add alpha to actively managed investment portfolios. There are also more systematic opportunities for investment strategies that tilt towards climate-transition winners and for thematic climate-solutions portfolios. We look at this in more detail in our article Climate scenario analysis –  dispersion is king, underscoring the value of active management

How climate scenario analysis is changing the questions we ask

How does this translate to your investments? In the coming months, we will fully integrate our climate scenario framework and insights into our business strategy, as well as the key stages of our investment process.

At the stock level, we can integrate the results into active stock selection by asking critical climate-related research questions that are informed by our scenario analysis. Our answers will complement our broader company research, including our assessment of the credibility of firms’ transition strategies. This in turn will allow us to construct portfolios that are resilient to different, plausible climate pathways. We explore this further in our article How climate scenario analysis is changing the questions we ask.

We will also fully integrate climate risk and opportunity into our Strategic Asset Allocation framework. We take you through this process in our article Climate scenario analysis – looking to the long term for investors.

Meanwhile, we are developing a wide range of innovative climate-change solutions for our clients, including net-zero-driven solutions. Indeed, investment teams across ASI are developing an array of climate-driven products to support the energy transition and meet investors’ climate goals. These include a multi-asset climate fund; a global equities climate and environment fund; and a credit climate-transition bond fund.

Final thoughts …

We believe our approach to climate-scenario analysis is unique and sets us apart from other asset managers. It helps us understand how physical climate change and the energy transition affect the investment returns of the companies and markets in which we invest. We believe it also allows us to build more resilient portfolios and generate better long-term returns. Perhaps most importantly, the framework is the beginning, not the end. Our approach will continue to develop and evolve as we move towards a more sustainable world.

Download the white paper

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.