There is growing appetite among investors to allocate their portfolios in a more climate-aligned way. In some cases, this is driven primarily by concerns about the financial risks associated with climate change. For example, some investors report under Task Force for Climate-Related Financial Disclosures (TCFD) guidelines. Others wish to align their portfolios with 2050 net-zero objectives as outlined in the recently launched Net Zero Investment Framework. 1
At ASI, we’ve been working to address investors’ demands by exploring how the transition to net-zero emissions might affect long-term portfolio returns. We’ve developed a state-of-the-art climate scenario tool kit to allow us to estimate the effect of different climate scenarios on investment returns. We’re able to look at both generic asset classes (e.g. US equities, UK equities) and also innovative strategies such as climate-aligned index trackers and products focused on climate solutions.
Charts 1 and 2 show a base-case forecast for growth in electric vehicles, and solar and wind power in the coming decade.
At ASI, we’ve been working to address investors’ demands by exploring how the transition to net-zero emissions might affect long-term portfolio returns. We’ve developed a state-of-the-art climate scenario tool kit to allow us to estimate the effect of different climate scenarios on investment returns. We’re able to look at both generic asset classes (e.g. US equities, UK equities) and also innovative strategies such as climate-aligned index trackers and products focused on climate solutions.
The financial impact of the climate transition
The world is almost certainly not on course to achieve the Paris Agreement goal of ‘well-below 2C’. But it is starting to move in the right direction. Stronger government policies and improvements in low-carbon technologies mean large-scale change is very likely in several important business sectors. These include energy, transport, heavy industry, mining, real estate, infrastructure, farming and forests.Charts 1 and 2 show a base-case forecast for growth in electric vehicles, and solar and wind power in the coming decade.
Chart 1: Electric vehicle sales by region
Chart 2: Electric power generation by source
The predicted trends translate into very high rates of earnings growth for companies in these sectors. Analysts have estimated that aggregate earnings from renewable power generation will rise from around US$50 billion today to US$1 trillion by 2050.2 Conversely, demand for coal and, further into the future, oil and gas will eventually start to fall, suggesting low or negative earnings growth for these sectors.
When forecasting long-term equity returns in our strategic asset allocation, we use a simple discounted cashflow approach of the kind used widely by fundamental equity investors. In this model, long-term investment returns are highly sensitive to growth rates. In the simplest discounting equation3, the higher the growth rate, the higher the company’s value. So, if the winners of the climate transition have the kind of growth rates implied by Charts 1 and 2, they will merit high valuations.
High growth is even more valuable in the current secular economic environment because it’s harder to find. Also, the risk-free component of discount rates is extremely low. The risk-free rate is used in the standard discounting equation. Valuation is an inverse function of interest rates, so the lower interest rates go, the higher the valuation. The combination of low interest rates and high growth rates justifies high prices (see Table 1).
When forecasting long-term equity returns in our strategic asset allocation, we use a simple discounted cashflow approach of the kind used widely by fundamental equity investors. In this model, long-term investment returns are highly sensitive to growth rates. In the simplest discounting equation3, the higher the growth rate, the higher the company’s value. So, if the winners of the climate transition have the kind of growth rates implied by Charts 1 and 2, they will merit high valuations.
High growth is even more valuable in the current secular economic environment because it’s harder to find. Also, the risk-free component of discount rates is extremely low. The risk-free rate is used in the standard discounting equation. Valuation is an inverse function of interest rates, so the lower interest rates go, the higher the valuation. The combination of low interest rates and high growth rates justifies high prices (see Table 1).
Table 1: Interest rates and growth rates determine an asset’s fair value
Source: Aberdeen Standard Investments, Dec 2020
- IIGCC Net Zero Investment Framework 2020.
- UBS ref
- P = D/(r-g) where P is fair value price, D is dividend in year 1, r is discount rate (comprised of the risk free interest rate and the equity risk premium), and g is the earnings growth rate. Low risk rates and high earning growth justify high valuations.