If we do not take action, the world lies on a path towards significant climate change with serious consequences for the entire world population. This will also influence the financial markets, either by new climate policies that are enforced to limit global warming or by the economic consequences of climate change. We take a closer look at the different climate scenarios and analyze their impact on investment portfolios.
This research paper is written by Gosse Alserda and Menno Altena, Investment Strategists in the Client Investment Solutions team of Aegon Asset Management.
By the year 2100, if no new measures are taken, the temperature on earth will probably rise to levels of 4°C higher than the pre-industrial period. This will have a significant impact on the habitability of many areas on earth. Even if large-scale measures are put in place to combat rising temperatures, it is likely that the impact of climate change will be with us for a long time to come.
Limiting global warming requires abrupt transition
In the Paris Climate Agreement, 185 countries agreed to limit the increase in global warming to 1.5°C above pre-industrial era levels. However, the measures currently being implemented are completely inadequate if we want to stand a chance of achieving this 1.5°C scenario. Additional climate policy is essential to achieve the 1.5°C scenario, whereby consumers and companies alike will have to make significant changes to their behavior and processes within a decade. This abrupt transition will come at a cost – directly or indirectly – to greenhouse gas emitters. Companies that emit a relatively high amount of greenhouse gases – or whose products are emission intensive - will see their profits decrease, resulting in losses for investors in those companies.
In this paper, a stress scenario based on carbon emissions per invested euro is used to study the potential impact of an abrupt transition on the investment portfolio. Figure 1 illustrates the negative return shocks as a consequence of different levels of carbon prices, based upon current carbon emissions for producing and consuming the products of the companies within four equity indices. The losses that occur in this scenario can be limited by putting more emphasis on sustainable investment solutions. Institutional investors who wish to gain insights into the financial risks of an abrupt transition can use this scenario to estimate the potential impact on the value of their portfolio.
Figure 1: Financial shock for different carbon prices. Source: Aegon Asset Management
Absence of policy measures have longer-term economic impact
We also investigate a scenario where little or nothing is done to curb climate change. In this scenario, scientists estimate a rise in temperature of 4°C or more in the long term. Compared to the abrupt transition, the short-term impact with the 4°C scenario is limited. However, in the long term, the impact of such a rise in global temperature will be significant: uninhabitable areas due to droughts and floods, more frequent, extreme weather events, and lower productivity of agricultural lands. Figure 2 plots the predictions in temperature rise and the impact on GDP growth according to several scientific studies. The estimates vary, but science generally agrees that the impact of a significant rise in global temperature on global GDP growth will be large.
Figure 2: Impact of global warming on GDP growth according to scientific studies. Source: Nordhaus and Moffat (2017), Aegon Asset Management
Given the gradual and long-term nature of the impact of this scenario – both on the climate and on the financial markets – there is less short-term necessity to adjust the portfolio from an investment risk perspective. However, from an environmental and societal perspective, this scenario is directly relevant. Investors can act now by investing their capital in such a way that the longer-term negative effects of global warming can be prevented.
Combination of transition risk and economic risk is more likely
The most likely outcome will be somewhere in between. A scenario between 2°C and 3°C temperature rise will see some transition risks but also some geophysical risks. It will therefore have characteristics of both the scenarios we discussed before. Carbon emissions will need to be reduced, resulting in a redistribution of profitability between companies, but the impact will be lower than we illustrated for the 1.5°C scenario. Furthermore, the geophysical risks will manifest themselves more acutely than the 1.5°C scenario. For example, there will be more extreme weather events leading to lower productivity and lower economic growth. But again this impact will be less than in the 4°C scenario.
Global warming will have serious consequences for the habitability of the earth. In order to limit the rise in temperature to not more than 1.5°C, countries will need to enforce climate policies that require an abrupt transition. Companies that emit a relatively high amount of greenhouse gases – or whose products are emission intensive - will see their profits decrease, resulting in losses for investors in those companies. When little or no action is taken to curb climate change, the rise in temperature – in the 4°C scenario - will have longer-term negative effects on the global economy. Investment portfolios that are more tailored towards sustainable investing can both mitigate the short-term climate policy risks, as well as contribute to limiting global warming and its economic consequences on the long run.