The price of the future
Climate change is not new. The potential link between CO2 emissions and global warming was suggested as early as 1896 by Svante Arrhenius, a Swedish scientist. Levels of CO2 in the atmosphere began to be recorded by Charles David Keeling in 1958, laying the foundation for seminal scientific works that have firmly linked increases in global temperatures to greenhouse gas concentrations. And yet, only now are many investors truly waking up to the potential consequences of climate change.
Prompt measures to fight climate change could mitigate its impact, but they rest on societies’ willingness and ability to act. These, in turn, depend on myriad political, economic and societal factors, which render precise predictions of our economic and ecological future impossible. Nonetheless, schematic scenarios do exist, based on representative pathways designed by scientists.
Since the 1980s, the development of Integrated Assessment Models (IAM), which combine findings from the physical, biological, economic and social sciences, has greatly helped quantify the potential impact of climate change and can be used to inform policy making. However, highly divergent conclusions have been drawn from such simulations, as illustrated by the works of W. Nordhaus and N. Stern. For instance, their assumptions for the loss in annual economic output should global temperatures rise by 3oC range from 2% in the case of Nordhaus to 14% in the case of Stern2. And while the latter already advocated forceful action in 2006, the former, who adopts an "optimal path" perspective, is generally more nuanced.
Economists nonetheless agree that emissions of greenhouse gases are an externality (they generate a cost for society that emitters do not bear), which markets have so far failed to internalise. Putting a price on carbon is thus not only seen as a necessity; it is also widely considered as the optimal way to transition towards a low-carbon economy. Nonetheless, the price at which carbon emissions should be taxed remains subject to intense debate (estimates vary from USD40 to several hundreds of USD per tonne3). Of course, governments also have a major role to play in steering investments and behaviour through appropriate incentive schemes (subsidies, taxonomy, etc.).
The effects of climate change on asset classes are notoriously hard to assess given the wide variety of factors at play. Whether humanity choses to tackle climate change through innovation or ‘degrowth’, for instance, will mean dramatically different outcomes for our economic future. We therefore adopt a scenario-based approach, incorporating many variables to identify all potential risks and opportunities.
Major trends can be detected by analysing each asset class’s specific drivers and the transmission mechanisms from economic variables (such as real growth, inflation and interest rates) to asset prices. As the physical impact of climate change materialises and investor awareness grows of the cost of transition to a low-carbon economy, large differences could appear (for example, in the cost of capital) between climate-resilient assets and the rest.
Climate change is not just about risk. As the covid-19 crisis has shown, even major pandemics generate opportunities. Companies providing innovative solutions to climate change – or those exhibiting high resilience to it – can be clear beneficiaries, both in relative and absolute terms. Financial innovations, such as green bonds, will also facilitate the steering of capital flows towards climate friendly projects.
Central banks, wary of the potential consequences of climate change on financial stability, are increasingly likely to include ecological considerations in their decision-making process. This may lead to ultra-low interest rate policies to create the conditions required for massive long-term investment by public and private entities alike. Returns from fixed-income instruments could suffer as a consequence.
Climate change simply cannot be overlooked by asset owners, who can choose from a wide range of options available. Some may simply opt to avoid the most polluting firms, whereas others could aim to exert influence on corporate strategies through active shareholder engagement. What truly matters is that all, whatever their stance, have the opportunity to act now.