The Price of the Future—how climate issues could affect economies and financial markets
While the true physical impact of climate change may only reveal itself over several decades, major transition efforts by governments, corporations, investors and citizens alike are already gaining momentum, with noticeable consequences for macroeconomic balances and financial markets.
In financial markets, a strong self-reinforcing mechanism is at play that should not be underestimated. As soon as a sufficiently large share of the investment community starts acting according to strict environmental criteria, these become de facto market-moving drivers worth monitoring.
There is significant evidence suggesting that we have reached that point. Valuations and performances of assets with contrasting environmental, social and governance (ESG) profiles have started to diverge notably. Research points to excess returns of 100-300 bps between ‘Paris Agreement-aligned’ benchmarks and regular cap-weighted indices, with an acceleration in recent years. Professional investors are rushing to integrate new, expanded datasets and benchmarks into their investment process as a result and are engaging more forcefully with corporates on ESG matters. Flows into sustainable assets also leave little doubt that a major rebalancing is underway.
'In financial markets, a strong self-reinforcing mechanism is at play that should not be underestimated.'
Carrots and sticks
There is intense debate as to how best to overhaul economies to reach carbon neutrality in the space of just 30 years as required under the terms of the 2015 Paris Agreement. In the end, the debate boils down to carrots and sticks. Some would like to emphasis penalties on parties that fail to meet climate goals, whereas others think positive incentives are most likely to achieve results.
Those who prefer the sticks-based approach want to build sufficient constraints into the economic system (for instance via carbon pricing or regulation) to force the pace of change towards carbon neutrality. The concept of a carbon tax in particular, has been gaining traction in recent years. By contrast, a carrots-based approach aims to create massive rewards for economic stakeholders that come up with low-carbon solutions. Subsidies and grants for large green infrastructure investments would fall into this category.
Policy makers are likely to adopt a mixture of these two approaches, both of which have their merits but differ significantly in a number of respects. The first difference concerns who bears the cost. In the more punitive approach, most of the cost is immediately transferred to corporations and consumers, which are left coping with higher prices due to additional taxes or regulation. If they adopt an approach more skewed towards positive incentives, states are more likely to leverage their own balance sheets to free up resources. But while the economy might receive an immediate boost, the cost of such government incentives would be passed on to future generations via public debt.
'Whatever the path embarked upon, transitioning towards carbon neutrality is an unprecedented challenge that will require all economic sectors and stakeholders to undertake massive change.'
Second, both approaches prioritise different things. A carrots-based system tends to give precedence to economic growth at the risk of underdelivering on real climate transition, whereas a sticks-based approach puts more emphasis on ensuring significant emissions reduction—but at the price of a more immediate hit to economic activity.
Whatever the path embarked upon, transitioning towards carbon neutrality is an unprecedented challenge that will require all economic sectors and stakeholders to undertake massive change. All asset classes will logically be impacted. Cash-flow projections can no longer ignore the potential consequences of climate change on the durability of business models and potential margin erosion linked to carbon pricing. Valuations of sustainable businesses will increasingly reflect their superior resilience and lower financial, regulatory and reputational risk. Interest rates are also likely to be affected as central banks progressively include climate considerations in their decision-making process.
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