Foresight

How climate change could impact investment returns over the next 30 years


Each year Schroders’ team of economists helps investors take a truly long-term view with 30-year return forecasts for a range of asset classes around the world.

Uniquely, these forecasts take into account the impact of climate change, which is overlaid across a series of building blocks to come up with our estimates.

This year we’ve refined the methodology to better capture the impact of climate change on our return forecasts. In particular, the analysis now reflects the fact that temperature rises are not uniform, but determined within our modelling. It also captures the transition impacts of economy-wide decarbonisation and a shift in investment towards clean energy.

The results from our latest update are slightly lower forecast returns across equities and fixed income. More than ever, the findings emphasise the importance of an active approach for the years to come.

How our forecasts work

Part one of our paper, which can be found here, explores our methodology in detail. In summary, we use a three-step approach to incorporate climate change into our macro economic assumptions.

  1. The physical cost of climate change: what happens to output and productivity as temperatures rise.
  2. The transition cost: the economic impact of steps taken to mitigate those temperature increases.
  3. Stranded assets: we take account of losses incurred when oil and other carbon based forms of energy have to be written off. This happens when it is no longer possible to make use of them and they are left – or stranded - in the ground.

Productivity is a key driver of asset returns in the long run. In equities, our return assumptions use a Gordon’s growth model approach, in which returns are generated through the initial dividend yield and the growth rate of dividends (via earnings growth). Earnings are assumed to grow in line with productivity, because we believe that over the long term productivity is a good measure of how well capital is invested.

In fixed income, productivity also plays an important role as we can use it to modify our interest rate and bond returns. Long run equilibrium interest rates move in line with changes in trend growth in the economy. Assuming that the supply of labour is not affected by climate change, then changes in productivity feed directly into changes in trend growth. In turn, this directly affects the long run or equilibrium interest rate for the economy.

What’s different compared to last year is that this time we’ve worked with Cambridge Econometrics to apply its E3ME energy-economy model to our productivity and inflation forecasts. These are the key inputs into our return forecasts through their influence on interest rates and profits growth.

The E3ME is a global macroeconometric model that captures the interactions between economies, energy systems, emissions and material demands.

Last year alongside temperature changes, our focus was on the impact of higher carbon taxes on future growth and inflation. Using the E3ME model we are now able to fully capture the transition impacts of economy-wide decarbonisation and a shift in investment towards renewables.

Find out more in part 1 of our paper here.

Winners and losers of climate change

Part two of the paper (found here) includes our 30-year return forecasts for cash, bonds, credit, equities, and real estate, incorporating the impact of climate change.

Our base case for climate change remains that some action is taken to reduce carbon emission. We’ve called this the “partial mitigation” scenario.

This has an impact on an economy’s productivity. In simple terms, the productivity of ‘colder’ regions generally increases as annual temperatures increases. On the other hand, productivity is broadly lower in ‘hotter’ regions due to temperature rises. But some ‘hotter’ economies can boost their productivity by investing in low-carbon technologies.

Cash return forecasts are revised lower

One of the key building blocks for our long-run forecast is our assumption regarding the returns on cash. There forecasts are almost entirely driven by movements in key policy rates in the major developed economies.

Overall, our real cash rates in the developed world are assumed to be lower compared to last year’s forecasts, which is largely a consequence of the Covid-19 pandemic. To arrive at our nominal cash return forecast, we combine our assumption on real cash rates with inflation expectations over the next 30 years.

With climate change, our cash return forecasts for developed economies such as the US, UK and Japan are lower but higher for economies such as South Korea and Singapore (chart 1). The upgrade has been mostly driven by our climate change adjustments to productivity.

30-year-returns-1.jpg

Sovereign and credit bond returns weighed down by cash downgrades

Our return assumption on sovereign debt builds on the return we have for cash, adding a term premium to forecast the returns to longer maturity (10-year) bonds.

Compared to last year, sovereign bond forecast reductions for the major developed markets are largely driven by downward revisions in our assumptions on real cash returns.. In comparison, our government bond returns for Asia Pacific have been upgraded since last year, as cash returns for Australia and Singapore are now higher than our previous estimates.  

Meanwhile, our credit returns are forecast using the excess return of  both investment grade and high yield over sovereign bonds. The two key drivers of credit’s excess return are the changes in spreads and the expected loss through defaults, both of which are closely linked to the economic cycle.

For investment grade credit, we also attempt to account for losses from credit rating downgrades. Given that we have revised US, UK and eurozone cash returns lower, it should not be surprising that credit returns are also expected to be lower as a consequence of climate change.

Equity return forecasts are broadly lower with climate change

Climate change matters a lot for equities. The associated higher temperatures and costs of transition, including stranded assets, affect equities through their effects on productivity growth. Once we adjust for stranded assets in our partial mitigation scenario, it is clear that there will be winners and losers as a result of climate change.

Chart 2 shows the total impact of climate change on our equity returns. In particular, European equities will see a productivity boost thanks to a shift to clean technology and see minimal losses in terms of stranded assets.

Climate change is bad news for equity investors in emerging markets, although this region still delivers higher returns compared to most of the developed markets. The US will also see lower returns in a partial mitigation scenario due to the drag from stranded assets and transition costs.

30-year-returns-2.jpg

While climate change factors are behind the largest portion of the changes in this year’s forecasts, updates to our underlying equity assumptions also play a key role. In particular, relative to last year, starting dividend yield assumptions are driving lower equity returns in most of these markets.

30-year-returns-3.jpg

Equities still on top with sovereign and credit left further behind

To summarise, compared to last year, we have generally revised expected fixed income returns lower given the fall in the long-term neutral interest rates. Our equity returns forecasts have fallen for most developed economies.

US equity returns are slightly lower due to climate change and the decline in the initial dividend yield assumption. This has contributed to the downgrade in the forecast for global equities.

By contrast, there have been upward revisions to equity return forecasts in Asia Pacific led by productivity gains. Meanwhile, our forecasts suggests that credit and property will still deliver better returns than sovereign bonds. Overall, the return gap between sovereign bonds and equities has widened since last year.

So investors will still feel pressured to move up the risk curve in search of higher returns, over the next 30 years, underlining the importance of investing actively.

Part two of the paper can be found here.

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