Foresight

How climate change may impact financial markets


Each year Schroders’ economics and multi-asset teams join forces to produce 30-year return forecasts for a range of asset classes around the world. Until now, these forecasts have been agnostic on the subject of climate change, making no explicit adjustments for the physical and transition costs associated with global warming.

Ultimately, the potential channels through which climate change could impact growth and financial returns are too numerous, and indeed often unknown, for us to hope to model every moving part, particularly considering data constraints in poorer economies. Instead, we adopt a three step process.

The first step is a focus on what happens to output as temperatures rise, which we will refer to as the ‘physical cost’ of climate change. The second considers the economic impact of steps taken to mitigate those temperature increases, or the ‘transition cost’. This second step is slightly more complicated, in that there are a range of possible transition scenarios. Finally, we adjust for the effects of stranded assets. This is where we take account of the losses incurred where oil and other carbon based forms of energy have to be written off, as it is no longer possible to make use of them, such that they are left in the ground.

Notable throughout is the range of uncertainty, not only around the economic relationships but also policy responses. The choice of economic model, carbon price and the use of funds raised by a carbon tax all have material consequences for the final estimate. While we do alight on a central scenario, it would be remiss of us not to acknowledge the wide range of possible outcomes around this baseline.

Physical cost assumptions

First, considering the modelling of the physical impact, a non-linear relationship between temperature and productivity seems more plausible than a linear one. With temperatures much above 35 degrees Celsius, for example, the human body simply cannot function for long. Meanwhile, Russia and Canada are already enjoying benefits of a warmer world as the Arctic becomes more navigable. For this reason, we will take the Burke and Tanutama (2019) results as our assumption for the physical cost modelling. We then need to decide which iteration of their model we want to use. The authors ran models allowing for lagged effects as well as one in which contemporaneous impacts only were considered. Again, to us, a lagged relationship makes more sense. We are used to allowing 12 to 18 months for monetary policy to feed through, and responses to warmer temperatures are also likely to take time to fully play out.

Transition cost assumptions

Secondly, we need to make an assumption about the likely policy response. Inevitably, political calculations will at least partially drive the decision made by policymakers, rather than economic concerns over efficiency or climate-driven concerns over the degree of warming. Ultimately, we arrive at the conclusion that while we may see the adoption of a carbon tax, ‘optimal’ pricing may prove too expensive – both financially and politically – leading to suboptimal pricing and climate outcomes. This seems particularly likely when we consider that major economies face little short term incentive to reduce emissions, as many benefit from a warmer world.

 

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