Five market-moving sustainability risks with potential to impact now
Financial markets tend to view climate-related risks as long-term. But there are several factors that can impact portfolios within the coming few years – even months.
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Global warming and the energy transition are long-term themes – which is why Schroders has integrated these factors into our long-term return assumptions. As global warming intensifies over the next few decades and as we move towards the goal of achieving net-zero emissions, we want to help investors navigate the risks and opportunities arising along the way. These may have significant impact on markets and performance of portfolios. It is not just the physical or fundamental transmission of the sustainability-related risk or opportunity to financial markets that matters. Risks and opportunities can also be transmitted via the policy and controversy transmission mechanisms. These latter two mechanisms tend to crystalise world events into much more immediate-term market impacts.
We believe the following are among the investment themes unfolding over the next 6 to 24 months.
1. Extreme temperatures causing disruptions to economic activity
Extreme temperatures and precipitation are observed in various regions of the world. Severe heat in the US and Latin America, Southern Europe and parts of Asia is exacerbating dry conditions, affecting agricultural output, hydropower generation and shipping. One way these disruptions impact markets is via putting upward pressures on inflation. For example, recent research from the ECB found that the extreme heat recorded in the three summer months of 2022 alone caused a cumulative annual impact of 0.67 percentage-points on food inflation and 0.34 percentage-points on headline inflation in Europe, with larger impacts across Southern Europe.
The increase in food inflation is prominently visible in the record-high prices for multiple commodities including cocoa, coffee, olive oil, and oranges. Concurrently, years of sparse rainfall have strained global hydropower generation. This is becoming a significant issue in countries like the US, China and India, where the loss in electricity output could lead to higher energy prices. The US Energy Information Agency (EIA) has analysed the effects of drought in California. The analysis forecasts wholesale electricity prices in the state would increase by 5-7% relative to the median case in a drought scenario.
Power outages also mean a drag on industrial activity as the Chinese economy experienced in the summer of 2022, where factories had to shut down due to lack of electricity (chart 1). Finally, low precipitation also leads to worryingly low water levels, limiting the navigability of major trade waterways, such as the Panama Canal. This can mean higher shipping costs and delays in transportation of goods, impacting industries that rely on timely delivery of raw materials or finished products.
Climate-flation is likely to be an important investment theme as extreme temperatures continue to impact activity in various sectors. Investors can navigate the upward pressure on yields by reducing their interest rate exposure to markets heavily reliant on hydropower production and where food inflation has a big weight in the Consumer Price Index (CPI) basket. Additionally, another way investors could navigate this risk is by reducing their exposure to equities with high levels of supply chain dislocations.
Moreover, this summer, record warm ocean temperatures in the Atlantic were expected to lead to above-normal hurricane activity according to the National Oceanic and Atmospheric Administration (NOOA). Hurricane Beryl made landfall in Texas in July. Beryl was the earliest Category 5 (the most severe category for tropical storms) hurricane that has formed in the Atlantic, causing substantial damage in the US. Over 400,000 workers reported an inability to work due to adverse weather conditions in July. This figure didn't merely set a record, it exceeded the average for July by more than ten times (see Chart 2).
Hurricane Beryl likely served as an early indicator of the upcoming US hurricane season, with peak activity typically expected in mid-September. As a result, we may see softer labour data over the coming months.
2. Metals protectionism jeopardises the energy transition
The shift from fossil fuels to renewable energy sources is heavily reliant on metals such as lithium, cobalt and nickel. In response to growing demand and limited and geographically concentrated supply, some key producers may start adopting protectionist policies, e.g. export restrictions and, tariffs in order to protect domestic industries while ensuring availability for their own energy transition needs. This protectionist move could pose a significant challenge to the global energy transition by disrupting supply chains and increasing costs. Production is currently geared towards the following countries: China, Democratic Republic of Congo, Australia and Chile. The largest consumers likely to be most affected are US, EU, Japan, and South Korea. Investors could play this theme by allocating more to industrial metals and commodity currencies such as the Australian dollar.
3. Higher home insurance prices in the US on the back of more severe floods, storms, and wildfires.
According to insurance brokerage Policygenius, homeowners’ insurance costs in the US reached approximately $175 billion in 2023, reflecting a 21% upswing from the previous year. The notable rise is predominantly attributed to the impact of climate change, which has resulted in a greater frequency of severe wildfires, floods, and storms in the country.
US CPI only accounts for renters’ insurance without considering homeowners insurance. As a result, the surge in home insurance prices is not mirrored in the US inflation, and less likely to trigger a policy response from the Federal Reserve (Fed). Rising housing costs are however likely to be a drag on household spending, while putting downward pressure on house prices in markets severely exposed to extreme weather events. A notable example is Florida, where average household insurance premiums now comprise about nine percent of the state’s median household income, a figure set to rise. If rising costs of home ownership through higher insurance costs becomes overly onerous, varying divergences between house prices could emerge within a country, a state or even a county. In cases where defaults turn systematic, it could pose a risk to both insurance companies and the banking sector.
4. Slowdown of European sustainability legislation, as more right-wing support prevails. Suggestive of broader ESG backlash in EU as political agendas evolve?
There has been a notable increase in the representation of right-wing parties in the EU parliament. These parties often express scepticism regarding climate policies, and their political clout could potentially decelerate the EU's swift progression towards green energy. This shift increases the uncertainty for clean energy investors within the EU.
The election of Ursula von der Leyen for a second 5-year term as President of the European Commission will ensure that existing EU Green Deal laws are likely to remain as they are. However, it could be harder to get new green policies proposed, challenging the role of the EU as a climate leader.
On the other side of the Channel, the UK is likely to witness a boost to its green energy transition as the new Labour government wants to make Britain a clean energy superpower, investing in solar and wind technologies. In addition, Labour also wants to align both the to align both the ETS carbon market and the CBAM tax scheme with that of the EU. Should the UK also implement a carbon tax at its border, additional pressure would be exerted on the key exporting countries to raise carbon pricing schemes domestically. Investors could leverage the formulation of this ‘carbon club’ by favouring emerging market (EM) equities with a low carbon intensity vs those with higher carbon intensity.
5. Another round of corporate governance reform in Japan increases investors’ appetite for Japanese stocks
Some investors have partly attributed the recent rally in Japanese equities to corporate governance reforms in Japan. By maintaining a monthly list of companies that voluntarily disclose information on “action to implement management that is conscious of cost of capital and stock price”, the Tokyo Stock Exchange (TSE) has effectively pressured listed companies to deliver greater shareholder value. The initial focus was on companies with a price-to-book ratio below one. However, of late, the scope has expanded to encompass improvements in the overall management culture in Japan.
Japanese firms have gradually improved their governance practices due to pressure from various stakeholders. We believe this has played a role in the recent outperformance of Japanese equities. If this improved governance continues to augment capital efficiency and the modus operandi of Japanese companies, it could potentially drive sustained robustness in the Japanese equity market. Research conducted by Goldman Sachs shows that companies that have responded to TSE’s request for better governance have outperformed those that don’t.
Conclusion
Our sustainability risks and opportunities framework seeks to identify specific events that could feasibly occur in the world in the foreseeable future. We then assess the materiality of these risks and opportunities to financial markets and to our portfolios, and consider which actions we might take to position for them. Not everything that can happen, will happen. But being able to identify risks and opportunities in advance, puts us in a stronger position to respond proactively rather than simply reacting as situations evolve.
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