Stockholm (NordSIP) – Modelling how a paradigm shift like climate change and the energy transition will affect macroeconomic and financial variables is a daunting task. At a recent webinar, Schroders presented their forecasts for the 30-year impact of global warming on annual portfolio returns. Details about the model and its predictions were published in two separate reports and suggest an increased spread between developed and emerging markets.
Methodology – Costs, Temperature and Returns
The authors, Economist Irene Lauro (Pictured, right), and Strategist Tina Fong, explain that the model takes a three-stage approach. “The first step is a focus on what happens to output and productivity as temperatures rise, which we 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’. 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 and they are left in the ground.”
Although the three-step approach is a legacy of last years’ report, the authors have tweaked the details. While last year Schroders economics group had assumed a constant yearly rate of temperature increase of 0.04°C, the researchers were now able to allow the temperature increases to be determined within the model based on other variables.
“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,” the authors say. “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.”
The assumptions about the relationship between productivity and returns are also important. “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).” For fixed income, the authors followed Laubach and Williams, according to whom long-run equilibrium interest rates move in line with changes in trend growth in the economy.
Winners and Losers
Based on those assumptions, the authors model 30-year returns for cash, bonds, credit, equities, and real estate. In the main “partial mitigation” scenario, some action is taken to reduce carbon emissions. However, global warming is not altogether avoided in this scenario.“Temperature increases are more limited thanks to the introduction of carbon emission mitigation policies,” the authors explain.
However, as the authors argue, “higher temperatures are not always bad for growth”. Citing research presented by Burke and Tanutama at the US National Bureau of Economic (NBER) Research in 2019, Lauro and Fong argue that the effect of temperature increases depends on countries’ baseline temperature. Warm countries’ productivity falls with global warming, whereas it increases in colder countries. The alternative scenario is the “no climate change scenario.” It is notable that the warm-cold dichotomy overlaps to a very large extent with the developed-emerging market split.
The baseline scenario’s productivity dichotomy holds true for inflation as well. According to the authors, “overall, climate change will be inflationary where productivity is lower than in a no climate change scenario,” such as in South Korea, India and Singapore. In this case, cash returns, bond yields and equity market returns all rise.
“In comparison, [climate change] has a deflationary impact on the eurozone, Japan, UK and Taiwan, as they see an improvement in productivity thanks to a shift to clean technology,” the report adds. Unsurprisingly, cash returns, bond yields and equity returns all fall. “This has largely been driven by downward revisions to our policy rate forecasts for these economies,” presumably because the consensus has changed towards a more accommodative stance on the part of central banks.
Featured Image courtesy of Schroders