BlackRock’s Weekly Market Commentary: Don’t ignore climate risks in portfolios

By BlackRock Investment Institute

Severe climate events around the world this year have intensified debate around the effects of climate change and the risks they pose to portfolios. Investors should no longer view the transition to a low-carbon economy as a distant event only, in our view, as it is happening here and now. Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today, in our view.

Chart of the week

Equity return assumption change: green transition vs. no-climate-action

For illustrative purposes only. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise – or even estimate – of future performance. Sources: BlackRock Investment Institute, with data from Refinitiv Datastreamand Bloomberg, August 2021. Notes: The chart shows the difference in U.S. dollar expected returns over the next five years from August 2021 for four sectors of the MSCI USA Index in our base case of a “green” transition (policies and actions taken to mitigate climate change and damages, and to limit temperature rises to no more than 2 degrees Celsius by 2100) vs. a no-climate-action scenario. The estimated sectoral impact is based on expected differences in economic growth, corporates earnings and asset valuations across the two scenarios. Professional investors can access full details in our Portfolio perspectives and CMAs website.

The latest report from the United Nations’ Intergovernmental Panel on Climate Change (IPCC) confirmed the accelerating global warming. It assesses that greenhouse gas emissions from human activities are responsible for about 1.1 degree Celsius (or about 2 degrees Fahrenheit) of warming in average global temperatures since the 19th century, and the warming will continue for decades even if immediate actions are taken to sharply reduce emissions. The IPCC still sees a narrow window for limiting warming to 1.5 degree Celsius if there is a coordinated effort to achieve net-zero emission by 2050. Our climate-aware return assumptions assume a successful transition to a low-carbon economy consistent with Paris agreement goals, and that will deliver an improved outlook for growth and risk assets relative to doing nothing. We see climate-resilient sectors such as technology and healthcare likely benefitting the most from a “green” transition, and carbon-intensive sectors with less transition opportunities such as energy and utilities likely lagging. See the chart for return assumptions in our base case vs. a no-climate-action scenario.

Attention on climate change is running high – as extreme weather events have occurred frequently in recent years. The increasing frequency of these events will continue even if global warming is limited to 1.5 degree Celsius, according to the scientific consensus reflected by the IPCC. Severe heat waves that happened once every 50 years in the pre-industrial world are now happening roughly once a decade, and will likely occur once every six years in a 1.5 degree scenario, according to the report. This IPCC report, focused on the physical science of climate change, is one of the four the UN panel plans to release between now and September 2022. The other three will focus on the impact of climate change on society and on natural systems, as well as on the pathways to achieve net-zero emissions. Global governments are due to meet in late October at a key UN climate conference to discuss how to accelerate efforts to achieve their net-zero goals.

Extreme weather events have helped elevate climate risk to a key concern among investors. Consider the two baskets of climate risks: physical risks (think of hurricanes and wildfires and their potential damages to real assets) and transition risks (financial risks arising from the transition to net-zero, stemming from changes in taxes, regulation, technology and business models). The window for a successful transition to net-zero by 2050 – a goal set by many governments – is shrinking, as pointed out by the IPCC. We could see the window for positioning portfolios shrinking too. Accelerated actions to reach net-zero would drive transition risks to be more rapidly priced in by financial markets. Absent that, we would likely see continually accelerating physical risks as a result. Altogether, the pathway to net-zero remains a highly uncertain one, but regardless of the path taken, we see the implications on portfolios accelerating.

The bottom line: We are still in the early stages of a tectonic shift toward sustainable investing, and the full consequences of this shift are not yet in market prices. We expect “green” assets that are likely to benefit from the transition to a low-carbon economy to outperform during this shift. This is one reason for investors to keep tabs on the progress of climate change and that of climate transition. We see two key aspects in the climate transition: technology and policy. The tech transition has already begun in some key sectors such as utilities and autos, and as the window to achieve net zero by mid-century narrows, we expect policy levers to be pulled harder – and this could result in a steeper transition. We believe doing nothing about climate change in portfolios is no longer an option.