BlackRock’s Weekly Market Commentary: EM Climate matters to global returns

Climate change and the transition to a low-carbon future will be a key driver of long-term asset returns. Our capital market assumptions (CMAs) are based on an orderly transition aligned with Paris Agreement goals. We’ve seen encouraging development from the ongoing UN climate summit (COP26). There are risks to that path. In particular, a successful transition in EMs is key for achieving the global climate goals – and for portfolio outcomes over coming years.

Chart of the week

Distribution of resources and assets in EMs and high-income economies

All the climate pledges announced at COP26, if met in full and on time, would be enough to limit the rise in global temperatures to 1.8 degrees Celsius by 2100, according to the International Energy Agency (IEA). This is an improvement from a 2.1 degrees increase in the agency’s analysis just last month. But it is still far off the goal of net-zero emissions by 2050 to limit warming to 1.5 degrees, and many pledges remain to be implemented. Implemented policy still points toward a 2.6 degrees rise. This will be particularly challenging for EMs outside China, which account for more than a third of global emissions even though they only make up a small share of the investment universe. See the chart above. We estimate EMs will need at least US$1 trillion per year in order for the world to achieve net-zero emissions by 2050 – more than six times current investment, as detailed in our recent publication The big emerging question. We exclude China from our estimate – given its greater capacity to finance its own journey to net zero and contribute to the global effort.

Yet so far public funding – in the form of grants or grant-equivalent finance – has been insufficient in mobilizing private capital at scale, while the high-risk nature of EMs is a major barrier for private capital. The only way to mobilize private capital at the scale and pace needed, in our view, is for governments that have the capacity to provide support to absorb some of the potential losses on EM investments. If EM climate funding needs are not met, global temperature rises could exceed those in our base case scenario for our CMAs. Greater physical risks would lower global growth and reduce returns broadly. In general we assess the economic costs of unchecked climate change far outweigh those of transitioning to net-zero emissions. We estimate a cumulative loss in global output of nearly 25% in the next two decades if no action is taken to mitigate climate change, compared with an orderly transition scenario.

EMs are typically more vulnerable to climate-related physical damages, and their growth outlook and asset returns in turn could suffer more. Such a scenario would likely increase our strategic preference for DM equities. Our CMAs already favor DM equities in part because sectors that are likely to benefit from the green transition – such as tech and healthcare – account for a larger share of DM indexes, while carbon-intensive sectors such as energy and utilities occupy a smaller share. Yet a flood of capital flows into EMs – in addition to the necessary funding and investment – could potentially improve the outlook for EM assets on a strategic horizon. Development of new industries and transition of existing companies could make EM equities more resilient to the transition to a lower-carbon world, and allow the asset class to better seize opportunities in the transition. This dynamic isn’t captured in our current assumptions.

Tactically we are neutral EM ex-China equities due to less policy support and a greater risk of scarring in these economies. In addition valuations as measured by the equity risk premium appear not as attractive relative to history. We are moderately overweight EM local-currency debt given its attractive income potential and historically cheap currency valuations.

The bottom line: Climate change and the net-zero transition are key to investment outcomes over the long term. Our base case is an orderly transition – and a successful transition in EMs is key to that, in our view. We believe the only way to mobilize private capital at the scale and speed needed to fund climate actions in EMs is through risk-burden sharing and greater public sector exposures to loss, with potential tools including green investment banks.