Client Update - 3rd September 2021
Having just returned from an unseasonably warm break with the family, I thought it interesting to reflect on some musings with regards to global climate change, and as investors, what we can do to help. As I have written before, the effects of climate change and attempts to mitigate it should be factored into long-run economic expectations. Even though there are more and more commitments to reduce carbon emissions and thus limit the rise in global temperatures, there remains a significant risk that climate change is already so advanced that it will impact on the economy and society in big ways. A Swedish Riksbank paper discusses the link between climate change, the impact it can have on the economy and real interest rates.
Investors building portfolios that are less exposed to carbon and to the effects of climate change are increasingly considering physical risks to assets and business (flooding, rising sea levels, health effects from heat events and the potential disruption of ecosystems). They also have to account for transition costs by thinking about carbon pricing, regulation, the cost of investing in new technology, exiting from operations and changing consumer trends. These can have aggregate macroeconomic costs as well.
It is not difficult to see how climate change leads to weaker future economic growth. Could it be that these risks are already factored into real rates today? The Riksbank argues that climate change creates uncertainty. We do not know whether human policy actions will be able to control climate change and the worst effects of it. That uncertainty can impact economic behaviour (less investment and more precautionary savings). This additional point is interesting, that economic agents react to shocks and disasters (defined as something that causes a sharp drop in economic output) and this can lead to higher savings and lower investment. Climate change might mean that there are more frequent disasters (weather events), and this could already be influencing expectations and savings behaviour in the aggregate.
Within the last generation, the world has experienced two major shocks. First the global financial crisis and then the COVID-19 pandemic. Both led to sharp drops in output and both changed behaviours – either forced by regulation or by choice, driven by increased fear of additional shocks. If climate change potentially means lower growth, more uncertainty, and the risk of more frequent shocks, then it can be an influence on real interest rates today.
Bond yields are low and many investors and commentators think they are at the wrong level, given strong growth and rising inflation. Obviously monetary policy plays a role. But maybe this “uncertainty principle” does as well. COVID was a shock and continues to be a danger. The risk is that it can continue to play a negative role in setting expectations, influencing more risk-averse consumers and businesses. Precautionary savings might remain high until there is much more certainty that COVID has been eradicated, and we are certainly not at that point yet. This supports our general view that nominal bond yields cannot rise that much, unless inflation provides an upside surprise to the current consensus of it being temporary.
If we accept that the risks from climate change do impact on future economic growth expectations and generate uncertainty, the question is what can be done? Governments need to be more aggressive in setting out climate change mitigation policies and using fiscal policy to invest in technologies to meet those goals. If the private sector’s desired investment levels are too low, then the public sector needs to step up by investing itself (deficits and borrowing) or by changing the economics to make private businesses invest (carbon taxes). By doing more now, there may be less uncertainty about the future. Moreover, increasing policy action now can actually lead to higher potential economic growth through the development and diffusion of new technologies and reductions in risks associated with climate change. This is a focus in our Environmental, Social and Governance portfolios (ESG), that your adviser can talk to you more about should you wish.
For now though, have a lovely weekend.