Climate to shape asset allocation

With climate change likely to influence the outlook for the global economy and financial markets, investors need to factor this dynamic into allocation decisions, says Fidelity International.

The expected role of climate change, and the policies aimed at slowing it, in shaping the path of economic growth this century should be a wake-up call for investors.

In response, they should incorporate both physical climate risks and policy transition risks into capital market assumptions to gain a more complete picture of potential returns in the 21st century.

“We think investors are under-estimating the impact of climate change and policies to tackle it on economic growth, inflation and asset prices,” said Salman Ahmed, Fidelity’s global head of macro and strategic asset allocation.

He added that since different climate scenarios will have differentiated impacts on long-term risk and return projections, incorporating climate change pathways into strategic asset allocation decisions is crucial.

A tricky juggling act

Policymakers face a big challenge: a trade-off between the high upfront cost of moving quickly towards net-zero carbon targets, and the long-term physical damage to economic growth and societal cohesion caused by rising temperatures if they delay action.

For example, on the one hand, policies to encourage the green transition include introducing a carbon price and both public and private sector investments in new energy technology.

At the same time, increasing physical risks to the environment from rising temperature and extreme weather events will take their toll unless aggressive and far-reaching action to transform our current economic model is taken to reduce emissions.

“The task of mitigating climate change is a difficult one,” said Anna Stupnytska, global macro economist at Fidelity. “It will require tight policy coordination between countries with different emission rates, economic incentives and political objectives.”

The fund house believes that an effective response will require putting a price on carbon emissions, which have been both a free and fundamental part of economic growth for more than a century and a half.

“As carbon prices rise, this will contribute to inflation rising meaningfully from baseline levels,” explained Ahmed.

Crucially, to achieve net zero by 2050, he said the carbon price trajectory is projected to be exceptionally steep – from around $3 per tonne currently (on average) to $150 to $200 per tonne by the middle of this decade, $200 to $300 per tonne by 2030 and around $700 to $800 per tonne by 2050.

Yet the costs associated with delaying tackling climate change are likely to be much greater, added Stupnytska. “The effects of rising temperatures [will] spread unevenly across the globe and occur in a non-linear fashion over time.”

New benchmarks and processes

Given the overwhelming science on climate change, Fidelity believes that mainstream long-term macroeconomic projections – and, consequently, the consensus capital market assumptions used by the investment industry – underplay both the magnitude and geographical dispersion of climate impacts on growth and inflation.

Against this backdrop, as modelling techniques which map the transmission of climate change pathways on macroeconomic variables become more robust, Fidelity is focused on building climate-aware capital market assumptions using the Network for Greening the Financial System (NGFS) framework.

“We believe the NGFS framework will become the industry standard as key central banks, such as the European Central Bank and the Bank of England, use the same design to run climate risk stress tests,” explained Ahmed.

As a result, the asset manager plans to use this framework to underpin its strategic asset allocation process.