We are only at the beginning of a very long period in which climate change will have a considerable and ever greater impact on markets. Current research shows that investors are not prepared for this.
Financial markets are not prepared for the scale of disruption caused by climate change. This is the result of a recent study. In September, the United Nations Principles for Responsible Investment (PRI) – a network of investors whose members include 500 global investment managers – published a report. The bottom line? The markets have not priced in the upcoming political measures to combat climate change. More importantly, the report concludes that investors should expect policies by 2025 to be "pronounced, abrupt and disorderly" because of the delay.
Schroders' climate change team has long believed that climate change disruption is not priced in by markets. It is said that financial markets are relatively quick to price in short-term, minor changes in a company's outlook – but that they struggle to price in uncertainty, inflection points and disruption. But that is exactly what climate change is bringing.
How long will it take for voters and politicians to realize that the long-term consequences of inaction far outweigh the costs of switching to renewable energy? Will voters support measures that reduce carbon dioxide emissions to zero by 2050 – or will they deny them support in tough economic times?
Turning points are often recognized only in hindsight. Only the early indicators of the changes to come can be identified. It's not easy to imagine a dramatically different situation than the one you currently find yourself in. You reassure yourself by finding reasons why change will be slow to happen. We believe the shift from fossil energy to renewable energy and electric vehicles represents such a tipping point. Full decarbonization of these industries is moving into the realm of possibility with the technologies that now exist. Yet few investors have grasped the magnitude of the changes ahead.
As we have argued elsewhere, markets find it very difficult to price in disruption. Business leaders often face a dilemma: Even when they recognize a threat to their business, they often tend to protect their existing revenue streams. Investors also tend to focus too much on short-term cash flows of a company facing disruption. They believe the stock is "cheap" compared to current earnings and then are surprised when the company goes downhill. Declining businesses are usually not a good investment. Restructuring is very expensive, staff morale suffers, and fixed costs cut into profits.
Until recently, market attention to climate change disruption focused on coal. These are the most obvious "orphan" investments as developed countries turn away from coal plants. Coal prices have fallen to multi-year lows and an early closure of a coal plant is announced every week.
Spanish utility Endesa recently announced the closure of its two coal-fired power plants in Spain. This results in a loss of much or all of the value of 1.3 billion. Euro of these plants. Significantly less attention is being paid to other sectors of the economy that are also facing disruption from climate change. Real estate and aviation are two examples where climate change impacts have not yet been factored into prices.
The aviation industry has performed extremely well so far. Record economic expansion and the growth of the global tourism industry have provided steady growth for the industry. Over the past decade, the MSCI World Aerospace and Defence sector has generated an annual total return of 13.8% – twice the annual return of the MSCI World.
The assets in this industry (mainly airports and aircraft) are very long-lived, so future conditions for the industry are exceedingly important. Unlike the automotive industry, there is no economically viable technology for the aviation industry to significantly reduce its emissions. The continued expansion of the industry is thus not consistent with many long-term goals and plans currently being prepared by governments. After decades of lowering the cost of air travel, causing the industry to grow and grow, prices must now be raised to either drive demand down or absorb the cost of the industry's carbon footprint. CO2 emissions per passenger kilometer are very high for air travel.
CO2 emissions (per passenger kilometer)
Source: Bernstein Research, Sep 2019
Figures from Bernstein Research suggest that 40% of the industry's profits would have been lost last year had it had to cover the cost of its CO2 emissions. In the future, this burden will be even higher as emissions increase.
At the same time, videoconferencing technology has advanced to the point where it eliminates much of the need for business travel. Business travel is most profitable for airlines. But as more and more companies strive for carbon neutrality, air travel is coming into the crosshairs. The next ten years are not likely to be as encouraging for the industry as the past decade.
Real estate assets
Until recently, the physical effects of climate change were rather theoretical for many people. Increasingly extreme weather events and rising sea levels, however, have created greater public awareness to the extent that this is impacting real estate prices. For example, in October, a report by investment group CLSA (Credit Lyonnais Securities Asia) and CWR (China Water Affairs) addressed the impact of flooding due to rising sea levels on Hong Kong. In particular, they examined Super Typhoon Mangkhut of 2018, which triggered a storm surge of 3.9 m in Hong Kong's Victoria Harbour, and Super Typhoon Hato, which reached 5.6 m in Macau's Inner Harbour. The report concludes that the storm surge in Hong Kong could have been much worse.
"Mangkhut could have caused a tidal wave of 5, 7 m, resulting in flooding of Hong Kong's Central financial district. According to our calculations, floodwaters could have reached Des Voex Road, which would have been extremely expensive and exceedingly disruptive."
Potential storm surge from super typhoon Mangkhut
Source: CWR, "New Atlantis," Sep. 2019. Based on a digital terrain model (5m) from the Hong Kong Land Authority, Google Maps. Location of tide gauge, according to HKO website. Infographic by China Water Risk, copyright, all rights reserved.
Let's turn to another region that is highly vulnerable to the effects of climate change. Schroders' Data Insights Unit and Global Cities team recently calculated the path of hurricanes in the Atlantic Ocean. The analysis took place as part of an ongoing project to integrate climate risks into models for evaluating real estate prices in urban areas. The figure below shows a simulation of hurricane tracks over the past 100 years, mapped one on top of the other. The precarious position of Florida and North Carolina clearly stands out in the analysis.
1919 – 2019 Scaled intensity of tropical storms
Source: Data Insights Unit (data analysis department), Schroders
Gillian Tett, in an article for Financial Times 1, also referenced the increased risk of flooding in Florida in the face of rising sea levels, as well as the fact that more frequent hurricanes are driving up the frequency and severity of property losses.
The article describes the organizational barriers that exist in financial institutions with regard to considering this information. This is important because flood-related losses are expected to triple in South Florida over the coming decades – a time horizon, by the way, that is exactly the same as the duration of an average new U.S. mortgage. While the insurance industry will recover its premiums relatively quickly as flooding and losses increase throughout the year. However, homeowners face rising insurance costs and home prices are under pressure. People are being relocated and destroyed homes are being rebuilt.
Assets seem immune to emerging factors for now, until a certain number of participants recognize the new information and factor it into their investment decisions. At this point, dramatic changes in valuation can occur. We are only at the beginning of a very long period in which climate change will have a significant and ever-increasing impact on asset prices.
1 Gillian Tett, ' Climate change could cause a new mortgage default crisis' – Financial Times
The views and opinions expressed herein are those of the author and do not necessarily represent the views expressed or set out in any other communication, strategy or fund of Schroders or any other market participant. These may change.