The investment industry has got itself into a funk about environmental inputs into investing, so much so that many investors seem frightened to even talk about it. There are fundamental questions about potential conflicts that some past ESG approaches have had with fiduciary duty as well as their efficacy. We are going to leave that debate to one side in this note and focus on something that we think is more fundamental for the long-run health of end-investors’ portfolios.
Our appeal to investors is to think differently about how plausible the case for a quick energy transition is. What is the real meaning of a slower transition for investment praxis? This exercise has nothing to do with deciding whether or not to exclude a given company or whether or not engaging with corporations is in the interests of investors. Instead, the debate is more fundamental—about how to protect the long-run purchasing power of investors. This debate raises difficult questions of strategic asset allocation (SAA), how to achieve diversification in the presence of much greater path risk, whether diversification is even possible and governance. It is still right for investors to be exposed to an energy transition as there is considerable scope for further capital to be deployed in this area. We also want to draw attention to the cross-asset implications of this topic.
We outline a view that it will likely be socially or politically unacceptable to engineer an energy transition within a time frame compatible with restraining temperature increases to 1.5°C to 2°C versus pre-industrial levels. Yes, there has been rapid progress in building capacity in renewable-power generation, and its price has fallen dramatically. However, it is much harder to decarbonize industrial processes and transport, progress on carbon sequestration is slow, and enforcing changes in behaviors is difficult. This challenge ultimately leads to a core debate in contemporary political philosophy. A de-growth agenda would try to tackle this by an outright reduction in growth, but this approach raises difficult moral questions, not to mention being politically impossible in democracies. Calls to reform the nature of capitalism are intellectually interesting but will take time. Impairing standards of living will not be regarded as politically, socially or morally acceptable in advanced economies, nor will preventing an improvement in standards of living for those living in extreme poverty in emerging economies. This is all happening in parallel to other forces such as deglobalization and declining size of working-age populations in developed markets and China, which plausibly raise equilibrium inflation and reduce growth rates.
We are not taking a normative approach to investment advice in this note; instead, we attempt to outline the implications of a slower energy transition on temperature and then, in turn, what they would means for macroeconomic variables of growth and inflation. The scale of uncertainties in the temperature prognosis, not to mention the impact of a given climate outcome, make this a macro force that is fundamentally different from the other contemporaneous forces of deglobalization and demographics—not least because of the risk of non-linearities. This situation leads climate to have a different role when it comes to setting forecasts and resulting asset allocation.
This point does not seem to be reflected in many industry approaches to asset allocation. The bottom line is a significant increase in path risk, and hence a much greater need for diversification. However, with government bonds unlikely to be reliable diversifiers, how is this diversification to be achieved? A key response lies in asset allocation. A deeper question is whether diversification, in the traditional meaning of the word, is even possible in the context of a “bad” outcome of climate change. This points to a need to rethink governance and regulation rather than just asset allocation. Another conclusion is that there is a greater need for real assets, but some of these might also be exposed to higher costs, such as insurance. We consider what this means for portfolios.
