Financial markets tend to view climate-related risks as long-term. But there are several factors that can impact portfolios within the coming few years — even months.
A new report by London-headquartered multinational asset manager Schroders lists five “market-moving sustainability risks” with the potential to impact the markets over the next six to 24 months.
“It is not just the physical or fundamental transmission of the sustainability-related risk or opportunity to financial markets that matters. Risks and opportunities can also be transmitted via the policy and controversy transmission mechanisms. These latter two mechanisms tend to crystallise world events into much more immediate-term market impacts,” write Schroders’ environmental economist Irene Lauro and multi-asset strategist Ben Popatlal in a note released on Aug 22.
1. Extreme temperatures causing disruptions to economic activity
Severe heat in the US and Latin America, Southern Europe and parts of Asia is exacerbating dry conditions, affecting agricultural output, hydropower generation and shipping. One way these disruptions impact markets is by putting upward pressure on inflation, note the Schroders analysts.
“For example, recent research from the European Central Bank found that the extreme heat recorded in the three summer months of 2022 alone caused a cumulative annual impact of 0.67 percentage points (ppts) on food inflation and 0.34 ppts on headline inflation in Europe, with larger impacts across Southern Europe.”
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The increase in food inflation is prominently visible in the record-high prices for multiple commodities including cocoa, coffee, olive oil and oranges, say Lauro and Popatlal.
Concurrently, years of sparse rainfall have strained global hydropower generation, affecting countries like the US, China and India, where the loss in electricity output could lead to higher energy prices.
The US Energy Information Agency (EIA) has analysed the effects of drought in California. The analysis forecasts wholesale electricity prices in the state would increase by 5%-7% relative to the median case in a drought scenario.
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Power outages also mean a drag on industrial activity as the Chinese economy experienced in the summer of 2022, when factories had to shut down due to a lack of electricity.
Finally, low precipitation also leads to worryingly low water levels, limiting the navigability of major trade waterways, such as the Panama Canal. This can mean higher shipping costs and delays in the transportation of goods, impacting industries that rely on the timely delivery of raw materials or finished products, say the analysts.
“Climate-flation” is likely to be an important investment theme as extreme temperatures continue to impact activity in various sectors. According to Lauro and Popatlal, investors can navigate the upward pressure on yields by reducing their interest rate exposure to markets that are heavily reliant on hydropower production and where food inflation has a big weight in the Consumer Price Index (CPI) basket.
“Additionally, another way investors could navigate this risk is by reducing their exposure to equities with high levels of supply chain dislocations,” they add.
Moreover, this summer, record warm ocean temperatures in the Atlantic were expected to lead to above-normal hurricane activity, according to the National Oceanic and Atmospheric Administration (NOOA).
Hurricane Beryl made landfall in Texas in July. Beryl was the earliest Category 5 hurricane — the most severe category for tropical storms — that formed in the Atlantic, causing substantial damage in the US.
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Over 400,000 workers reported an inability to work due to adverse weather conditions in July. This figure didn't merely set a record, it exceeded the average for July by more than 10 times.
Hurricane Beryl likely served as an early indicator of the upcoming US hurricane season, say the analysts, with peak activity typically expected in mid-September. “As a result, we may see softer labour data over the coming months.”
2. Metals protectionism jeopardises the energy transition
The shift from fossil fuels to renewable energy sources is heavily reliant on metals like lithium, cobalt and nickel. In response to growing demand and limited and geographically concentrated supply, some key producers may start adopting protectionist policies, such as export restrictions and tariffs, to protect domestic industries while ensuring availability for their own energy transition needs, say Lauro and Popatlal.
This protectionist move could pose a significant challenge to the global energy transition by disrupting supply chains and increasing costs, they add. “Production is currently geared towards the following countries: China, the Democratic Republic of Congo, Australia and Chile. The largest consumers likely to be most affected are the US, the EU, Japan and South Korea.”
Investors could play this theme by allocating more to industrial metals and commodity currencies such as the Australian dollar, say the analysts.
3. Higher home insurance prices in the US
According to insurance brokerage Policygenius, homeowners’ insurance costs in the US reached approximately US$175 billion ($228.29 billion) in 2023, reflecting a 21% upswing from the previous year.
The notable rise is predominantly attributed to the impact of climate change, which has resulted in a greater frequency of severe wildfires, floods and storms in the country, say Lauro and Popatlal.
US CPI only accounts for renters’ insurance without considering homeowners insurance. As a result, the surge in home insurance prices is not mirrored in the US inflation and is less likely to trigger a policy response from the US Federal Reserve, according to the analysts.
“Rising housing costs are, however, likely to be a drag on household spending while putting downward pressure on house prices in markets severely exposed to extreme weather events. A notable example is Florida, where average household insurance premiums now comprise about 9% of the state’s median household income, a figure set to rise.”
Rising costs of home ownership through higher insurance costs could become “overly onerous”, they add. “In cases where defaults turn systematic, it could pose a risk to both insurance companies and the banking sector.”
4. Slowdown of European sustainability legislation, as more right-wing support prevails
There has been a notable increase in the representation of right-wing parties in the EU parliament. These parties often express scepticism regarding climate policies, and their political clout could potentially decelerate the EU's swift progression towards green energy, say Lauro and Popatlal.
Is this suggestive of a broader ESG backlash in the EU as political agendas evolve? The Schroders analysts say this shift increases the uncertainty for clean energy investors within the EU.
The election of Ursula von der Leyen for a second five-year term as President of the European Commission will ensure that existing EU Green Deal laws are likely to remain as they are, they add. “However, it could be harder to get new green policies proposed, challenging the role of the EU as a climate leader.”
On the other side of the Channel, the UK is likely to witness a boost to its green energy transition as the new Labour government wants to make Britain a clean energy superpower, investing in solar and wind technologies.
In addition, Labour also wants to align both the Emissions Trading Scheme (ETS) carbon market and the Carbon Border Adjustment Mechanism (CBAM) tax scheme with that of the EU.
“Should the UK also implement a carbon tax at its border, additional pressure would be exerted on the key exporting countries to raise carbon pricing schemes domestically,” write Lauro and Popatlal. “Investors could leverage the formulation of this ‘carbon club’ by favouring emerging market equities with a low carbon intensity versus those with higher carbon intensity.”
5. Another round of corporate governance reform in Japan
A short stock market rout owing to the Bank of Japan’s rate hike notwithstanding, some investors have partly attributed the recent rally in Japanese equities to corporate governance reforms in Japan.
By maintaining a monthly list of companies that voluntarily disclose information on “action to implement management that is conscious of the cost of capital and stock price”, the Tokyo Stock Exchange (TSE) has “effectively” pressured listed companies to deliver greater shareholder value, say the Schroders analysts.
“The initial focus was on companies with a price-to-book ratio below one. However, of late, the scope has expanded to encompass improvements in the overall management culture in Japan,” they add.
Japan started efforts to improve the valuation of their listed issuers in 2022. According to Tokyo Stock Exchange (TSE) disclosures, 50% of the stocks listed on its Prime Market traded below book value as of Sept 30, 2022. After the start of its “Value Up” programme in 2023, this ratio improved to 36% as of April 15.
The Schroders analysts cite research conducted by Goldman Sachs, which shows that companies that have responded to TSE’s request for better governance have outperformed those that have not.
Japanese firms have gradually improved their governance practices due to pressure from various stakeholders, add the analysts. “We believe this has played a role in the recent outperformance of Japanese equities. If this improved governance continues to augment capital efficiency and the modus operandi of Japanese companies, it could potentially drive sustained robustness in the Japanese equity market.”
Photos: Bloomberg
Charts: Schroders
