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Climate-aware Return Assumptions

As investors, we’re typically building portfolios around long-term asset classes (stocks, bonds and cash) using risk, return and correlation assumptions and creating a strategic asset allocation. As faith-consistent investors, we additionally incorporate investable expressions of our faith-values --- though the two are intertwined; how does one effect the other?

We’ve found a fairly consistent value of “the environment” across all the faith investment policies and guidelines we’ve read and FBAOs we’ve engaged, with many drawing links between carbon-based energy use and climate change; reducing the former reduces the latter and related long-term ill effects on people and planet. But does this expression of environmental values affect long-term asset class assumptions?

Blackrock Investment Institute recently out with research “Climate-aware return assumptions” on how a transition to economy-wide lower carbon emissions will impact expected asset class assumptions, based on a clear belief that a transition to a lower-carbon economy will happen, but will move slower than overall energy growth.

A few interesting findings for us:

  • Expect structurally higher inflation and higher market volatility --- “[low carbon transition will cause] sharp demand shifts in the economy…[creating a] new regime of greater macro and market volatility… [and] inflation will be more persistent longer term…”

  • Don’t outright exclude “carbon-intensive companies” --- “We believe a portfolio that only gets exposure to the transition through low-carbon sectors and companies could miss important investment opportunities. A decarbonized economy will require the transformation of companies across all sectors… capex [spending needed for this transition] will in turn increase demand for the materials and inputs needed to retrofit and renew buildings, power and transportation systems. Investors can gain exposure to the transition through the assets of carbon-intensive companies with a credible transition plan or that act as enablers of the transition by supplying key materials, equipment and services.

  • Expect higher returns for “sustainable assets” --- “We believe that capital will keep flowing into sustainable assets…as investor preferences shift…[and] will likely push up the value of sustainable assets over time.”

Overall, their portfolio implications are:

  • Overweight inflation-linked bonds

  • Favor developed markets over emerging markets

  • Maintain investments in carbon-intensive companies with credible transition plans or who supply goods needed for the transition.

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