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Rising Climate Change Risk Not Yet Factored in by Markets

Maria Elena Drew, Director of Research, Responsible Investing

Limited impact on near-term cash flows is masking longer‑term risk

Key Insights

  • Climate change has seen a dramatic increase in attention in recent years, and this has been reflected in its prominence as an investment issue.
  • Despite this focus, however, only those sectors facing high transition risk, like fossil fuel producers, have seen valuations materially impacted.
  • In our view, rising climate change risk is not being reflected in broader valuations due to the limited impact of climate factors on near-term cash flows.

Last year we saw a dramatic increase in concern over climate change, which was reflected in its prominence as an investment issue. Despite all this attention, however, climate change has only had a significant impact on the valuations of select sectors—specifically those facing extremely elevated transition risk, such as fossil fuel producers. We believe valuation dislocations have been limited to a narrow universe of companies because climate change has not been particularly impactful to near‑term cash flows for the broader market.

This is not to say that companies are not vulnerable to climate change today, but more that they are not yet directly feeling the impact. In many instances, insurance is covering physical risks. Meanwhile, governments have not started to regulate or tax companies for greenhouse gas (GHG) emissions, deforestation, or other catalysts of climate change. We believe that valuations will eventually start to factor in climate change risks—and opportunities—affecting virtually our entire investment universe, albeit to varying degrees.

The Science Behind Climate Change

For the world to have a chance of at least minimizing the impact of climate change, it is necessary to keep global temperatures to within +1.5°C from preindustrial levels. To experience less severe impacts from climate change, global temperatures need to stay within +2.0°C. The UN’s Intergovernmental Panel on Climate Change (IPCC) Special Report on Climate Change found that keeping the global temperature rise to +1.5°C would require a 45% reduction in net emissions by 2030 and net zero emissions by 2050. Keeping to +2.0°C would require a 25% reduction in emissions by 2030 and net zero by 2070.

Minimizing the Impact of Climate Change Is a Challenge
(Fig. 1) Required reduction in net GHG emissions

As of 2018.
Source: UN Intergovernmental Panel on Climate Change.

Viewing Our Investments Through a +1.5°C and +2.0°C Lens

Science indicates that keeping the global mean surface temperature rise to less than +1.5°C will be extremely challenging, if not impossible. Therefore, in our view, the probability that our investments will need to be capable of adapting to either a +1.5°C or +2.0°C scenario is high. Even keeping global warming within these parameters means there will be climate change impacts that will affect the investment landscape, such as rising sea levels, increased storm frequency, hotter, more frequent heat waves, and shifting growing seasons.

In its 2019 Global Warming of 1.5°C report, the IPCC aggregates the various scientific climate models that keep global warming within a +1.5°C pathway. Taking the midpoint of these models implies a massive re‑engineering of the world’s energy infrastructure, including significant energy efficiency gains as well as transitioning away from fossil fuels and into renewables between now and 2050. Potentially even more material to many investment cases is how the regulatory landscape might evolve to meet a +1.5°C or +2.0°C scenario.

Climate Change in Our Investment Analysis

How our investee companies are assessing their exposure to climate change and building environmental sustainability into their long‑term strategic planning are key concerns for our analysts and portfolio managers. We believe that almost the entire investment universe will feel some impacts of climate change—through revenues, sourcing, or cost structure—and companies that can create economic value with a low or zero carbon footprint will be better positioned than peers in a world of rising environmental regulation. Figure 2 illustrates some examples of where we believe climate change factors are most material across equity and fixed income credit markets.

Opening Quote We believe that almost the entire investment universe will feel some impacts of climate change—through revenues, sourcing, or cost structure... Closing Quote

When we evaluate climate change factors in our investment thesis, we believe that fundamental analysis, coupled with our Responsible Investing Indicator Model (RIIM) analysis, is a real strength. RIIM can help our analysts compare how one potential investment stacks up versus another on a range of climate‑related issues. Applying RIIM portfolio analysis can also help portfolio managers quantify the amount of risk they are taking on climate‑related issues across the whole portfolio and compared with its benchmark.

In addition to our RIIM analysis, the responsible investing team works closely with our sector analysts in evaluating climate change factors. Work done by the responsible investing team can range from company‑specific analysis, such as assessing environmental ratings on real estate companies, to more thematic work like creating a carbon tool. This tool allows our analysts to input their own gross domestic product (GDP), energy efficiency, de/reforestation, and other forecasts to understand how certain assumptions compare with a +1.5°C and +2.0°C pathway.

Climate Change and the Investment Universe
(Fig. 2) The impact will be felt more materially in certain sectors

As of December 2019.
Source: T. Rowe Price.

The Disconnect Between Science, Policy, and Corporate Reporting

A profound disparity exists between science and policy regarding climate change. Despite the prominence of this issue in society, we continue to see varying levels of commitment from governments on combating rising temperatures. On the global stage, nations were unable to come to an agreement at the UN Climate Change Conference COP 25 summit held in Madrid. However, on a regional and national level, there has been action to push policy closer to science. Perhaps the most notable is the European Union (EU) Green Deal, which contains a series of proposed legislation aimed at moving the EU to net zero GHG emissions by 2050.

Opening Quote Despite the prominence of [climate change] in society, we continue to see varying levels of commitment from governments on combating rising temperatures. Closing Quote

While we have seen improvement over recent years, an ongoing issue that impacts the quality of environmental, social, and governance reporting we can provide to our clients is corporate disclosure. Even for the most widely reported environmental metrics, namely total GHG emissions and total carbon emissions, we find that disclosure levels are low across most benchmarks.

We can compensate to some degree for low disclosure levels by using estimated carbon emissions (provided by third parties), but it still does not allow for full coverage of benchmarks and portfolios in many cases. Additionally, estimating carbon emissions for a company is a very difficult task, so accuracy is a concern, and we would caution clients about making decisions based solely on this quantitative dataset. As companies start to report these data more consistently, and in a standardized format, we will likely see notable adjustments.

Important Information

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

EEA ex-UK—Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only.

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© 2020 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc.



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