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Global Weekly Commentary: Net-zero transition reprices assets
Key points
Theory vs. evidence
We now have evidence that the shift toward sustainability is leading to a repricing of assets across the board—and believe it has a lot more room to run.
Market backdrop
U.S. inflation hit new 40-year highs, sending bond yields soaring amid market expectations of more rate hikes. We see the market’s hawkish view as overdone.
Week ahead
UK CPI and employment data this week may give a read on further tightening by the Bank of England. We believe markets are pricing in too many UK rate hikes.
The transition to decarbonize the world is happening and investors can no longer ignore it. Increasing investor preferences for sustainable assets are leading to a great repricing that has a lot of room to run, in our view. This doesn’t preclude browner assets such as traditional energy stocks from staging rallies at times. This is a feature of transition, we believe, as they can benefit from mismatches in supply and demand as the economy is being rewired to reach net-zero carbon emissions.
Asset repricing: It’s happening
Relative returns of green vs. brown sectors, 2016-2025
Past performance is no guarantee of current or future results. Forward looking estimates may not come to pass.
Sources: BlackRock Investment Institute, with data from the Center for Research on Security Prices, Feb. 1, 2022. Notes: To estimate climate-driven repricing, we attribute historic returns to two drivers: cashflow news and discount rate (DR) news. We then identify the DR news associated with climate change using carbon emission intensity (CEI) as a proxy. To isolate the DR component of returns, we apply the standard decomposition formula of Campbell (1991) using a standard factor model of expected returns (which embed well-known predictors such as value, momentum, and quality). Attribution to climate scores is then given by forecasting regressions of DR news on a measure of CEI. Sector returns are MSCI US Sector index- weighted averages of stock-level returns. Green represents the technology sector, the most “green” in our work, whereas the utilities sector is the most “brown” in the repricing. The 2016-2019 bars represent the total repricing over this period; and the 2021-2025 expectation is the cumulative repricing we expect over that period. The estimate is highly uncertain and is based on factors including risk premia effects in other long-run transitions such as demographic trends, market pricing of green bonds, and investor survey data on how much return they would be willing to give up to for more sustainable assets. See Sustainability: the tectonic shift transforming investing of February 2020 for details.
How do we know the repricing is happening? Our method strips out common drivers of returns, such as news on earnings, or the impact of factors such as momentum and growth. This allows us to isolate the cost of capital and measure how it’s being affected by changing investor preferences for sustainable assets. We proxy the exposure of a company to the transition by measuring its carbon-emission intensity, or direct CO2 emissions as a share of enterprise value. What do we find? Relatively green sectors such as tech repriced positively (left chart) in 2020 whereas browner ones such as utilities showed the mirror image (right).
We posited in 2020 there was a tectonic shift toward sustainable assets underway as investors would increasingly embrace sustainability. Capital and investments would start to flow to more sustainable assets and away from less sustainable ones. We argued that this would cause a repricing over time as we believed markets would get ahead of the actual transition to a greener world. Our new analysis shows the repricing effect is real and growing, as it was negligible in the period 2016-2019 (the left bars in the charts). We believe the repricing has much more room to run, based on factors such as investor preferences for greener assets and historical changes in risk premia for similar long-run transitions such as demographics (the right shaded bars). See Managing the net-zero transition of February 2022 for details.
If that’s right, why have browner assets such as fossil fuel companies staged such a rally in the past year? Context is key. First, our repricing analysis controls for factors not directly tied to the long-run transition, such as surging demand amid the unique restart of economic activity last year. This exposed an underlying fragility in energy markets: a mix of geopolitical factors and weather-related supply disruptions hit just as European inventories were low. The result: spiking prices of fossil fuels and their producers. Second, the performance of traditional energy stocks tells you something about how the economy is currently wired. But it doesn’t say anything about where it’s going.
The rewiring will involve a massive re-allocation of resources, in our view, and transform the macro environment. There will be periods when traditional energy can benefit from mismatches in supply and demand. The root cause is that transition of the energy sector has so far been lopsided, we believe, with extra investment in renewables failing to keep pace with reduced capex in fossil fuels. The higher fossil fuel prices rise, the more competitive renewables become. The outlook for renewables is bright, and we also see lower-carbon fossil fuels playing a key role in ensuring continuity of affordable energy during the transition. The world will need to pass through shades of brown and green to reach net-zero by 2050, we believe.
Our bottom line: We see the transition driving a relative return advantage for greener sectors such as tech and healthcare over browner sectors such as energy for years to come, all else equal. There will be periods when browner assets outperform, and we see investment opportunities in low-cost oil and gas producers leading decarbonization within their sectors. Withholding capital or indiscriminately divesting from these industries is counterproductive to the transition and investor portfolios, in our view.
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