By Irene Lauro, Environmental Economist, and Ben Popatlal, Multi-Asset Strategist, at Schroders

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.

We believe the following are among the investment themes unfolding over the next 6 to 24 months.

1. Extreme temperatures causing disruptions to economic activity

Extreme temperatures and precipitation are observed in various regions of the world. 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 via putting upward pressures on inflation. For example, recent research from the ECB found that the extreme heat recorded in the three summer months of 2022 alone caused a cumulative annual impact of 0.67 percentage-points on food inflation and 0.34 percentage-points on headline inflation in Europe, with larger impacts across Southern Europe.

The increase in food inflation is prominently visible in the record-high prices for multiple commodities including cocoa, coffee, olive oil, and oranges. Concurrently, years of sparse rainfall have strained global hydropower generation. This is becoming a significant issue in 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.

Power outages also mean a drag on industrial activity as the Chinese economy experienced in the summer of 2022, where factories had to shut down due to 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 transportation of goods, impacting industries that rely on timely delivery of raw materials or finished products.

Climate-flation is likely to be an important investment theme as extreme temperatures continue to impact activity in various sectors. Investors can navigate the upward pressure on yields by reducing their interest rate exposure to markets 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.

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 likely served as an early indicator of the upcoming US hurricane season, 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 such as lithium, cobalt and nickel. In response to growing demand and limited and geographically concentrated supply, some key producers may start adopting protectionist policies, e.g. export restrictions and, tariffs in order to protect domestic industries while ensuring availability for their own energy transition needs. This protectionist move could pose a significant challenge to the global energy transition by disrupting supply chains and increasing costs. Production is currently geared towards the following countries: China, Democratic Republic of Congo, Australia and Chile. The largest consumers likely to be most affected are US, EU, Japan, and South Korea. Investors could play this theme by allocating more to industrial metals and commodity currencies such as the Australian dollar.

3. Higher home insurance prices in the US on the back of more severe floods, storms, and wildfires.

According to insurance brokerage Policygenius, homeowners’ insurance costs in the US reached approximately $175 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.

If rising costs of home ownership through higher insurance costs becomes overly onerous, varying divergences between house prices could emerge within a country, a state or even a county. 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. Suggestive of broader ESG backlash in EU as political agendas evolve?

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. This shift increases the uncertainty for clean energy investors within the EU.

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 ETS carbon market and the 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. Investors could leverage the formulation of this ‘carbon club’ by favouring emerging market (EM) equities with a low carbon intensity vs those with higher carbon intensity.

5. Another round of corporate governance reform in Japan increases investors’ appetite for Japanese stocks

Japanese firms have gradually improved their governance practices due to pressure from various stakeholders. 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. Research conducted by Goldman Sachs shows that companies that have responded to Tokyo Stock Exchange’s request for better governance have outperformed those that don’t.

Conclusion

Our sustainability risks and opportunities framework seeks to identify specific events that could feasibly occur in the world in the foreseeable future. We then assess the materiality of these risks and opportunities to financial markets and to our portfolios, and consider which actions we might take to position for them. Not everything that can happen, will happen. But being able to identify risks and opportunities in advance, puts us in a stronger position to respond proactively rather than simply reacting as situations evolve.

Further reading : Five market-moving sustainability risks with potential to impact now.