Investing in the future

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Much of global asset allocation is asleep and needs to look much harder at climate change risks argues Craig Mackenzie head of strategic asset allocation at Aberdeen Standard Investments.

The amount of capital that needs to be deployed to meet the Paris climate change target of 2° is around US$3 trillion a year with the world currently deploying less than US$1trillion.

“There is a real need to step up the allocation of capital to achieve the transition,” Mackenzie says.

“That is where strategic asset allocation (SAA) comes in. If pension funds, insurance companies and wealth managers are not shifting our capital towards low carbon opportunities the money is not going to flow. SAA need to be more aware of the risks and opportunities.”

He notes that asset allocators do have one thing on their side – that they are working on a ten year horizon which he contrasts with a equity manager working to a one-year benchmark who will happily take a 6% dividend on offer from an oil stock.

“Yet the SAA community has been somewhat asleep and need to wake up and start looking much harder,” he adds.

He says that the ‘bread and butter’ of asset allocation is returns forecasting but that allocators may be missing out on important changes.

He says that with climate change, the firm has the shape of the story though not all the answers.

Renewables 10-year growth rate hard to find outside of tech

“We are going to see a more than a doubling in global renewable electricity and when I do my return forecast for equity sectors – I see a sector that will grow at 10 per cent per annum compounded
– that earnings growth rate is very hard to find outside the tech sector,” he adds.

“If I compared that to every other sector, this is going to have one of the best growth rates. The valuations are not pricing this level of growth. There is a growth opportunity in renewables that I don’t think is captured by standard asset allocation views.”

Warning from coal index

He says the other part of the story remains the potential drag on returns and indeed derating of fossil fuels.

Asset allocators must ask themselves could oil follow the same trend as US coal

“The lack of growth in fossil and negative growth in coal is going to be one of the key stories in the next decade – when peak oil is going to occur and when do markets fully price that in. The key variable we don’t know the answer to is the penetration in electric vehicles.”

He says we do know that there has been a truly impressive collapse in the cost of batteries of around 80% and that by the mid 2020s, electric vehicles will fall to cost parity while the range problem is disappearing as an issue.

Some countries such as the UK and Netherlands plan to ban internal combustion engine vehicles by 2040 if not earlier.

“There are opportunities in auto sector for EVs, but that is going to have a knock-on effect for oil and gas companies. Given they are 12 per cent of the FTSE 100 that will have significant implications for investors in the FTSE 100 UK such as pension funds and insurance companies.”

He says there is a warning in a chart showing the fall in the predominantly US coal index which has declined markedly despite President Trump’s vocal support for the sector.

“One of the forecasters DNV has issued an energy outlook forecasting peak oil in 2026. If we see a rise in EV, that could lead to dramatic falls in oil prices. Will that chart [for coal} be the one we show for BP or Shell if we change the date to the mid 2020s? That is a key question if you are allocating to equities. We have a live debate about when do we start writing down the oil and gas sector?”

He adds: “We think that what is essential for climate aware SAA is doing scenario forecasts. We are building our own scenario capabilities to make some of these punchy judgments. That is what is going to drive this shift of $50 trillion from pension funds and insurers. Once climate scenarios become embedded it will allow us to shift more quickly.

Listed energy infrastructure with low equity correlation can replace government bonds

He also says that another more prosaic reason is the long term outlook for government and investment grade bonds, that once enabled relatively easy asset allocation shifts as the business cycle matured offering 10 year returns around 5.5% for government bonds and 1% more for investment grade before the financial crisis, but that today might not offer a positive return.

Listed renewables offer the returns of pre-crisis sovereigns with low equity correlation

Indeed the firm’s view of demographics and inflation suggests this is unlikely to change significantly any time soon.

He says that listed energy infrastructure can now provide a similar diversifier with a correlation to equities or 0.1 to 0.14 and with a return of around 6%. It now makes up to ten per cent in strategic portfolios.

“Our strategic portfolios finda diversification elswhere such as in EM bonds but also 10 per cent in green energy infrastructure.”

Efficient frontiers

He says that currently what you hear from strategic allocators are fiduciary objections and that as a result they say they can’t allocate the necessary capital.

He says the firm has been working with its portfolio optimisers to explore creating another dimension on its efficient frontier space allowing it to select from portfolios with the biggest climate impact. He finds that it is quite possible to get from 4% allocated to clean energy to 10% and to achieve the same return.

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