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Wellington’s Central Macro Team believes climate change is an emerging megatrend that will reshape the global economy and that we will be studying from a variety of perspectives for many years to come. Recent headlines — from deadly flooding in China and Germany to historic wildfires and hurricanes in the US — are adding momentum to the trend.
From a policy perspective, political leaders and societies around the world have made up their minds: The time has come to begin the long, complex process of decarbonizing the economy. While that much is clear, we believe the significance of this macro inflection point, which will lead to massive changes in infrastructure spending, regulation, and geopolitical dynamics, is underappreciated. It will be decades before we know whether the ultimate objectives of decarbonization are realized, but in the meantime, investors should expect climate change to have ever larger and more material effects on economic growth, the cost of capital, and the performance of a vast range of companies and industries.
In this note, we outline the conclusions from a joint research project that our team, working closely with Wellington’s Climate Research Team, conducted on the global, regional, and geopolitical implications of reshaping the world’s economic framework for a lower-carbon future.
The road to economic disruption
Looking across our areas of coverage, we see three broad drivers of economic disruption emerging as the efforts to address climate change intensify:
The economic response to climate change will require spending across the public and private sectors in all countries. Public infrastructure spending will change and accelerate, potentially boosting overall investment spending by 1% – 2% of GDP. Increased government spending and incentives, along with changing consumer preferences, should, in turn, spur more private sector spending on innovation and new technology. Figure 1 highlights specific areas of spending focused on mitigating the effects of climate change and adapting to those that can’t be avoided.
2. Green finance and regulation
Finance is changing, and over time all finance will be green. The cost of capital will increase or decrease depending on a company’s position on the carbon spectrum. Carbon markets will be directly investable and a significant new financial market whose price will be material to future outcomes for many companies.
We’re already seeing the effects on access to capital at the company and project level, and these trends will only intensify. Europe and China are moving in this direction most rapidly, but it will be an important factor in the US as well — particularly at the state and local level where there are many initiatives already being launched to foster the roles of a green financial system (i.e., enhancing the return on green investments, reducing the returns on polluting investments, and increasing investor/consumer preference for green choices).
3. Geopolitical factors
Climate change will trigger resource conflicts and migration globally, while destabilizing countries and regions, particularly in equatorial and nearby areas that are home to many emerging markets and geopolitical hotspots. Over time, the national security narrative and the climate policy narrative will become more intertwined, with a variety of macro and market implications. Growing resource scarcity, for example, will inevitably drive conflict and raise defense spending. On the other hand, adaptive solutions to climate change like those highlighted in Figure 1 may help to prevent mass climate migration and the accompanying political stress. (Read more on climate change as a national security threat.)
A brief survey of our regional views
There is strong policy momentum in the US, Europe, and China. But of course the specific commitments, policy initiatives, and potential outcomes vary.
US — Climate change is a top priority for the Biden administration, whose goals include net-zero carbon emissions by 2050 and a carbon-free power sector by 2035. The levers to achieve these goals will include increased investment in sustainable and eco-friendly infrastructure (part of a broader US infrastructure revival discussed here), as well as tougher environmental regulations. The infrastructure proposals, including the climate-related initiatives, could provide a lift in economic growth of 50 bps – 75 bps over the next few years, putting some upward pressure on interest rates. There are risks, as well. For example, the plans mark another step up in federal spending that could contribute to somewhat higher inflation. Read more on the US outlook here.
Europe — The European Union (EU) joined others in committing to net-zero carbon emissions by 2050, but didn’t stop there, announcing that it would also reduce emissions more aggressively up front — by 55% from 1990 levels by 2030. In agreeing to a new budget framework for 2021 – 2027 and to the Next Generation EU package, EU leaders committed to focusing 30% of spending on climate‐related projects. These commitments are, at least currently, strongly backed by the electorates. Europe will also substantially increase prices/taxes on carbon, reshaping economic incentives and triggering large declines in carbon-intensive capex and spending, while driving up clean spending. Read more on the European and developed market outlook here.
China — China announced a target of zero net emissions by 2060 and brought forward its peak emissions date to before 2030. The peak emissions pledge was not a surprise, as the rate of decarbonization is already at or above the rate of economic growth. The net-zero carbon commitment, however, will require an overhaul of the entire economic structure. The Chinese government plans to tackle this challenge by reworking the national energy structure and increasing energy efficiency; establishing a carbon price and developing a Green Financial System; adopting a framework for environmentally sustainable economic activities; and investing in mitigation, adaptation, and innovation solutions. Read more on the outlook for China here.
A few thoughts on other emerging markets
There is great diversity in the energy mix of different emerging markets, with some having broad access to renewables while others have no choice but to burn oil and coal. These and other circumstances will determine the choices and constraints these countries face in addressing climate change. Multilateral institutions like the World Bank are already considering climate issues in dealing with sovereign debt restructurings, grants, and other types of subsidized lending. And international cooperation will be essential to help incentivize countries to take actions that sometimes can be very expensive in terms of money and opportunity cost.
It seems clear that emerging markets are generally more vulnerable than developed markets given their geographical position, capital stock, the internal distribution of their populations, and the types of economic activity that are dominant. This is unlikely to incentivize mitigation spending but could significantly raise the need for (and return to) adaptation spending.
The economic big picture
In coming years, the response to climate change, on both the spending and regulatory fronts, will dramatically reshape economic and market outcomes in a way that investors cannot afford to ignore. Globally speaking, we would expect the impact on GDP and employment over the next decade to be positive, dominated by the rise in capital expenditures. In the longer term, we would prepare for higher energy prices to depress energy-intensive capital expenditures and consumption.
The sustained rise in spending we’ve described will have strong multiplier effects, lifting investment and income in the global economy. Climate-related geopolitical disruptions will further pressure great-power competition in a variety of regions. Finally, even as the world moves forward with decarbonization, the required infrastructure rebuild will initially (perhaps over the first decade) drive demand for oil higher — and inflation with it. Longer-term, rising energy/carbon prices will also have a sustained, direct impact on inflation. That should lead to higher real and nominal interest rates.