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Thinking about different ways the future could play out is a good idea. We all do it, both in our daily lives and at work. At times, it helps us to avoid risks. At others, to consider new perspectives and ideas.
As an equity investor, Baillie Gifford conducts such thought exercises whenever researching a stock before and after buying it. We call the process ‘scenario analysis’. It helps us explore conditions that might create long-term growth, while also considering the potential for loss and failure. This process of imagination is a powerful tool, but it needs to retain a dose of caution. Genuinely different and challenging scenarios are hard to construct and use well. We all have biases that can result in misleading insights and false comfort.
The climate and energy transitions are obvious candidates for scenario analysis. They involve big change, massive uncertainty and high complexity. We have encountered technological revolutions before, but the prospect of accelerated, simultaneous and likely permanent change to the global climate is new. It is very hard to imagine and difficult for any of us to integrate into our worldviews.
Enter the financial regulators. Concerned that asset managers and other financial actors have underpriced climate-related risks and under-communicated them to clients, the authorities are introducing scenario analysis requirements.
That’s a positive development. The problem is the regulators’ preference for quantitative models that seek to provide apparently precise numerical answers to questions of future risk and opportunity.
Quantitative v qualitative models
The weaknesses of quantitative models are well-documented but boil down to the sheer complexity of trying to represent reality in a manageable set of calculations and numerical outputs. The current offerings ignore many physical effects that climate change scientists suggest are likely to occur – from compounding severe weather to locally extreme temperatures, sea-level rises and more. There are similarly surprising omissions in the social and economic spheres – limited coverage of economic sectors; poor fiscal, social and institutional dynamics; and they lack the learning curves and network effects that drive new technologies.
So it’s really no surprise that some climate change models have suggested only a marginal effect – or even that some stock indices (and portfolios) could benefit – from temperatures rising towards 3C above the norm in the latter half of this century (for example, see note 5 on page 20 of the Climate Financial Risk Forum Guide 2023).
Worse still, there’s a risk that many investment managers will treat the models as something to be ‘done to’ their funds rather than ‘done by’ them. Lacking engagement with the underlying scenarios, they will miss key learnings and fail to take appropriate actions.
By contrast, our investment approach – managing relatively concentrated portfolios picked for their potential to deliver growth over the long term – makes us predisposed to prefer a qualitative approach. As fundamental researchers, we like the richness of narrative detail and provocation this allows. Qualitative scenarios don’t need to ignore issues just because they are hard to model in numbers. And they can include the reality that sits outside ‘economics’ to account for the apparently irrational decisions that people make and the societal and technological tipping points that can lead to large and rapid change.
So in 2022, we decided to develop our own qualitative climate scenarios. We had two main aims:
- to rigorously test and flex our assumptions about the future and, by doing so, make better investment decisions for our clients
- to better inform our clients about the nature of their portfolios relative to the unfolding climate and energy transitions
We also hoped that our work would be useful to others – particularly regulators and other modellers looking to better develop the financial system.
Climate change narratives
The first iteration involved creating more complete narratives based on the three possible worlds currently referenced by the UK’s Financial Conduct Authority and the Network for Greening the Financial System (NGFS), a body representing the world’s central banks and financial supervisors.
The three scenarios boil down to:
- a smooth orderly transition that limits temperature rises to about 1.5C above pre-industrial levels this century
- a volatile, disorderly transition that eventually limits rises to about 1.5C
- a failed, ‘hot house’ world in which temperatures rise by about 3C
And our aim was to create versions that:
- were internally consistent
- acknowledged the full range of possible physical effects of climate change at global and regional levels
- explored all types of solutions, from greater use of renewables to changes in people’s behaviour
- recognised the human-related pressures that might arise, such as migration and conflict
Knowing that we lacked the expertise to do this alone, we asked two external organisations to take the lead. Each has brought an independence of view alongside subtly different skillsets.
The first is the Deep Transitions project led by Prof Johan Schot, a joint endeavour of Utrecht and Sussex universities. It has brought a social science perspective of transformative systems change. The second is Independent Economics, a macroeconomics consultancy. It has provided us with the experience of Dr John Llewelyn (ex-Organisation for Economic Co-operation and Development) and Dr Dimitri Zenghelis (ex-head of the Stern Review Team at the Office of Climate Change and now at the Bennett Institute at the University of Cambridge).
Scenario testing
A year on, we have our first-round narratives. Our partners penned them after working with our climate specialists and pilot investment team – Baillie Gifford’s International Growth Strategy. In a process we are now rolling out more broadly, scenario engagement consists of a mix of reading and workshops, with teams then deciding on their own follow-up actions and research.
We have more to learn but intend this initiative to be an ongoing, developing activity. As the world changes, new technologies will emerge, and our investment opportunities will evolve. So we can rework the scenarios and consider how best to interact with them.
The box below gives a taste of some of the questions raised by the work so far. It’s still too early to report on specific fund findings, but we are happy to share our experience with clients, peers and beyond. The initial narratives are also freely available on request through us or directly from Deep Transitions and Independent Economics.
We hope you find them useful and that they ultimately leave us better prepared and with better investment outcomes in the years ahead.
Email us to request more details of the initiative, and if you are an institutional client, join our Climate Scenarios webinar in October.
Questioning the future
The following are some examples of the questions our narratives raise to help our investment teams consider climate change’s impacts, explore different time frames and edge cases, and think about the positioning and adaptability of the companies we invest in:
- Why might interventions or innovations to achieve a successful transition be constrained in a world with accelerating physical impacts?
- What does history tell us about the circumstances that enabled governments to make disruptive policy changes?
- What’s the difference between a policy world led by sticks (carbon taxes) versus carrots (subsidies)?
- How can we prepare for short-term volatility in an overarching pathway (such as the shock to gas supply caused by the invasion of Ukraine)?
- Where might we already be past the tipping point for new technologies and behaviours? What could be the spin-off network effects?
- Which regions might experience significant physical climate stress or be havens for new growth?
- Is it realistic to assume that atmospheric and marine geoengineering will continue to be excluded from generally accepted solutions?
- What changes in social norms and values are consistent with each pathway? How might these affect the investment opportunity set?
Risk factors
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in September 2023 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.
All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.
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