The FINANCIAL -- A new report from Mercer modelling the potential impact of climate change on investments, has found investors cannot ignore the implications for investment returns. The research reveals investors can manage the risk most effectively by looking ‘under the hood’ of their portfolios and factoring climate change into their risk modelling, which requires a significant behavioral shift for most.
The report, titled “Investing in a time of climate change.” outlines actions for investors to manage key downside risks and access opportunities. It is the culmination of a research project that began in September 2014 and will be launched in London today; ahead of negotiations for a new global climate agreement at the end of 2015 in Paris.
The investment modelling in Mercer’s report estimates the potential impact of climate change on returns for portfolios, asset classes and industry sectors between 2015 and 2050, based on four climate change scenarios and four climate risk factors. The four scenarios represent a rise in global temperature above pre-industrial era temperatures of 2°C, 3°C and two 4°C scenarios (with different levels of potential physical impacts).
Mercer collaborated with 16 investment partners, collectively responsible for more than US$1.5 trillion, to produce the report. It was supported by IFC, the private sector arm of the World Bank Group, in partnership with Federal Ministry for Economic Cooperation and Development, Germany, and the UK Department for International Development (DFID). The study was also supported with contributions from Mercer’s sister companies NERA Economic Consulting and Guy Carpenter, and input from 13 advisory group members.
The investment modelling supports the following key findings:
Climate change will give rise to investment winners and losers
Based on the scenarios modelled, climate change is expected to have an impact on investment returns; investors need to take action to understand and mitigate the risks and maximize value at the asset, industry sector and portfolio level.
The biggest risk is at the industry level
Differentiation between winners and losers is most apparent at the industry level – For example, depending on the climate scenario which plays out, the average annual returns from the coal sub-sector could fall by anywhere between 18% and 74% over the next 35 years, with effects being more pronounced over the coming decade (eroding between 26% and 138% of average annual returns over the next 10 years). Conversely, the renewables sub-sector could see average annual returns increase by between 6% and 54% over a 35 year time horizon (or between 4% and 97% over a 10-year period) depending on the climate scenario.
Asset-class return impacts will be material, but vary widely by climate change scenario
Growth assets are more sensitive to climate risks than defensive assets.
A 2°C scenario could see return benefits for emerging market equities, infrastructure, real estate, timber and agriculture. A 4°C scenario could negatively impact emerging market equities, real estate, timber and agriculture.
A 2°C scenario does not have negative return implications for long-term diversified investors at a total portfolio level over the period modelled (to 2050), and is expected to better protect long-term returns beyond this timeframe.
Chair of Mercer’s Responsible Investment team, Jane Ambachtsheer, said, “Whilst it is challenging, we have attempted to quantify the potential investment impacts of climate change. We recognise that markets do not always price in change; they are notoriously poor at anticipating incremental structural change and long-term downside risk until it is upon us.”
“Our report identifies the ‘what?’ the ‘so what?’, and the ‘now what?’ in terms of the impact of climate change on investment returns. These insights enable investors to build resilience into their portfolios under an uncertain future.
“This report can act as a guide to creating an action plan. Whether it is setting portfolio de-carbonisation targets, investing in solutions that address risks and opportunities, or increasing engagement with managers and companies, our report shows investors how they might take action. Engaging with policy makers is also crucial and helps empower investors in their role as ‘future makers’,” said Ms Ambachtsheer.
Mercer’s Global CIO for Mainstream Assets, Russell Clarke, added a portfolio construction perspective, saying, “This study helps us better prepare to navigate the changes that such a structural and systemic issue as climate change may represent. We believe it’s a significant investment risk that investors should be aware of and able to act upon in close collaboration with investment managers.”
IFC Director for Climate Change, Christian Grossman, commented, “This new study led by Mercer could not be more timely on the road to the UN Climate Change conference in Paris."
"In a time of climate change, this study can help investors address uncertainty by guiding them on assessing their exposure to climate risk and improve the resilience of their portfolios. It can also send a clear message to policy-makers that resolving the uncertainty around the policy direction of carbon pricing will be an important first step toward transitioning to a low carbon economy,” said Mr Grossman.
Other investment partners commented on their involvement in the project, as follows:
“Institutional investors require actionable information to adequately reflect climate risks and opportunities into asset allocation. While global warming is a fact, we face great uncertainty around policy measures and the financial impacts in the nearer term are little understood. The Mercer study is an important step in channeling scientific and regulatory insights on climate change into the investment process and could become a standard toolbox for the strategic asset allocation.”
Karsten Löffler, Managing Director,Allianz Climate Solutions GmbH
“The multi-scenario, forward-looking approach to this study makes it unique. Investors will be able to consider allocation optimisation, based on the scenario they believe most probable, to help mitigate risk and improve investment returns.”
Brian Rice, Portfolio Manager, CalSTRS
“The Church of England National Investing Bodies have adopted a climate change policy which recognises climate change as an urgent ethical issue with important financial implications. In our policy we say that we want to be at the forefront of institutional investors addressing the challenge of transition to a low carbon economy. Our participation in this study has enabled us to grow our understanding of the investment implications of climate change and to consider ways in which, as investors working with others, we can help prevent dangerous climate change occurring.”
Edward Mason,Head of Responsible Investment,Church Commissioners for England
"Cbus sees climate change as a significant issue for our investment portfolio over the longer term. We believe that participation in this study gives us insights into the range of impacts that climate change may have on our investments, and enable us to better prepare for the climate change-related challenges ahead."
Kristian Fok, Executive Manager Investment Strategy, Cbus
“As a long-term investor, the Environment Agency Active Pension Fund recognises that climate change is a financially material risk. We have integrated the findings arising from the previous Mercer study in setting the Fund’s current investment strategy, and participating in this update allows us to build on our existing approach to managing climate risk. By adopting a strategic asset allocation that is robust in incorporating both the risks and opportunities presented by climate change, we will continue to act in the best long term interest of our members.”
Dawn Turner,Head of Pension Fund Management,EAPF
"The results from the 2011 climate change study that we participated in showed that climate change may have large impacts on our investment portfolio. Therefore, we have participated in the follow-up study to further develop our knowledge, our methods and our risk management regarding climate change."
Mikael Angberg,CIO, AP1
“As a long-term, intergenerational investor, we need to understand the investment risks and opportunities associated with climate change. This study will help us calibrate our investment strategies accordingly.”
Adrian Orr, CEO, NZ Super
"State Super Financial Services recognises the importance of understanding climate change risks to our investment portfolios and we identified this study as an opportunity to meet this objective and further develop our broader ESG approach for our clients' benefit."
Damian Graham, CIO, State Super Financial Services
“Climate change forces investors in the 21st Century to reconsider our understanding of economic and investment risk. This study provides the New York Common Retirement Fund with valuable insights that will inform our efforts to manage climate risk and build out our portfolio in ways that protect and enhance investment returns.”
New York State Comptroller Thomas P. DiNapoli,Trustee of the New York State Common Retirement Fund
“This report highlights that investors should see the opportunities in addition to the risks from climate change. The tides are turning toward a low carbon future and away from the unsustainable status quo. Investment is needed to accelerate this unavoidable trend and those who are ahead of this trend, the report shows, may in fact better secure their financial future. It is now time for us to make sure that our investments are safe for the long term, safe financially and safe for our precious planet.”
David Nussbaum, Chief Executive, WWF-UK