Investment managers should consider climate change

11 June 2015

Climate change has a large impact on the (future) returns enjoyed by investors. According to a new research from Mercer, investors should therefore increasingly incorporate growing climate change risks into their portfolio strategy as part of the wider risk mitigation approach. With the best long term outcome for investors, as well as humanity as a whole, a sticking to the 2 C target set out in the 2009 Copenhagen conference.

The risks posed by climate change on humanity, as well as the wider biodiversity of the planet’s various ecosystems is now well established. Climate change is an environmental, social and economic risk, expected to have its greatest impact in the long term. But to address it, and avoid dangerous temperature increases, change is needed now.

In a new report, titled ‘Investing in a time of climate change’, Mercer presents an overview of the top 10 global risks facing the globe*. The 10 year risk horizon is topped by water crisis as fresh water becomes less available, followed by a failure to mitigate the risks associated with climate change  - with further consequences of social instability and food crisis in part feeding into each other creating high levels of wider uncertainty for investors.

Risks of Highest Concern by Time Period

In the study, the global consultancy explores the importance of climate change risk on investment returns, ultimately concluding that climate related risk factors should be standard considerations for investors, such that investors need to view it as a new return variable. The advisors base their finding on four different climate scenario’s, each with a different climate change outlook, and resulting impacts on investment models.

Four models
The consultancy merges climate science models with quantitative economic data to develop four models that place humanity as a whole on a trajectory to different levels of global warming, with the ultimate ‘choice’ in model eventually creating different results for long-term investment portfolios. The climate models are technically referred to as integrated assessment models (IAMs).

The first model is called the ‘Transformation’ model, characterised by strong climate change mitigation that puts the globe on a path to limiting global warming to 2°C above pre-Industrial-era temperatures this century. The scenario sees strong carbon emission mitigation, with peak emissions in 2020, thereafter falling 56% relative to 2010 levels by 2050.

Summary of the Scenarios

The second model is called the ‘Coordination’ model’, and is a scenario in which policies and actions are aligned and cohesive, limiting global warming to 3°C above pre-Industrial temperatures this century. The scenario sees substantial climate-mitigation action, with emissions peaking after 2030, then falling by 27%, relative to 2010 levels, by 2050.

The ‘Fragmentation’ model (Lower Damages) sees limited climate-mitigation action and lack of coordination, resulting in a 4°C or more rise above pre-Industrial-era temperatures this century. The ‘Fragmentation’ (Higher Damages) sees the same limited climate-mitigation action as the previous scenario, but assumes that relatively higher economic damages result.

The consultancy notes that the Transformation model is the best for the long term outlook of investments – while the high damage Fragmentation model has the least mitigation costs but also the worst wider social and economic outcomes.

Climate Impact on Returns - by Industry Sector

Investment consequences
The different models each have different consequences on investment portfolios. Particularly the energy sector is expected to see considerable fluctuations depending on the pathway humanity follows. Coal’s average expected annual returns could be reduced from 6.6% per annum to between 1.7% and 5.4% over the next 35 years, depending on the scenario. Oil and utilities could also be significantly negatively impacted over the next 35 years, with expected average returns potentially falling from 6.6% to 2.5% and 6.2% to 3.7% respectively. This would negatively impact unprepared investors. Renewables have the greatest potential for additional returns: depending on the scenario, average expected returns may increase from 6.6% to as high as 10.1%.

There are also material impacts to be considered at the asset class level. For all asset classes climate change is expected to either have a positive or negative effect on returns dependent on the future scenario. There is however one exception – developed market global equity is expected to experience a reduction in returns across all scenarios.

Climate Impact on Returns - by Asset Class

Long term investment outlook
“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”, comments Jane Ambachtsheer, Chair of Mercer’s Responsible Investment team.” While politicians have a role to play in which of the scenarios eventuates, with scientists and international agreement placing the 2C scenario as the best of possible worlds for our current situation – investors will in Ambachtsheer's view too need to get on board to ensure they are ready for the growing risks of reality. She typifies climate change as a “structural and systemic issue”, that poses a “significant investment risk that investors should be aware of and able to act upon in close collaboration with investment managers.”

* To produce the report, Mercer collaborated with 16 investment partners, collectively responsible for more than $1.5 trillion. 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).