Climate Change Could Alter Investment Strategies

How will a global rise in temperature affect investment performance? Which sectors will be more profitable—or less?

Investors cannot ignore implications for investment returns, according to a new report from Mercer that models the potential impact of climate change on investments. The research suggests investors can most effectively manage the risk by looking under the hood of their portfolios and factoring climate change into their risk modelling, which requires a significant behavioral shift for most.

“Investing in a Time of Climate Change” outlines actions for investors to manage key downside risks and access opportunities. This strategic thinking is not new. In 2012, Mercer conducted a survey of institutional investors and found that more than half had decided to include climate change considerations in their future risk management and asset-allocation decisions. 

Using four climate change scenarios and four climate risk factors, the investment modeling estimates the potential impact of climate change on returns for portfolios, asset classes and industry sectors between 2015 and 2050.

The scenarios represent a rise in global temperature of 2°C, 3°C and 4°C above preindustrial-era temperatures, with different levels of potential physical impact for each. (There are two separate scenarios for 4°C.)

First, according to Mercer, climate change will give rise to investment winners and losers. Based on the scenarios modeled, climate change is expected to have an impact on investment returns, and investors need to take action to understand and mitigate the risks and maximize value at the asset, industry-sector and portfolio levels.

Winners and losers are most apparent at the industry level. Average annual returns from the coal subsector, for example, could fall by anywhere between 18% and 74% over the next 35 years, depending on which climate scenario plays out. Effects could be more pronounced over the coming decade, eroding between 26% and 138% of average annual returns over the next 10 years. The renewable energies subsector, on the other hand, could see average annual returns increase 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.

The impact on asset-class returns will be material but vary widely by climate change scenario, the report suggests, with growth assets 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. But a 4°C scenario could hurt these asset classes because of chronic weather patterns—long-term changes in temperature and precipitation—that pose risks to the performance of asset classes such as agriculture, timberland, real estate and emerging market equities.

In the case of real asset investments, these risks can be mitigated through geographic risk assessments undertaken at the portfolio level. To embed these considerations into the investment process, the first step is to develop climate-related investment beliefs alongside other investment beliefs.

The picture changes at the portfolio level: The 2°C scenario has no negative return implications for long-term diversified investors at a total portfolio level over the period modeled—i.e., to 2050—and is expected to better protect long-term returns beyond this time frame.

Despite the challenges of forecasting what has yet to occur, Alex Bernhardt, principal and head of responsible investment, U.S., at Mercer, says the report attempts to quantify the potential investment impact. “We recognize that markets do not always price in change,” he says. “They are notoriously poor at anticipating incremental structural change and long-term downside risk until it is upon us.”

Next: How can investors buffer portfolios against uncertainty?

The report identifies the “what?,”  the “so what?,” and the “now what?” of the impact of climate change on investment returns, according to Bernhardt, who contends these insights enable investors to build resilience into their portfolios in an uncertain future.

Investors have two key levers in their portfolio decisions: investment and engagement. From an investment perspective, resilience begins with an understanding that climate change risk can have an impact at the level of asset classes, of industry sectors and of subsectors, the report says. Climate-sensitive industry sectors should be the primary focus, as they will be significantly affected in certain scenarios.

“Advice on portfolio implementation consideration will depend on the plan’s views of the likelihood and impact of scenario outcomes,” Bernhardt tells PLANADVISER.  DC plan sponsors that believe in the materiality of climate change to investment returns will want to make available climate-aware plan options, Bernhardt says. Advisers can support communication to make plan participants aware of the risks and opportunities associated with climate change.

Investors also have numerous engagement options. They may engage with investment managers and the companies in their portfolio to ensure appropriate climate risk management and associated reporting. They may also engage with policymakers to help shape regulations.

The implications for long-term, intergenerational investors are clear, and chief executives and investment strategists from a range of pension and institutional investors, including the superannuation funds in Australia and New Zealand, express support for these investigations into managing investment portfolio risk.     

Brian Rice, portfolio manager of the California State Teachers’ Retirement System (CalSTRS), points to the study’s multi-scenario, forward-looking approach as a unique feature. “Investors will be able to consider allocation optimization, based on the scenario they believe most probable, to help mitigate risk and improve investment returns,” he says.

“Climate change forces investors in the 21st century to reconsider our understanding of economic and investment risk,” says Thomas P. DiNapoli, trustee of the New York State Common Retirement Fund. “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.”

Bernhardt says the report is a guide that investment committees can use to create an action plan. “Whether it is setting portfolio decarbonization 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,” he says. “Engaging with policymakers is also crucial and helps empower investors in their role as ‘future makers.’” 

“Investing in a Time of Climate Change” was produced in collaboration 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 U.K. 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 report is the culmination of a research project that began in September 2014 and will be launched in London on Thursday, ahead of negotiations for a new global climate agreement in Paris at the end of this year.