Here is a trillion dollar question: How will the portfolios of long-term asset managers like pension funds, foundations and endowments be affected by climate change? These institutions, in contrast to commercial banks, are legally obligated to take a long-term view in managing their returns. A new report by Mercer, a leading consulting and investment services firm, provides the first look at yet another window on the complex consequences of climate change—the implications for strategic asset allocation.
A headline result of the study is the estimated increase of up to 10 % in overall portfolio risk, primarily due to policy uncertainty—equivalent to as much as US$8 trillion by 2030. Traditional equity and bond holdings—usually the most conservative forms of hedging against uncertainty –- are most at risk of underperformance. In contrast, carefully selected investments in climate- sensitive sectors may actually reduce overall portfolio risk.
The International Finance Corporation (IFC) and UK’s Carbon Trust, along with 14 institutional investors collectively managing over US$2 trillion, funded the analysis, which was carried out by Mercer. The analysis looks at impacts by sector, region, and asset category (bonds, private equity, real estate, etc.) and builds on a set of climate change scenarios out to 2030 developed by the Grantham Research Institute at the London School of Economics and the consulting firm Vivid Economics.
The risk-return profile of traditional assets—say in fossil fuel or “old” technology investments –may now look quite different compared to their historical benchmarks, while investments that may have previously not seemed attractive—say in renewable energy—may present far more favorable returns in light of climate policy risk. The report estimates that investment opportunities in low carbon technologies could reach $5 trillion.
Clean energy today accounts for a very small portion of asset allocation—less than 1% of portfolios for most large pension funds. Even one additional percentage point in allocation would represent a doubling of monies made available to low-carbon assets. However, before this can happen there are several steps that need to be taken. One key is to create a consistently defined class of climate-friendly investments, an issue already linked to the efforts of the World Bank and IFC to market “green bonds” and other new financial products. Another will be for pension funds and other long term asset managers to look in more detail at their portfolios and investment strategies.
This study, while an excellent and important contribution to our understanding of the financial implications of climate change, also illustrates some of the persistent limitations in our ability to project future damages without further improvements in the science of climate change impacts. The modeling done for the study concludes that the physical impacts of climate changes cause limited investor losses during the study period, as significant affects only begin to appear in the later part of the analysis. This is a result largely dictated by the inability to predict and attribute economically quantifiable climate impacts until greenhouse gas concentrations reach levels expected post 2030.
As recent unprecedented climate events in places as diverse as Pakistan, Russia, Brazil and Australia show, climate impacts are already contributing to rapid increases in commodity prices (food, coking coal, copper) affecting markets and investor returns. As the authors recognize, the problem is that by then not only investors but the entire world may have few meaningful options for reducing climate risk—a challenge perhaps beyond the scope of financial measures.
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