Risk/return impact of climate change?

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How big a risk/return impact could climate change have on a portfolio, and when might that happen?

According to a number of modelled scenarios lead and researched by Mercer.

  • Climate change can inevitably have an impact on investment returns, so investors need to view it as a new return variable.
  • Industry sector impacts will be the most meaningful. 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 more pronounced over the coming decade (eroding between 26% and 138% of average annual returns). 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).
  • Asset class return impacts could also be material – varying widely by climate change scenario. For example, 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. Growth assets are more sensitive to climate risks than defensive assets.
  • 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.

In the first instance, under a 2°C, or Transformation scenario, investors could see a negative impact on returns from developed market equity and private equity, especially in the most affected sectors. On the flip side, this scenario would be likely to lead to gains in infrastructure, emerging market equity, and low-carbon industry sectors.

Under a 4°C, or Fragmentation (Higher Damages) scenario, chronic weather patterns (long-term changes in temperature and precipitation) 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 in the investment process, the first step is to develop climate-related investment beliefs alongside other investment beliefs. These can then be reflected in a policy statement, with related investment processes evolved accordingly. The next step is portfolio-oriented activity, including risk assessments, new investment selection/weights and, finally, enhanced investment management and monitoring.

What plan of action can ensure an investor is best positioned for resilience
to climate change?

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 sub-sectors. Climate-sensitive industry sectors should be the primary focus, as they will be significantly affected in certain scenarios.

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

Climate change is an investment risk
Failure of economies to adapt to climate change is among the top five risks globally, according to this year’s report from the World Economic Forum (the Forum),9 which ranks the risks of highest concern to the Forum’s 900 global stakeholders.

“What happens in the next 40 years is critical for all humanity for centuries to come. What happens in the next 10 years sets the range of what’s possible.” — Alex Steffen, futurist16

The research was conducted as a global collaboration, led by Mercer, with input from 16 asset owners and asset managers (four in US, four in Australia/New Zealand and eight in Europe), representing more than $1.5 trillion in assets under management.

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