An uptake in climate scenario analysis, driven by the Bank of England’s climate stress testing exercise, is leading firms to question how they can use climate scenarios as a central planning tool. To better manage the increasing risks associated with climate change, we need improved understanding of underlying scenarios within business and a broader suite of planning scenarios made available from third-party modelling firms.
When we think about climate modelling, we think about scenarios that lead to 2 or 4 (or however many) degrees of warming. Unlike other risk management techniques however, we don’t assign a probability distribution to these. How do we therefore prepare for the likely financial impacts of climate change?
The UN Principles for Responsible Investment (PRI), in collaboration with Vivid Economics and Energy Transition Advisors have developed a model that projects the expected impacts of the likely policy changes that will be required if we are to meet global climate targets. The Forecast Policy Response (FPS) represents a well thought-out climate scenario which some may wish to consider as a central planning scenario. It broadly aligns with the World Economic Forum’s rapid energy transition narrative and reinforces that:
- Climate risks are not yet priced by the market
- Climate risks could be material for asset portfolios
- Climate risks are not distributed in line with market capitalisation or even at a sector level
Asset owners who have not yet incorporated climate risk into their investment strategies, particularly those who are UN PRI signatories, should carefully assess the outcomes of the research and consider what action may be required to understand climate risk, assess the risks in their portfolios and implement appropriate solutions.
Full details can be found directly from model results at https://www.unpri.org/inevitable-policy-response/the-inevitable-policy-response-policy-forecasts/4849.article, however, I have explored below some of the key takeaway’s from the model results as well as some of the considerations that asset owners will need to make in light of these. I hope they prove to be useful:
Key takeaway 1 – The net value impact of the IPR is a 3% fall in the current index value. This amounts to $1.6trillion, or over half of UK GDP.
Climate aligned portfolios are not in conflict with strong risk-adjusted returns. A cultural shift, driven by top-down education on the sustainable finance agenda may be required, in order to embed a ‘climate lens’ on overarching investment decisions.
Climate impacts are expected to emerge over the next 15-50 years, so are a particular consideration for long-term investments such as pension funds. Pension funds are also particularly exposed to the risks associated with passive investments, as discussed below. Pension fund managers and trustees will need to consider what is more risky; leaving your customers in a passive strategy exposed to a material financial risk or moving them to a responsible strategy which may underperform initially but would be expected to perform better in the long run?
Key takeaway 2 – Passive investors are unlikely to be as exposed to the upside as the downside of the Inevitable Policy Response.
Passive investments are not currently seen as ‘good enough’ by many investors and investor initiatives when it comes to mitigating the risk associated with climate change. This is due to many passive funds being index trackers and many indices still having significant investments in carbon-intensive sectors and firms. Active investments however drive up fund management charges and are therefore not considered a financially viable option, particularly for large pension scheme defaults.
To reduce carbon risk, it could be possible to work with index providers to create custom indices that overweight companies performing well on carbon emissions and underweight companies that score poorly, providing a passive option that is at least ‘tilted’ towards a green economy. If investing in a passive ‘green’ fund, it is important to consider whether it aligns to your own responsible investment strategy, particularly with regards to exclusions.
One area that could lend itself to passive investing is the green bond market. The green bond market is arguably the most standardised area of ESG investing, especially compared to ratings-based ESG funds. It is therefore far easier to assess the climate impact of the fund and to build a passive investment portfolio that aligns to your green targets.
It is important to also consider that asset managers will increasingly find that their response to the Inevitable Policy Response is a differentiator. Although active investments are more expensive it is expected that investors will gain higher returns as a result. They may therefore be willing (and in fact it could become the norm) to pay for the right expertise to navigate the IPR.
Key takeaway 3 – The magnitude of transition risk impact depends on when re-pricing occurs.
If markets only reprice at the last moment, the impact could be 1.5 times higher than that predicted. This implies that the earlier credible policy announcements can be made before implementation the better, as this allows investors and companies more time to adjust, and reduces the risk of a sudden and larger impact on valuations.
Delayed decision to withdraw from asset holdings at risk of value destruction could leave you ‘holding the baby’. Sudden withdrawal however results in large transition impacts, particularly where markets are not deep. Truly responsible investment strategies should aim to minimise both physical and transition risk impacts of climate on society and the economy. This can only be achieved through timely action.
Responsible investment strategies should be closely tied together with quantitative scenario analysis and disclosures, as part of an overall ‘sustainability’ value chain. Effective investment strategies are derived from quantitative analysis of potential investment impacts and in turn provide a strong and structured narrative that you take to the market. It is also linked closely to how you manage your existing risk management framework, in the sense that you will need to define your investment beliefs and risk appetite in the same way that you measure risk and return. A holistic approach is therefore required in order to embed sustainability across your business and to move from strategy to proposed action.
Jo Freeman-Young, Senior Consultant, ESG team, EY
Jo will be joining our panel for our upcoming webinar: As easy as ABC? Why ESG must be at the heart of Scotland’s fintech future