Climate Risk Factors Bring the Long-Term into Closer, Sharper Focus
Imagine the investable universe could be examined through a telescope. The simplest scope might give you a better view of the more obvious risks and opportunities out there on your investment time horizon. However, just as an astronomer needs to see farther and in more detail than the casual stargazer, professional investors need more sophisticated systems of lenses allowing for greater magnification.
The standard model of such an investor’s telescope would likely have a lens system to zoom in on such things as market risk, credit risk, liquidity risk, and perhaps even counterparty risk. However, you would be hard pressed today to find one to sharpen your focus on the future investment implications of climate change. Extending the astronomy metaphor, too few investors today are looking at that part of the sky.
A recent year-long study led by global consulting firm Mercer culminated in the June 2015 release of the Investing in a Time of Climate Change report, which aims to help investors better understand risk at a global, regional, asset class and sector levels. Adapting asset allocation modeling to quantify the relative influence of four key risks through scenario analysis, Mercer quantified the influence of technology, resource availability, impact and policy (TRIP) on asset class and sector returns. A recent article by Katy Lederer in The New Yorker magazine called the study “the most comprehensive from an asset-allocation perspective” to date.
Sliding the first lens into place affords investors a close-up of the rate of progress and investment into technology needed to support the transition to the low-carbon economy. Investors will need to allocate funding to low-carbon technologies based on an understanding of the speed, scale and success of such technology, both existing and new.
The speed and scale of investment flows into technology will be influenced by policy (e.g., carbon pricing, low-carbon mandates, minimum efficiency standards), how easily we can allocate to cost-effective, low-carbon investment solutions (e.g., absent subsidies or carbon pricing), private sector demand (e.g., businesses seeking to be 100 percent renewable), and investor targets related to portfolio decarbonization (e.g., divestment and clean-technology commitments). Technology should play a significant role in any investment portfolio that seeks to be resilient in the face of climate-related investment risks.
The second lens on which investors need to focus regarding climate risk is resource availability. We assessed the influence of climate change on temperature and precipitation, which in turn can produce chronic weather patterns affecting air, water, natural materials and agriculture. The investment impact is tied to the risks of scarcity and abundance – scarcer resources becoming more expensive and possibly fueling geopolitical tension or even conflict; abundant resources leading to price drops and lower growth.
There are companies and sectors that are highly exposed to these risks in our portfolios now. The risk of being blind to the role of climate-related stresses on natural resources and our dependency on them will lead to destruction of value, according to our risk analysis.
The third lens provides a view of the physical impact of climate change on the environment caused by climate change-induced shifts that cause extreme weather. For investors, this risk might be viewed as more frequent and more extensive damage to property, infrastructure, agriculture and timberland holdings that are subject to flooding, hurricane activity and wildfire. Clearly, it is closely correlated to resource availability.
Level of coordinated ambition to adopt and adhere to policy among governments is risk factor many investors overlook.
In the Mercer report, policy is listed as the fourth risk factor. It is a lens belonging to our investment telescope, but it is actually closer to the first factor: technology. This is due to the previously mentioned expectation that technology investment flows will correlate largely with the extent of policy interventions. There may be a future decoupling if or when successful new technologies become less reliant on policy settings, but for now these two factors remain well-linked.
Policy is broadly defined as all of the international, national and sub-national targets, mandates, legislation and regulations meant to reduce greenhouse gases emitted by human activity (i.e., anthropogenic climate change). This might involve the setting of higher carbon prices, emissions thresholds and incentivizing low-carbon alternatives. The level of coordinated ambition to adopt and adhere to policy among governments is the risk factor many investors overlook.
Policy can be classified into two categories: encouraging substitution of higher-emission technologies with low emission ones on the supply side (e.g., moving from coal-generated electricity to solar), and discouraging consumption of products generating emissions on the demand side (e.g., through pricing and emissions labeling).
The degree to which climate-related policy action takes place and its anticipation by investors remain the crucial factors to consider when evaluating the investment impacts of policy as an investment risk factor.
Although linked to technology, policy ultimately has implications for resource availability and impact too, with positive policy action playing a critical role in protecting investors from the negative sensitivities their assets have to those two risk factors.
What does positive policy action look like? The 2014 Global Investor Coalition Statement on Climate Change offers some pointers, calling on governments to:
• Provide stable, reliable and economically meaningful carbon pricing.
• Strengthen regulatory support for energy efficiency and renewable energy.
• Support innovation in and deployment of low-carbon technologies.
• Develop plans to phase out fossil fuel subsidies.
• Ensure national adaptation strategies are structured to deliver investment.
• Consider the effects of unintended constraints from financial regulations on low-carbon technologies and in climate resilience.
Have a safe TRIP
Climate change has many dimensions, but these four TRIP risk factors provide strong focal points for investors to identify the future implications of climate change. By zooming in and focusing on these risks, investors can be better informed and prepared, which can only increase their prospects of a safer journey into a still very uncertain future. As Galileo Galilei, once said: “All truths are easy to understand once they are discovered; the point is to discover them.” Mercer’s TRIP factors are designed to help investors on their journey of discovery.