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Investing in a Time of Transition

The “net zero emissions by 2050” announcements by governments and companies mean the “Race to Zero” is finally underway. The pace of that race is now likely to accelerate as institutional investors map their own transition course in growing numbers, with changes in capital allocation decisions to be felt by companies throughout the value chain. But can investors make transition-focused portfolio changes and still have confidence in meeting investment objectives? 

Institutional investors — those responsible for pension, insurance, endowment or wealth management funds — collectively manage trillions of dollars globally. They invest in companies across the global economy to deliver financial returns to members, beneficiaries and stakeholders over multiple years or decades — and they are all exposed to climate change.

Climate change is driving the transition to a zero-emissions economy to reduce the impacts of natural catastrophes and physical damages, caused by rising emissions and the associated temperature increases. The more successful our transition, the lower the physical damages. 

A Gradual Versus Sudden Transition

There is no single forecast for the transition or how successful we might be. It could be gradual and orderly, but “The Inevitable Policy Response” scenario, backed by the PRI (Principles for Responsible Investment), argues a sudden transition shift this decade is most likely. Mercer also includes stress tests on sudden scenario shifts in its scenario modeling guidance for a reason. 

A transition, of some description, is now generally accepted as the most likely direction of travel, given growing natural catastrophe threats, improving economics of transition solutions and visible changes in policy and consumer behavior. In the near term, the primary investor focus is to assess the companies that are either facing potential downside risks in the transition disruption, or that may benefit by providing transition solutions. However, given that a “well below 2 degrees Celsius scenario” is in long-term investor best interests, it also makes sense for investors to strategically support the low-carbon transition, where possible, by aligning their portfolios with that outcome. 

Investor Action: Growing Momentum

There has been talk about investor action on climate change for more than 10 years, with a cohort of leaders making it a priority to act, most noticeably over the past five years. They have led the way, establishing investor groups on climate change in key regions, with activities now captured under The Investor Agenda umbrella. This site outlines the coordinated engagements with global governments on policy expectations; investor disclosure on governance, strategic scenario analysis, risk management and metrics and targets; the growth in low-carbon investments; and the coordinated company engagement with the highest emitters through Climate Action 100+.

Investors are no longer simply looking at fossil fuel reserves or emissions intensity numbers and comparing their exposure relative to a benchmark — they are now assessing the transition capacity of companies.

These and other developments, regionally and globally, have provided the foundations for today’s heightened focus on planning for and engaging in the climate transition. Immediate risk mitigation and return opportunities remain a primary focus, but importantly, investors are now taking a strategic approach to aligning their portfolios with a 1.5 degree Celsius scenario outcome. This means investors have to set targets consistent with a “net zero emissions by 2050” ambition, with milestones for 2030. However, the real challenge is the next three years, when recognized decarbonization pathways suggest significant action is required. 

The United Nations coordinated Race to Zero campaign, including investor representation via the Net Zero Asset Alliance, representing 33 investors with $5.1 trillion under management. Rumor has it that an asset manager equivalent is coming soon. The Science-based Targets initiative has an agreed methodology for the financial sector, in a pilot phase, to assess the integrity of commitments across the sector. The Global Investor Coalition representing Investor Groups on Climate Change across Europe, Pacific and North America are also finalizing guidance to support their members to set climate action plans with the working groups including dozens of investors in each region, representing trillions of assets under management. However, while the evidence for ambitious action is growing, the question remains: How will implementing these commitments and action plans actually work?

How Can Long-Term Transition Alignment Meet Short-Term Objectives?

As with all strategic planning, it requires establishing where you are now, where you want to be and the possibilities for getting from A to B. This can be achieved by calculating the current portfolio emissions baseline, agreeing the annual emissions reduction percentages for genuine 1.5 degree Celsius alignment commitments and assessing where in the portfolio those emissions reductions could come from. 

Investors are no longer simply looking at fossil fuel reserves or emissions intensity numbers and comparing their exposure relative to a benchmark. Rather, they are now assessing the transition capacity of companies, supported (in listed assets) by the significant growth in the assessment data and tools available from the likes of FTSE, MSCI, ISS, Sustainalytics. The improvements mean there are now new “third generation” global equity indices that take company transition capacity into account. Transition capacity includes board skill sets, strategy, capital expenditures, patent registrations, revenue growth in transition solutions and disclosure. 

Strategic ambition and targets for measuring progress are key to establishing a transition in the portfolio, but capacity for short-term flexibility is also required to ensure other investment considerations such as liquidity, transition costs and pricing are recognized to deliver on both the long-term and short-term best interests of all beneficiaries.

A transition approach is not simply about divesting high carbon intensity companies — although, in reality, those assessed to have low transition capacity will be sold down by investors. It is focused on integrating transition capacity assessments into financial decisions; taking an active ownership approach with companies to support a successful transition; plus actively allocating capital to companies delivering solutions, ultimately building transition capacity across the portfolio. 

Methodologies for investors with diversified portfolios will continue to evolve. But the first steps for the initial years for most investors are clear. Investors who have begun the assessment process are now in active conversations with their fund managers on the company level, detailing and prioritizing change. Fund managers are actively creating and promoting new strategies. Some companies may be noticing these changes already — for others, it will only be a matter of time. 

Jillian Reid

Partner at Mercer

Jillian is a Partner in Mercer’s Sustainable investment team, advising super funds and other institutional investors on how to integrate environmental, social, and governance (ESG) factors, sustainability trends, climate change, and stewardship, within investment processes.

In addition, Jillian contributes to new intellectual capital and integrating Sustainable investment within Mercer globally, including within Investment Solutions. Jillian was project manager and co-author for Mercer’s 2015 Investing in a Time of Climate Change report and ‘The Sequel’ in 2019; she has written and presented on water, too much and too little; and helped multiple Boards to balance risk, return, and reputation implications for sensitive investment topics.

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