Investor Action on Climate Risk: Key Motivations and QuestionsPartner, Mercer Investments and Member of the Financial Stability Board Task Force on Climate Related Financial Disclosures
The international community is gearing up to negotiate a new global climate agreement in Paris at the end of 2015. But are today’s asset owners and investment managers prepared for the portfolio impact of the climate policy changes to be set in Paris and afterward? What are the key motivations for investor action and what should that action look like? These are among the questions investors need to be asking.
Climate change is an environmental and social risk, as well as an economic one. It’s a risk expected to have its greatest impact in the long term; however, in order to address it and avoid dangerous temperature increases, change must begin now. Investors cannot assume that economic growth will continue to be heavily reliant on an energy sector powered predominantly by fossil fuels.
A new report from Mercer, Investing in a Time of Climate Change, aimed at helping investors address these issues, outlines the motivations for investor action on climate risk, spanning short and long-term concerns, over the short, medium and long term.
Medium-Term Risk Management (Years)
The medium term consists of a few years, yet investors generally invest for the long term (i.e. many years). Long-term investors generally take a multi-year perspective when setting asset strategy. This is a vital component of investment oversight. Capturing climate change in risk assessments will be important for understanding and managing the asset-class and industry-sector risks and impacts on return identified in the report.
Yet few mainstream investors incorporate a detailed view on the policies that could underpin this change in investment analysis. Investors need to consider their risks by asking questions such as:
- Do sector weights across the portfolio reflect anticipated structural change? And is there enough focus on this in our portfolio construction process?
- Can investment managers articulate a clear perspective on the relevance (or otherwise) of climate risks to an investment mandate?
- Can we undertake a total portfolio risk assessment—including all real asset holdings, such as real estate, infrastructure, timber, and agriculture investments—to identify exposure to potential physical damage risk under different climate scenarios?
Medium and Long-Term Opportunities (Years)
No one can predict with certainty which way the stock market will move. Under the climate scenarios explored in this study, there are potential “first mover” advantages in some asset classes and lower-carbon industry sectors, such as renewable energy, green building materials, and sustainable transport. To capture medium-term opportunities, investors need to ask:
- Which asset classes are positioned to benefit from future opportunities?
- What active and passive equity products exist to tilt towards these sources of growth?
- How can attractive industry sectors be accessed through each asset class, and particularly in private markets?
Short-Term Risk (Months)
Although the study doesn’t account for short-term volatility driven by unanticipated climate risks, one scenario does anticipate swift policy action on climate in the near term: an increasing cost on carbon, designed to reduce emissions and limit temperature increases. This could erode expected gains in some sectors and produce annual losses. In considering this or other scenarios that may unfold, investors need to ask:
- What if climate change related policies are introduced at a level or within a time frame unanticipated by the market, either globally or in regional blocks? Might this lead to a broad market correction, or could certain assets be left “stranded”?
- Could fossil fuel subsidies be removed? Would this put major investments at risk?
- How quickly could the portfolio be repositioned if required, and what options exist today to hedge against future uncertainty?
Long-Term Cost of Inaction and Concerns of Beneficiaries (Decades)
This study uses a 35-year timeframe to explore the potential impacts of climate risk, but the most significant physical impacts resulting from climate change will be felt after 2050. This is an example of a long- term downside risk that markets struggle to address.
However, others with strategic focus are not ignoring this risk. U.S. and UK reports suggest that climate change is likely to create strategic military risks as the physical impacts amplify fragile social and economic conditions, for example, by reducing access to vital resources such as water or food.
There is strong evidence that, if we follow our current trajectory, there will be a high risk of irreversible and severe impacts across the globe. Looking to 2100 and beyond sharpens the focus on whether to mitigate now, or to adapt later at potentially significantly greater cost. Although adopting a long-term perspective is challenging in practice, it is not impossible. Investors need to ask:
- As a long-term investor, how long is my time horizon?
- Do we feel sufficiently knowledgeable about this topic? What are our investment beliefs?
- Do we have the governance framework to focus on strategically important long-term issues?
- What are the views of beneficiaries and clients?
- As asset owners, should we be more visible in calling for strong climate action by policymakers?
Make Tomorrow, Today
Investors face a number of barriers to action on climate change. It’s a challenge to take a long-term view in the context of an increasingly short-term market environment, since boards and investment committees face a range of competing priorities, while the average investor has little familiarity with climate-related risks.
Yet the investor implications of climate risk warrant a change in behavior. Investors need to incorporate evidence of the likely impact on their portfolios by a range of relevant climate change scenarios, along with practical suggestions for mitigating and managing their exposure.
In doing so, it contributes to the rapidly evolving knowledge and tools that are available to the investment industry to understand and manage climate risk. It is now up to investors to evolve. That process begins with the right questions—and a firm commitment to a sustainable future.