Modeling Asset Sensitivity to Climate Change
In a world facing the dramatic consequences and uncertain risk stemming from climate change, investors need to look beyond the typical 10-year time frame and consider the very long-term view, which extends to 30-plus years.
Unfortunately, existing modeling does not capture very long-term structural changes, precisely the type expected as the world manages the risks posed by climate change.
Mercer, as part of a collaborative study that culminated in the recent report, Investing in a Time of Climate Change, is aiming to redress that by adapting its investment model to incorporate the TRIP climate risk factors— Technology, Resource Availability, Impact, and Policy— and the four defined climate change scenarios reported in a previous BRINK article.
Modeling remains imperfect because any quantitative process continues to be limited in its ability to identify and manage specific structural changes. We all know these changes will give rise to new industry classifications, new developed markets morphing out of today’s emerging ones and new opportunities driven by technological advances and applications. Unfortunately, nobody can pinpoint precisely when and where these changes will occur. Nevertheless, enhanced modeling incorporating TRIP climate risks and the scenarios can tell us more than the traditional approach by highlighting which asset classes and industry sectors, including sub-sectors, are expected to have the highest sensitivity to climate change.
The Energy Sector
The energy sector is the most sensitive to climate change and is going to be significantly impacted. Within this sector, the greatest technological advances and subsequent efficiency gains are expected to occur in the renewable and nuclear industries. Renewable energy has the highest positive sensitivity (which in turn should lead to a positive impact on long-term returns), driven by ever more affordable technology that already gives renewables parity in some markets. Meanwhile, policies such as renewable targets and subsidies have had a significant impact on the initial growth of renewables to date, with that growth expected to continue.
On the other hand, climate policies aimed at lowering carbon emissions are expected to pose a risk to fossil fuels, which are also increasingly challenged by exploration limits and social activism. Energy supply is often centralized and nearer to coastal areas, making these facilities vulnerable to the physical changes caused by climate changes expected in decades to come. The energy sector is currently heavily weighted to oil, gas and coal, and therefore has mostly negative risk-factor sensitivities.
Climate Change Implications for Asset Classes
At an asset class level, climate change implications are better understood for equities given the relatively high level of integration of environmental, social and governance (ESG) issues, relative to other asset classes and the industry sector classifications. Developed market global equity stands to benefit from climate technology developments, but not much else. Those invested in emerging markets need to watch out for risks associated with resource availability and physical impact that could be detrimental to expected returns.
In particular, we expect:
- UK, Australian and Canadian equities to be more sensitive to climate risk, given the higher exposure of these regional equity markets to carbon-intensive sectors.
- UK and European equities to be less vulnerable to climate change policy shocks, given existing policy and commitments in place. We expect these markets to be better prepared for additional climate-related policy, given the relative transparency regarding the direction of future policy.
- Australian equities to be more sensitive to a climate change policy shock, given the greater level of policy uncertainty in this market and the historical lack of support from the Australian government. The U.S. will continue to drive global equity markets in the near term. Therefore, we would expect any significant policy developments in the U.S. to impact global equities to a greater extent than developments in other regions. Emerging market equities to benefit from additional climate change mitigation policy and technology developments, although there will be country-level differences across emerging markets and this is subject to the support and other terms of an international climate agreement. Emerging market equities are more sensitive to the climate-change risk factors associated with physical damages of climate change (physical impacts and resource scarcity) than developed markets, and also are more likely to face costs around adaptation to climate change. Thus, emerging markets are likely to receive greater relative gains from more ambitious mitigation policies than developed markets.
- That small cap equity offers considerable opportunity to invest in companies directly related to the shift toward a low-carbon economy.
Asset classes such as real estate and infrastructure stand to benefit from technology and policy, but have negative sensitivities to risks associated with resource availability and physical impact from storms and rising sea levels. Technology is already well-developed within the real estate sector. It allows older properties to be retrofitted to comply with increasingly stringent regulation around energy efficiency and to design new buildings with energy efficiency in mind. While extra short-term costs will be incurred, these should also be offset by savings in the longer term (e.g. savings in energy use), not to mention maintaining aesthetic appeal to tenants.
Fixed income generally remains a more difficult asset class for ESG considerations to be integrated relative to equities, real estate and infrastructure. However, one opportunity arising is the growth of the green bond market. The term “green bonds” is applied to bonds for which the proceeds raised are used to support projects or activities that have a positive environmental impact, such as those focused on energy efficiency or renewable energy. Although still a nascent investment area, the green bond market is growing rapidly and, in time, could offer attractive opportunities to investors.