The Climate Change Variable: Impact on Investor Portfolios
Climate change is going to have an impact on investor returns, whichever scenario of climate action and global temperature eventually emerges. The portfolios of institutional investors of all types will be affected, including insurers, corporations, pension funds, endowments and foundations, as well as individuals.
That is the first key finding of the Mercer-led report, Investing in a Time of Climate Change, which underscores the need for investors to view climate change as a new return variable, irrespective of their personal beliefs about the issue.
Our research further indicates that the most meaningful or pronounced impact will be at an industry sector level, particularly over the next decade. This finding is significant in itself because most of today’s investors are building their portfolios with a focus on asset classes. As we’ll see, returns at an asset class level will be impacted too, and this certainly warrants consideration. However, a greater focus on industry sector exposure in the future would seem advisable based on the report’s findings.
Industry Sector Impact
The chart below shows the potential climate impact on median annual returns for industry sectors over the next 35 years. The range shows the minimum and the maximum impact (or additional variability) across four climate change scenarios for each industry sector. These should be considered in context as a percentage of underlying expected returns without the influence of climate change, which typically range from 6-7 percent annually.
The energy sector is broken into its sub-sectors, as one of the most impacted industries. The bright spot in the energy sector is renewables, which have the greatest potential for additional returns: depending on the scenario, average expected annual returns could increase from 6.6 percent to as high as 10.1 percent.
Climate Impact on Returns—by Industry Sector
Median annual returns over 35 years
Asset Class Impact
There are also material consequences to be considered at the asset class level, with the outcome highly dependent on the scenario in many cases.
As can be seen from the chart below, only developed-market global equity is expected to experience a reduction in returns across all scenarios. For most other asset classes, climate change is expected to either have a positive or negative effect on returns across the four scenarios modeled.
Interestingly, over 35 years, real assets—including infrastructure, real estate, timber and agriculture—exhibit the most variability across the four scenarios with the potential for large return increases or reductions. Emerging market equity exhibits similar dynamics as real assets. Due to the heterogeneous nature of asset class exposures, these results may underplay more diverse effects within individual asset classes.
Private debt and hedge funds are expected to be insulated from the effect of climate change due to their inherently opportunistic nature and the diverse number of approaches to investing in these asset classes. Developed-market sovereign bonds are also not viewed as climate risk-sensitive at an aggregate level, as they remain dominated by other macro-economic factors, though there are exceptions: Japan, Australia and New Zealand.
Climate Impact on Returns—by Asset Class
Median annual returns over 35 years
Total Portfolio Impact
We can expect different asset classes to have an increase or decrease in expected returns depending on the future scenario. Here are a couple of examples of how a total “reference” portfolio might be impacted under the two most dramatic scenarios modeled in the Mercer report: Transformation and Fragmentation (Higher Damages).
In these charts, the climate return portfolio impact estimates are based on 10-year figures, consistent with the typical strategy-setting time frame for investors. These effects on 10-year returns will differ from 35-year effects shown above because they are driven by the relative impact of each TRIP factor in each scenario at 2025 versus 2050.
The black circle represents the full portfolio, with the width of each asset class section representing the size of the allocation. Asset class sections that are expected to experience a reduction in returns under a specific scenario will move towards the center of the circle, and asset class sections that are expected to experience additional returns will move outwards from the circle.
Investors should prioritize their actions for asset classes considering those with the largest weightings and largest movements inwards or outwards from the black circle, based on their view of scenario likelihood.
For a typical investor, the greatest portfolio risk is likely to arise from exposure to developed market equity, since this asset class is negatively impacted under all the scenarios modeled. Although small tactical adjustments to this asset class weighting may be possible, the primary way investors will likely reduce this risk exposure is through greater consideration of the underlying sector-level exposures of the asset class. Hedging this risk through strategic allocations to climate solutions or using a derivative mechanism is also possible.
Portfolio Impact—Transformation Scenario
(Median Annual Return Impact Over 10 years)
Under this scenario, key risks relate to developed market equity, private equity and low-volatility equity exposures, with expected gains driven by emerging market equity, real estate, infrastructure, timber and agriculture. Overall, we expect generally more dramatic impact at the asset class level compared to other scenarios, although the total net portfolio impact will be similar. However, this result belies an opportunity under the Transformation scenario, if effectively anticipated, to protect downside and capture upside by reducing exposure to vulnerable asset classes and pursuing opportunities in real assets or emerging markets.
Portfolio reallocations could be considered and additional risk-management measures (such as industry-sector exposure analysis and company-level engagement) employed. These are explored further in the following section.
Portfolio Impacts—Fragmentation (Higher Damages) Scenario
(Median Annual Return Impact Over 10 years)
Under a Fragmentation—Higher Damages scenario, the most significant negative returns are apparent in timber, agriculture, real estate and public equity allocations—both in emerging and developed markets. While the total net portfolio impact of this scenario is similar to the total net portfolio impact under the Transformation scenario, notably, under this scenario, no asset classes post gains over the 10-year period. This means the only way to address climate change under a fragmented policy scenario is to manage downside risk, as there will be limited opportunity for upside capture.
In order to manage a Fragmentation scenario outcome, where the physical impacts of climate change will be most acute, investors should consider undertaking geographic risk assessments at the portfolio level, as this will enable more granular management of long-term weather and short-term catastrophe risk.
So What Should Investors Do?
Beyond acknowledging that climate change is going to have an impact, the imperative for investors now is to first understand their portfolio exposures to the asset classes and industry sectors most sensitive to the TRIP factors and those with the greatest potential impact on returns.
Secondly, investors must position their portfolios accordingly, by integrating climate-risk management within the organization’s broader portfolio risk management function.
Investors will require a governance approach that enables them to build capacity to monitor and act on shorter-term climate risk indicators (1–3 years), as well as longer-term (10-plus years) considerations. Initially, a “safeguarding” position may be more practical; that is, where investors believe particular industry sectors or asset classes are likely to be at risk, they might change sector weights or, at a company level, tilt towards less carbon-intense companies within industry sectors.
This may evolve, as appropriate, into a more proactive approach involving deliberate portfolio structural biases towards low-carbon industry sectors or real assets over the long-term, which could involve a change of outlook on appropriate sector classifications and market benchmarks. It could also involve engagement with companies and regulators in an attempt to secure a less uncertain future for the fund and its beneficiaries, wherein beneficial climate change outcomes are secured. Such proactive investors are what we call “Future Makers.” Let’s hope they are the wave of the future.