The Impact of Climate Change on Asset Allocation


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Op dinsdag 17 mei 2011 vond het seminar 'Scenario's voor klimaatverandering - implicaties voor strategische asset allocatie' plaats in het Drijvend Paviljoen in Rotterdam. Deze dag stond in het teken van de invloed van klimaatverandering op beleggingen van pensioenfondsen.
Jelle Beenen was de dagvoorzitter en gaf tevens samen met Will Oulton (UK office) een presentatie over het rapport 'Scenario's voor klimaatverandering' dat onlangs is verschenen.

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The Impact of Climate Change on Asset Allocation

  1. 1. 17 May, 2011The Impact of ClimateChange on Asset AllocationJelle BeenenWill Oulton
  2. 2. Integrating systemic risks into strategic decisionmaking What did we learn from the global financial crisis? More ‘what if’ critical thinking is required Need to think long-term and strategically Risk is more than historical volatility and correlations Source of risk beyond mean-variance analysis Behavioural biases predominate (aka technology bubble, corporate governance failures, the financial crisis…climate change?) We overlook systemic risks Climate change is one of these risksMercer 1
  3. 3. Overview of the project:Examine the implications of climate change for asset allocationCollaborative effort led by Mercer together with 14 Asset owner partners 2 Industry sponsors – IFC and Carbon Trust 1 Climate change research partner – Experts were engaged from Grantham Research Institute at LSE, chaired by Nicholas Stern (author of Stern Review), together with Vivid Economics 9 Research group members – Industry experts were consulted on the methodology and research conclusionsMercer 2
  4. 4. What determines long term investment performance Determinants of Long-term Investment Performance Asset Allocation, 91.5% Security Selection, 4.6% Asset Class Timing, 1.8% Unexplained, 2.1% Source: Brinson, Singer & Beebower, “Determinants of Portfolio Performance II”, Financial Analysts Journal, May/June 1991Mercer 3
  5. 5. How are long term decisions made?Asset Class Return Risk CorrelationIndex-Linked Gilts (20-year duration) 4.46% 8.69% 1.00Fixed Interest Gilts (20-year duration) 4.46% 7.87% 0.66 1.00AA Index-Linked Bonds (20-year duration) 5.78% 11.89% 0.73 0.40 1.00AA Fixed Interest Bonds (20-year duration) 5.78% 11.30% 0.62 0.91 0.65 1.00Absolute Return Active Strategy 4.46% 1.58% 0.09 0.03 0.02 0.03 1.00ILGs (>5s) 4.46% 6.32% 0.96 0.70 0.67 0.64 0.14 1.00FIGs (all) 4.46% 4.26% 0.72 0.88 0.42 0.78 0.24 0.78 1.00FIGs (>15) 4.46% 6.05% 0.73 0.96 0.43 0.87 0.13 0.77 0.97 1.00UK £ Credit(all) 5.78% 4.61% 0.60 0.75 0.54 0.80 0.28 0.62 0.83 0.81 1.00UK £ Credit(>10) 5.78% 6.80% 0.68 0.91 0.61 0.95 0.14 0.72 0.90 0.93 0.88 1.00Conventional Property 6.46% 14.87% 0.06 0.20 0.13 0.25 -0.20 0.04 -0.04 0.09 -0.00 0.10 1.00HLV Property 5.46% 9.15% 0.18 0.31 0.17 0.33 -0.14 0.16 0.11 0.23 0.11 0.21 0.98 1.00Hedge Funds 4.46% 1.58% 0.09 0.03 0.02 0.03 1.00 0.14 0.24 0.13 0.28 0.14 -0.20 -0.14 1.00Commodities 4.46% 22.13% -0.16 -0.29 -0.21 -0.32 0.10 -0.17 -0.21 -0.27 -0.15 -0.29 -0.17 -0.21 0.10 1.00Infrastructure (Debt) 5.14% 7.33% 0.87 0.53 0.91 0.66 0.08 0.87 0.63 0.61 0.62 0.69 0.05 0.13 0.08 -0.17 1.00Infrastructure (Listed Equity) 8.14% 18.31% 0.31 0.25 0.51 0.45 0.05 0.30 0.18 0.21 0.26 0.35 0.18 0.12 0.05 -0.01 0.45 1.00Infrastructure (Unlisted Equity) 10.52% 30.17% 0.20 0.11 0.45 0.32 0.01 0.18 0.02 0.06 0.13 0.21 0.19 0.10 0.01 0.02 0.35 0.99 1.00Private Equity 11.39% 34.47% 0.17 0.08 0.43 0.30 0.00 0.15 -0.02 0.03 0.11 0.18 0.19 0.10 0.00 0.03 0.34 0.98 1.00 1.00Equities 8.79% 16.57% 0.28 0.21 0.49 0.42 0.05 0.27 0.14 0.18 0.24 0.32 0.18 0.12 0.05 -0.00 0.43 1.00 0.99 0.99 1.00Equities (Currency Hedged) 8.73% 15.94% 0.29 0.25 0.50 0.45 0.06 0.28 0.15 0.20 0.24 0.35 0.22 0.15 0.06 -0.07 0.43 0.98 0.97 0.97 0.98 1.00 Can this be all there is to it?? Mercer 4
  6. 6. Value at Risk, confidence interval. But where is the risk? Where should the focus be, on the red or on the green? 95%Mercer 5
  7. 7. Scenario Analysis Growth Inflation Temperature Equities Equities IL Bonds IL Bonds Credit Credit Insurance Insurance Commodities Commodities Commodities Commodities Rising ? Real Assets Real Assets Real Assets Real Assets Credit Credit Equities Equities Bonds Bonds Credit Insurance Insurance Credit Bonds Bonds Falling ?Mercer 6
  8. 8. Little consideration has been given to understanding what climate change means for long term risks and opportunities as part of strategic asset allocation decision making…Mercer 7
  9. 9. The participants Norwegian Government Pension FundMercer 8
  10. 10. A natural evolution: climate scenarios for capital marketsThe United Nations Intergovernmental The Stern Review on the Economics of Climate Change Scenarios – Implications Panel on Climate Change Climate Change for Strategic Asset Allocation (1990-2014) (2006) (2011) Six ‘emissions marker scenarios’ Two climate change scenarios Four scenarios (including one based (baseline based on IPCC ‘A2’) on Stern) Assesses scientific, technical and socio-economic information Examines the evidence on the Attempts to build on prior studies to concerning climate change, its economic impacts of climate change explore the impact of climate scenarios potential effects, and options for itself, and explores the economics of on markets through asset class and adaptation and mitigation stabilizing greenhouse gases in the regional analysis atmosphere Involves thousands of authors from Undertaken by Mercer, climate change dozens of countries Advocates as urgent priorities for experts and some of the world’s largest international cooperation: broadly asset owners similar global carbon price signals and using carbon finance to accelerate action in developing countries Mercer 9
  11. 11. The benefits of scenario analysis for SAA Not everything can be quantified Tail risks - think the unthinkable Be aware of risks and opportunities that might not otherwise have been considered Scenario planning to improve decision-making Signposts to prepare minds for explicit indicators of the futureMercer 10
  12. 12. Climate Change StudyThe 4 scenarios
  13. 13. The 4 Scenarios Regional Divergence Delayed Action Uneven progress on ‘Business as usual’ until cutting emissions, with 2020 strong leadership in Bad news about rapid some regions and climate change triggers a others lagging behind global policy ‘shock’, Currently most likely rapidly driving up the cost scenario of fossil fuels Cost of carbon Cost of carbon $15/tCO2e $110/tCO2e globally to 2020, then dramatic rise to $220/tCO2e 50 Gt CO2e emissions per year in 2030 50 Gt CO2e emissions per year in 2030 Comprehensive global Continued reliance on framework to cut fossil fuels and high emissions quickly and emissions of carbon deeply Little transformation to a Market anticipates the low carbon economy, policy measures, smooth increases physical adjustment ‘impact’ risks Cost of carbon Cost of carbon $15/tCO2e $110/tCO2e globally limited to EU ETS 30 Gt CO2e emissions 63 Gt CO2e emissions per per year in 2030 year in 2030 Stern Action Climate BreakdownMercer 12
  14. 14. Why scenario analysis? Every link in the chain from carbon emissions to their impacts is uncertain – Including efforts to cut emissions and adapt to climate change (driven in part by government policy) These uncertainties are new; historical records don’t really include them The uncertainties are ‘deep’, meaning probabilities cannot be assigned with confidence Ideally suited to exploring extreme events and searching for ‘black swans’ – “the methodical thinking of the unthinkable” Identifies storylines or sequences of events, and their consequencesMercer 13 13
  15. 15. Scenarios compared: carbon emissions Sources: Vivid Economics and Grantham Research Institute, based on Bowen and Ranger (2009), IEA (2007; 2009) and Enkvist, Naucler et al. 2007Mercer 14 14
  16. 16. Mercer TIP Model - Technology, Impacts and Policy (“TIP”) risk factors These factors estimate the potential impact of climate change on the return drivers of different asset classes, where: Technology (T) measures the rate of progress and investment flows into technology related to low carbon and efficiency which are expected to provide investment gains Impacts (I) measures the extent to which changes to the physical environment will impact (negatively) on investments Policy (P) – measures the cost of policy in terms of the change in the cost of carbon and emissions levels that result from policy depending on the extent to which it is coordinated, transparent and timelyMercer 15
  17. 17. Climate sensitive assets to the TIP risk factors Not only ‘sustainable assets’ but core assets also highly sensitive to climate change. The following lists the assets whose underlying risk/return characteristics are the most sensitive to the TIP risk factors: – Infrastructure – Private equity – (Some) emerging market investments – Real estate – Agricultural land – Timberland – Sustainable equity (broad and sector theme) – Efficiency/renewables (listed and unlisted) – Further development of green bond market – Maturing and expansion of carbon marketMercer 16
  18. 18. Climate Change StudyKey findings
  19. 19. Message 1: Climate change increases uncertainty forinvestors Finding Climate change increases uncertainty for institutional investors and can potentially have a significant impact on the performance of a portfolio mix over the long-term Action Embed an early warning system. Prudent risk management processes should build in climate change considerations into long-term strategic decision making processes, to help manage the uncertainties associated with climate changeMercer 18
  20. 20. Message 2: A factor risk approach that includes climatechange factors presents a solutionFinding Scenario analysis and a factor risk framework are helpful in considering how climate change might impact a portfolio To address this, we developed the “TIP” framework to examine risks more closely defined as: the rate of progress and investment flows into technology (T) the extent to which changes to the physical environment will impact on investments (I) the degree to which climate policy is coordinated, transparent and timely (P) to help mobilise behaviour changeAction Utilise scenario analysis and factor risk framework to review asset class sensitivities to climate changeMercer 19
  21. 21. Message 3: Equity Risk Premium and uncertainty arekey drivers for evaluating asset class impacts Finding: Our study concluded that the equity risk premium differential could be as great as 2% between a smooth mitigation scenario and a delayed action scenario over the next 20 years. – Knowing what risks to focus on will be key. Only one of the scenarios had a notable impact on inflation and interest rates (Delayed Action). – Of more importance for investment decisions out to 2030 will be the additional uncertainty that climate change produces and how sensitive different asset classes are to these uncertainties. Action: Review baseline assumptions regarding ERP and uncertainties around the baseline risk/return data across asset classes in light of the findings of this study. Seek innovative ways to capture uncertainties around climate changeMercer 20
  22. 22. Message 4: Technology, Impacts and Policy areadditional sources of risk for asset classes Finding: Traditional factor risks are an important consideration but in isolation are not sufficient to measure the investment uncertainties due to climate change. – A climate change investment risk framework was developed to examine this more closely. This was specified as a ‘TIP’ framework, defined as: the rate of progress and investment flows into technology (T) the extent to which changes to the physical environment will impact on investments (I); and the degree to which climate policy is coordinated, transparent and timely (P) to help mobilise behaviour change Action: Review asset class sensitivities to climate change in light of the findings of this report and consider possible impact on risk/return assumptions to incorporate climate change risks.Mercer 21
  23. 23. Message 5: TIP climate risk factors are potentiallysignificant Finding: Measuring the magnitude of the TIP factors reveals a potentially large mobilisation of capital and associated costs that is significant for investors. For example: – The cumulative value of the Technology factor to 2030 (for the mitigation scenarios) ranges between 9-13% of the value of global market capitalisation and 12-17% of the value of global institutional assets under management. – The cumulative value of the Impact costs to 2030 represent some 3-9% of global market cap and 5-12% of global AUM – The cumulative value of the Policy costs to 2030 falls in a similar range at 4-12% of global market cap and 6-16% of global AUM. Put another way, policy costs will be between 3x and 9x higher than they are today for all mitigation scenarios Action: You could start by embedding TIP factors into regular strategic discussions and review processes to ensure that the risks are being appropriately managedMercer 22
  24. 24. Message 6: Long horizon and real assets most sensitiveto climate change Finding: For the mitigation scenarios, we concluded that infrastructure, private equity, real estate and some commodities (timber, agriculture and carbon) are more sensitive to climate change, both in terms of the risk and opportunities. – Under the more efficient mitigation policy scenario, such as Stern Action, some of these assets will be better suited to manage the risks and capture the upside than equities and bonds. – For scenarios where policy is more uncertain and difficult to predict, such as Delayed Action, sustainability themed equities, renewable energy, green bonds and some commodities will be more resilient. Action: Go long and get ‘real’. Review asset mix in light of these findings, including allocation to long horizon and real assets, as well as ‘sustainability’ themed investments across different asset classes – Engage with active managers and look for new passive optionsMercer 23
  25. 25. Message 7: Regions that lead climate transformationmore resilient and appealing for long term investors Finding: The regions that are best placed to attract capital from long-term institutional investors will be those that take the lead in finding alternative sources of energy, improving efficiency, reducing carbon emissions and investing in new technology. – Based on the regions examined in this study, indicators of future investment flows out to 2030 suggest that the greatest upside potential could be in the EU and China. – This should be interpreted with caution as generalised conclusions are difficult to make as the impact will vary significantly by type of asset, as some regions have more supportive policies in place for renewable energy or focus more on building efficiency, for example. Action: Evolve and transform. Consider implications for assets where regional allocation is possible to nuance, such as equities, private equity, infrastructure and propertyMercer 24
  26. 26. Peer comparison – TIP contributionRegional divergence and Delayed action scenarios Peer comparison of TIP contribution to portfolio risk for each scenario40% 40%35% 35%30% 30%25% 25%20% 20%15% 15%10% 10%5% 5%0% 0% Technology Impact Policy Technology Impact Policy Technology Impact Policy Technology Impact Policy Regional Divergence Delayed Action Regional Divergence Delayed Action Fourth Quartile Third Quartile Second Quartile First QuartileMercer 25
  27. 27. Asset class sensitivity to TIP factors Listed Equities Fixed Income Commod RE Private Equity Infra Efficiency/renewables Efficiency/renewables Efficiency/renewables Sustainable equity Agricultural Land Inv grade credit Core, unlisted Global equity Global fixed Timberland Unlisted EMD EME LBO VC Sensitivity L M H VH L M L H H H M H VH H VH Regional Divergence Delayed Action Stern Action Climate BreakdownMercer 26
  28. 28. Real Estate sensitivity to climate change factor risks Climate Change Risk Factors Real estate Core Unlisted Technology High Impacts Low to Moderate Policy High Overall climate change sensitivity High Observations: – Technology: The largest carbon saving potential over the next few decades is actually from retro-fitting rather than new build (in particular installing better insulation to reduce heating and cooling needs). – Impacts: The main changes anticipated are in demand for heating and cooling as well as protection against intense precipitation and flooding (both coastal storm surges and fluvial). Little variation is expected given that the impacts tend to occur outside of the 2050 timeframe. – Policy: An estimate from McKinsey shows emissions abatement potential in the building sector of 28% reduction in greenhouse gas emissions per year by 2030. Furthermore, the IPCC report that net cost additions to achieve stabilised CO2 levels by 2050 will be 7% of total building costs worldwide.Mercer 27
  29. 29. Opportunities in Infrastructure & Real Estate The long horizon and the “real” nature of infrastructure and real estate investments, increase the importance of climate-change risk factors Infrastructure: – Explore opportunities in energy, transport and water/waste, such as decentralized electricity & heat generation, additional fuel capacity storage; electrification of rail, electric cars and battery charging replacement points, underground reservoirs, and desalination plants Real Estate: – Focus should be on unlisted (direct) core assets. Due to the long lives of buildings and the large global stock of inefficient buildings, the largest carbon-saving potential over the next few decades will be from retrofitting (in particular installing better insulation to reduce heating and cooling needs), not from new buildings – Opportunities in energy & water efficiency management, heat pumps, and solar space & water heating in buildingsMercer 28
  30. 30. In conclusion: Three key actions for investors Action 1: Enhance approach to asset allocation A factor risk framework can be applied – TIPTM – to enable measurement and management of Technology, Impact and Policy risks and opportunities at the portfolio level. Action 2: Allocate to climate sensitive assets Investments that will adapt to a low carbon environment within infrastructure, private equity, real estate, agriculture land, timberland and ‘sustainable’ themed assets will provide a hedge to climate risk. Action 3: Engage with policy makers The “P” factor contributes 10% of risk to a hypothetical portfolio. Investors are increasingly engaging with policy makers to proactively manage this risk.Mercer 29
  31. 31. Policy Climate policy risk is a notable source of risk for investors The longer the delay – the higher the potential impact costs for investors Investors should engage with policy makers on specific policy plans and specific details of proposed policy plans Collaborative engagement can be effective for institutional investors Policy Makers should therefore recognise that: – Policy is crucial for encouraging the mobilisation of capital – Policy should be clear, consistent, co-ordinated and long term. Policy uncertainty increases volatility and higher risk premium’s – Delay now will cost later. Unforeseen and dramatic policy intervention will have negative consequences on core assets of global portfolios.Mercer 30
  32. 32. Making portfolios more resilient to climate changeIdentify climate risk reduction / new opportunitiesinvestments (1) Long term Strategic (2) Evaluation of climate Asset Allocation Mix risks and new opportunities (4) Allocation to climate basket of investments (3) Assessment of existing exposure versus more resilient exposureMercer 31
  33. 33. © 2011 Mercer LLC. All rights reserved. Important Notices This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity, without Mercer’s written permission. The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. Past performance does not guarantee future results. Information contained herein has been obtained from a range of third party sources. While the information is believed to be reliable, Mercer has not sought to verify it. 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