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Integrating climate risks with your scenario planning

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A new perspective on incorporating climate-related risks and opportunities in scenario analysis for strategic investment decision-making

San Francisco became ‘the place to be’ for sustainable investment last week, when the city hosted two major conferences:

  • California Governor Jerry Brown and co-host Michael Bloomberg convened the 4000+ delegates Global Climate Action Summit 2018, which aimed to spur a surge of climate action and commitments from regions, cities, businesses, investors and the public sector; and calling on governments everywhere to step up their efforts to tackle climate change.

  •  At the same time, some 1,200 delegates attended the largest ever Principles for Responsible Investment's (PRI) annual conference, PRI in Person.

The sheer size of these two events and the number of influential speakers across politics, the public sector and business including Al Gore, Christiana Figueres, Lord Nicholas Stern and Harrison Ford clearly demonstrates that the practice of incorporating environmental, social and governance (ESG) factors into investment has now moved from a niche to a mainstream activity.

In particular, many of the side events hosted around town stressed an urgent need for investors to assess the climate-related risks their portfolios are exposed to, disclose their findings and act on the opportunities identified as part of the transition to a low-carbon, climate-resilient world. While investors and businesses alike seem to be making remarkable progress identifying their climate-related commitments, I was taken aback by the repeated mentioning of their struggle; how best to conduct scenario analysis of climate-related risks and opportunities (as recommended by the TCFD) and consequently how to truly integrate climate/ESG throughout their entire investment decision process.

Investors require sufficient returns to meet their financial obligations, such as paying pensions and claims. Empirical research shows that over 80% of investment returns are determined by how investors decide to strategically invest their funds across different asset classes such as equity, fixed income, real estate and alternatives[1]. Standard models that inform investors of how best to allocate their assets currently do not include information on climate-related risks and opportunities – even though climate change is increasingly recognised as being a key financial risk driver[2].

The key is therefore exploring how these models can be enhanced and collaborating with stakeholders and academia in creating a solution.

Understanding how to combine research-backed ESG and climate change insights with standard investment process modeling and analysis is the first step in this process. More specifically, integrating these quantified risks associated with climate change is key in enhancing the standard forward-looking financial scenario sets that drive strategic investment decision-making.

From our part, this has been the driver of our new Strategic Climate Solutions team which, in order to develop a solution, worked in close partnership with five clients (AP1, a.s.r., OPTrust, Pensioenfonds van de Metalektro (PME), Philips Pensioenfonds), along with support and/or expert feedback from various research institutes including: Cambridge Econometrics; Carbon Delta; I Care & Consult; the Institute for Environmental Studies – VU Amsterdam; the Grantham Research Institute at the London School of Economics; Potsdam Institute for Climate Impact Research; Sustainable Finance Lab; Utrecht University; and the University of East Anglia.

The resulting strategic asset allocation / asset-liability management approach uses a three-step methodology:

  1. First, existing academic research on climate-related risks and opportunities associated with several global warming pathways are identified
  2. Second, these climate-related ‘shocks’ are mapped to key macro-economic risk drivers, including growth rate, inflation and interest rates
  3. Third, the results of this mapping are then integrated into the forward-looking scenario set that already includes a wide array of standard financial and economic variables.

Attending the San Francisco events was inspiring and confirmed the need for new ‘climate-savvy’ scenario sets that can be used for asset-liability modelling and analysis. These scenarios are then included in the ALM analysis of a given portfolio, offering short- and long-term balance sheet simulations, where the resulting insights will increase the piloting investors’ understanding of the sensitivities of their investment strategies to climate-related risks and opportunities.

The industry is taking a big step forward in recognising the importance of climate factors, so it is crucial that investors are kept informed and supported in informing their decision making. For institutional investors like pension funds, this work can make a real difference to choices that will affect both short and long-term funding and risk levels.

Lisa Eichler, Co-Head Strategic Climate Solutions at Ortec Finance

[1] First State Investments (2013). Strategic Asset Allocation. In Multi-Asset Solutions Research Papers, Issue 6, September 2013.