Institutional investors need to get more serious in their engagement with policy makers by targeting specific people in environment departments and defining an action plan to tackle climate change risk, according to global head of research, responsible investment at Mercer, Danyelle Guyatt.
Guyatt, who was the primary researcher and project manager for Mercer’s recently released and much anticipated global co-operative climate change report, says investors need to engage with policy makers as part of a number of strategies she recommended to combat climate risk.
She says the collaborative efforts of groups such as the International Investors Group on Climate Change (IIGCC) have determined the right frameworks and have been effective in collaboration, and now those efforts are being bolstered.
“Now investors need to get more specific, define action plans and what they’re asking from whom,” she says.
As a result of Mercer’s recent study – Climate Change Scenarios: Implications for Strategic Asset Allocation – Guyatt says it is now obvious that climate change presents a real risk to institutional investors’ portfolios.
Mercer says that traditional approaches to modelling strategic asset allocation fail to take account of climate change risk, primarily because they rely on historical quantitative analysis.
The report uses scenario analysis to model climate change risks using a TIP framework – technology, impact and policy – and found that as much as 10 per cent of a portfolio’s risk could be attributable to climate policy.
Under this new strategic asset allocation, Guyatt says a breakdown of risks found that the equity risk premium is 72 per cent, technology (carbon) is 1 per cent, illiquidity premium 5 per cent, policy (climate change) is 10 per cent and credit risk premium is 12 per cent.
With this in mind she says institutional investors need to look at diversification across sources of risk, not traditional asset classes.
“Enhancing the approach to asset allocation, using a factor-risk framework is one action investors can take to combat these risks,” she says, adding an allocation to climate-sensitive assets and engaging with policy makers are also essential.
“For those investors managing money inhouse, instead of not investing because of climate change issues, they need to engage with the various departments, get connected and ask questions. It is intensive but it could pay off from a risk perspective,” she says.
Guyatt said her Canadian colleague, Jane Ambachtsheer, talks about these risks in a budget allocation framework, and challenges investors to consider if climate policy can account for up to10 per cent of portfolio risk, then that should account for one-tenth of the time.
The Mercer study, the first of its kind to apply specifically to asset allocation, took more than one year to complete and was conducted in a three stage process including Grantham Research building the scenarios, mapping the evidence and reviewing the investment impact, capital market assumptions and decision-making process.
The process analysed four scenarios and their impact on asset allocation and portfolio risk:
1. regional divergence, which was the most likely scenario and concluded there was an uneven process on cutting emissions with strong relationships in some regions, high uncertainty in investments and assets, making country selection important
2. business as usual until 2020, which would mean a bumpy market transition producing high volatility, high anticipated costs and lower risk premiums
3. “Stern” action, which had a low probability but the best outcome from an investment point of view, and included clear policy with smooth adjustment, and new investment opportunities
4. climate breakdown, which was a continued reliance on fossil fuels and high carbon emissions and meant real assets would be very risky in the future, but there would be low immediate asset allocation impact.
Mercer charted the difference in the portfolio risk from each of these scenarios that would be needed in order to achieve a 7 per cent return and found: regional diversification had risk of 11 per cent, delayed action 14 per cent, Stern action 9 per cent, and climate breakdown 12 per cent.