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Climate risk calls for new investment strategy

Climate risk calls for new investment strategy

Climate Investment

Karen Tursunov, a product development manager at Securities Services, says asset managers and asset owners must make investment decisions that align with emission reduction targets. New government policies focused on compliance with emission targets and the increasing frequency of natural disasters are leading to heightened climate transition and physical risk factors in financial markets. To assess climate risk, asset managers need to think beyond traditional risk measures that focus on market risk and are based on past history.

Climate change is unprecedented, will unfold over many years, and will depend on actual transition and physical risk factors. Stress testing can capture risks that fall outside typical market conditions.

Climate stress tests are distinct from traditional stress tests.

Traditional tests are based on historical events, while climate stress tests employ socio-economic scenarios that model future transition and physical risk. Europe has been at the forefront of climate stress testing with several recent initiatives from the Bank of England, ACPR, European Central Bank, and EIOPA. Securities Services can assist institutional clients in assessing climate risk through a stress test solution based on EIOPA’s 2022 climate stress test specification.

The stress test supports asset managers in quantifying the overall portfolio impact, quantifying the effect by asset class, and assessing exposure to sensitive sectors. The climate stress test can be conducted regularly to track results over time. With average global temperatures steadily rising, the critical question is what actions can be taken to limit it.

The concept of a carbon budget links carbon emissions to corresponding increases in average temperature. Global warming is projected to drag economic growth, with estimates indicating that every 1°C increase in global temperature could lead to a 12% decline in global GDP. Both the public and private sectors have committed to reducing carbon emissions.

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In the investment industry, two global alliances managing trillions in assets have pledged to reach ‘Net Zero’ emissions by 2050. On the public sector side, the EU’s ‘Fit for 55’ program aims to reduce EU-wide emissions by 55% by 2030. Addressing climate risk through robust stress testing and embracing sustainable investment practices are critical steps for institutional investors in navigating the path to a low-carbon future.

Nalini Feuilloley, head of responsible investment at BMO Global Asset Management in Toronto, says asset managers now consider physical risks in real-time rather than as a distant concern. “It’s very much being incorporated in terms of how holdings are weighted or how decisions are made on portfolios just like any other event-driven risk,” she says.

Marie-Justine Labelle, head of responsible investing at Desjardins Group, emphasizes that climate change affects investors from a top-down and bottom-up perspective.

“From the bottom-up, some sectors such as construction and housing are more affected by the physical risks of climate change,” Labelle explains. Even industries not immediately associated with climate risks, like financial services, are seeing impacts.

Ms. Feuilloley adds that many companies face physical risks in their supply chains, leaving few sectors unaffected. “Low water levels are impacting the transport of goods, setting many sectors back,” she explains. For example, low water levels in the Panama Canal recently affected global shipping.

Brian Kernohan, chief sustainability officer for private markets at Manulife Investment Management in Boston, says assessing physical climate risk has become crucial.

Assessing risk in evolving climate

“Our clients expect us to assess both transition and physical risks and to demonstrate competency in mitigating those risks,” he says.

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Many private market assets, such as farmland, agriculture, and commercial real estate, are particularly vulnerable to extreme weather events. Geographical location becomes a key part of the investment equation. “If a wildfire affects an invested forest, you could lose the forest.

We have to understand where that happens,” Kernohan explains. “In agriculture, it’s the risk of less water. Do you have enough water to grow the crops the investment is predicated on?”

These assessments are not static, he adds.

“It’s not a one-and-done. Like the weather, these assessments will continue to evolve.”

Climate stress testing dates back to the 1990s when scientists collaborated to create a scenario framework. They did so by sketching out a handful of narratives about how the world may evolve socially and economically.

These are now referred to as Shared Socioeconomic Pathways (SSPs). The narratives were combined with a range of projected emissions paths, known as Representative Concentration Pathways (RCPs). The SSP-RCP approach, endorsed by the Intergovernmental Panel on Climate Change (IPCC), became a standard framework.

However, two decades after its introduction, it shows signs of aging and does not adequately fulfill the needs of scenario users.

A revision is warranted along three distinct lines:

1. Richer Narratives: The narratives are presented in a rich and colorful language, but the only levers at the models’ disposal are the rates of demographic growth, carbon intensity, and energy intensity. There are, however, countless possible narratives.

2. Probabilistic Information: Current scenarios lack probabilities, making assessing which scenarios to worry about impossible. Without probabilistic information, scenario users have no clear way to prioritize.

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3. Modeling Choices: The modeling choice in the SSP/RCP set-up associates each narrative with the most likely trajectory for each driving variable, failing to convey the huge uncertainty around key estimates.

This creates a misplaced sense of predictability, often expressed in unjustifiable precision. To address these shortcomings, a revised approach is suggested. Recognizing the link between carbon intensity, energy intensity, and demographic growth to economic growth is crucial: richer countries tend to have lower fertility, use more services than goods, and use fewer emissions to generate energy.

We can estimate GDP per capita and all other main drivers by modeling economic growth and its uncertainty. While the method proposed is not the final word, it represents a step toward a probabilistic approach essential for future climate scenario modeling. This direction aims to offer more useful insights for policymakers and investors dealing with climate change uncertainties.

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