Climate change is set to bring a range of new challenges and opportunities to our economies and the companies which drive them. How can investors properly account for this systemic risk and build in into their investment portfolios?

The risks associated with climate change have already started us on the path of transitioning to a low-carbon economy. This process is a disruptive one and the impact it is going to have on the investment chain needs to be managed carefully. Investors will need to have the tools necessary to read and navigate through this transition.

To this end, Ortec Finance collaborated with Carbon Delta and Lombard Odier Investment Managers to create a methodology designed to integrate climate risk and opportunity across the investment chain from climate-informed asset liability modelling (ALM), to asset allocation and portfolio construction. The working group, which also involves Achmea IM, PME Pension and MN, met in April to discuss the initial framework. 

The physical and transition risks and opportunities presented by climate change are well documented. Research carried out by Ortec Finance and Cambridge Econometrics revealed that global temperatures could rise by 4°C in the event that our economies do not transition to a low carbon model. This would have a significant negative impact on global equity returns. However, in the event of an orderly, rapid transition, their research suggests global equity returns could be significantly boosted.

Climate-savvy portfolio analysis and strategic decision making

The most commonly-applied method of managing climate risk and opportunity in portfolios is at the company level. This method has its shortcomings, especially as it does not adequately address the systemic nature of the risks associated with different global warming pathways.

Lisa Eichler, former Managing Director Climate & ESG Solutions at Ortec Finance, said: “Climate change is a key systemic risk and will undoubtedly affect the performance of investments. Crucially, there is no way to diversify this risk away, which highlights how important it is to reflect it in the assumptions and economic models underlying the asset liability modelling and strategic asset allocation. This will ensure funds can manage their funding ratios in a way that is climate-informed.”

Ortec Finance and Cambridge Econometrics have developed a new methodology for embedding climate risk into top-down macro-economic modelling and scenario sets. Ortec Finance’s systemic climate risk-aware ALM incorporates this information to project how a series of different climate change scenarios would affect strategic investment parameters. Investors can leverage this information to inform their strategic asset allocation decisions.

Willemijn Verdegaal, former Managing Director Climate & ESG Solutions, at Ortec Finance says that, while integrating climate risk at the strategic asset allocation level gives investors an advantage, there is more that can be done.

She said: “The risks and opportunities presented by climate change need to be built into the entire investment process in a consistent way. This requires exploring how top-down, macro, and bottom-up, micro, analysis can be combined.”

The forward-looking analysis central to the bottom-up part of this methodology is built on cutting-edge data. Carbon Delta’s Climate Value-at-Risk® (CVaR) estimates the forward-looking costs to companies that would result from both physical risks and transition risks. This is done at country, sector and facility level and aggregated for a comprehensive picture. CVaR also accounts for potential opportunities arising from technological advancements, such as low-carbon technology patents, and factors that into future revenue projections. As part of this collaboration, both Ortec Finance and LOIM are integrating Carbon Delta’s CVaR metrics into their processes to ensure consistency of data from the ALM to the portfolio construction.

David Lunsford, Co-founder and Head of Development of Carbon Delta, said: “Companies that are increasingly able to generate revenue from innovations in low-carbon technology, for example, should be better able to protect and grow their businesses during the transition to a low-carbon future. This is what we are trying to assess by scoring companies’ based on the quality of the patents they control.

“CVaR works by aggregating both the risks and opportunities which stem from climate change so investors and their asset managers can better inform their analysis of a company’s expected future financial performance,” Lunsford continues.

Portfolio implementation

Foort Hamelink, responsible for integrating ESG in bespoke portfolios at Lombard Odier Investment Managers (LOIM): “Companies are a key contingent of this effort to transition to a low-carbon economy. Change on this scale inevitably creates risk, but it can also create huge opportunity.

“In order to ensure we are making more informed decisions, and to introduce a greater element of sustainability to investment portfolios, we believe it is essential to embed climate risk and opportunity into the valuation of companies and assets,” Hamelink continues. “And, in order to be truly effective, this needs to be reflected across the whole portfolio.”

In order to integrate climate risks and opportunities into portfolio management, LOIM have developed a solution for implementing low-tracking error portfolios that use LOIM’s proprietary ESG/CAR approach, as well as key climate-related metrics, including carbon intensity and Carbon Delta’s forward-looking CVaR data.

Closing the loop

Ortec Finance, Carbon Delta and LOIM then analyze how exposure to the underlying risk drivers identified in the ALM have diminished in the portfolio. The climate-related risks are reduced in a consistent manner throughout the investment chain because climate risks are better managed at the sector and holdings levels. All parties work from the same data points to ensure consistency, including those derived at the macro-economic, sectoral and company level. Risk parameters at the ALM level are improved as a consequence.

Anna de Jong-Wakley, Head of Sales and Solutions for Benelux, at Lombard Odier Investment Managers, says: “This collaboration is all about helping investors mitigate climate risk. We have created a means of measuring the potential impact of climate risk within portfolios for every step of the investment process. Mitigating climate change also reduces the probability of extreme climate scenarios. This represents a net positive for everyone.”

Learn more about Ortec Finance Climate & ESG Solutions.

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