Ortec Finance, the leading provider of technology and solutions for risk and return management for financial institutions, in partnership with Cambridge Econometrics, has supported global institutional investor GIC in updating its climate scenario analysis. The scenarios offer a practical tool to assess the impact of climate risks on investment portfolios and the wider economy.
Their analysis reveals that while there might be potential upside for certain markets, sectors and companies, projected returns are meaningfully lower over the long run across all scenarios versus a world with no climate change. Opportunities span emerging markets with currently low exposure to low-carbon utilities or nascent decarbonization and adaptation solutions. However, a hypothetical global portfolio of 60% equities and 40% bonds will see its cumulative returns decline by 10 to nearly 40% over a 40-year period, in comparison to a climate-uninformed baseline.
Compared to GIC’s initial scenario analysis with Ortec Finance, which was published in 2021, the updated analysis showcases increased volatility in macro variables more clearly. This is especially the case for GIC’s bespoke scenarios which reflect its views and assumptions on the complexities associated with climate policy development and the way markets react to climate risks. These two scenarios – ‘Delayed Disorderly Transition’ and ‘Too Little Too Late’ - map out the impact of extreme weather and policy shocks as well as more disruptive market pricing-in mechanisms and sentiment shocks. For example, sharp policy responses to extreme weather shocks might see GDP and inflation fluctuate widely.
Rachel Teo, Head of Sustainability and Total Portfolio Sustainable Investing, GIC said: “Climate scenario analysis plays a vital role in helping long-term investors such as GIC stress-test our portfolio against the impact of climate-related risks over the long run. It’s been our pleasure to collaborate with Ortec Finance and Cambridge Econometrics to quantify how climate-related transition, physical and market risks affect a range of macro and investment indicators. By incorporating the scenario findings into both top-down and bottom-up investment processes, this exercise will enable us to focus our efforts on mitigating strategies to create a more resilient portfolio.”
Willemijn Verdegaal, Managing Director Climate & ESG Solutions, Ortec Finance said: “GIC’s follow-up exercise with an updated set of climate scenarios highlights the key role of climate scenario analysis in enabling investors to quantify how climate change drivers affect risk-return assumptions, assist with the stress testing of their portfolio and identify areas with heightened risks.
We look forward to partnering again with GIC and other investors to continually assess the evolution of drivers of climate change and its impact on the portfolio and incorporate potential new ways the investment environment could play out and updating our modelling methodologies.”
The updated scenarios incorporate two new major features:
Firstly, they present an additional fourth scenario, ‘Too Little Too Late’, which is aligned with a 2-3⁰C outcome. This scenario assumes both high transition and physical risks, given the delayed introduction of climate policies which fail to limit the physical impact of climate change. It offers a narrative that reflects GIC’s concerns as an investor and is not included in any climate scenario sets currently in the market.
The second feature is an update on the supply side effects of physical climate risks on inflation which are inflationary and counteract the deflationary impact of lower growth resulting from physical risks.
The four climate scenarios explored include Net Zero, Delayed Disorderly Transition, Too Little Too Late and Failed Transition. The two bookend scenarios, Net Zero and Failed Transition, were sourced from Ortec Finance’s 2022 standard set of ClimateMAPS’ climate scenarios. Delayed Disorderly Transition and Too Little Too Late were custom scenarios developed by Ortec Finance and GIC to incorporate GIC’s specific views such as the potential for disruptive market pricing and the possibility of insufficient policy actions.
The analysis outlined the following main climate change-related risks:
- Timing and sufficiency of climate policies (timely, delayed, late, or none, and whether they are sufficient to meet the Paris climate goals or not)
- Extent of physical risks (both acute and chronic)
- Whether markets price in future climate-related drivers smoothly or disruptively, and if this will result in sentiment shocks.
Find out more about GIC’s latest climate scenario analysis in ‘Integrating Climate Scenario Analysis into Investment Management: A 2023 Update’
GIC is a leading global investment firm established in 1981 to secure Singapore’s financial future. As the manager of Singapore’s foreign reserves, GIC takes a long-term, disciplined approach to investing and is uniquely positioned across a wide range of asset classes and active strategies globally. These include equities, fixed income, real estate, private equity, venture capital and infrastructure. Its long-term approach, multi-asset capabilities and global connectivity enable it to be an investor of choice. GIC seeks to add meaningful value to its investments. Headquartered in Singapore, GIC has a global talent force of over 1,900 people in 11 key financial cities and has investments in over 40 countries. For more information, please visit www.gic.com.sg or follow on LinkedIn.
About Cambridge Econometrics
Cambridge Econometrics is an award-winning economics consultancy based in Cambridge (UK), Brussels, Budapest and Northampton, Massachusetts. Their globally recognised macroeconomic model E3ME underpins its rigorous and independent approach to helping clients make evidence-based investment and policy decisions with confidence, providing clear, intelligent and actionable insights. E3ME fuels Cambridge Econometric’s strategic partnership with Ortec Finance through simulating interactions and dynamics of the economy for climate scenario analysis, testing the impact of different global temperature pathways and assessing the impact of physical and transitional climate-related risks.
The four climate scenarios used in GIC’s updated climate scenario analysis
Net Zero (NZ): Sourced from Ortec Finance’s ClimateMAPS 2022 standard set of climate scenarios that is characterized by an early, orderly, and ambitious transition to a 1.5˚C warming trajectory by 2100. Global emissions reach net-zero by 2050. The scenario accounts for the physical risks associated with 1.5˚C. The market’s pricing-in of transition and physical risks are smoothed out.
Delayed Disorderly Transition (DDT): A bespoke scenario developed to reflect GIC’s assumptions that the world is slow to implement climate policies until a surge in extreme weather events occurs that is historically unprecedented in terms of frequency and intensity but within the range of scientific forecasts. These events result in a global recession. The world shifts gear and acts. Policies required, such as regionally-differentiated carbon pricing and subsidies for clean technologies, are much more substantial compared to what is needed in the NZ scenario due to the delay in taking climate mitigation actions. The climate policies are ultimately sufficient to reduce emissions and keep global warming below 2⁰C by 2100. Markets price in future climate change-related risks over a much shorter period compared to the NZ scenario. There is also a sharp sentiment shock as markets overreact to sudden extreme weather and policy shocks. The transition is thus disorderly with equity markets falling sharply. However, over time the sentiment shock (which is not fundamentally driven) dissipates and economies and markets recover.
Too Little Too Late (TLTL): A bespoke scenario developed to reflect GIC’s assumptions, like the DDT scenario, where policymakers are forced to act only when public pressures rise in response to severe extreme weather shocks. However, unlike DDT, responses by policymakers are insufficient to cut emissions sufficiently to keep global warming below 2⁰C. Only a series of intensifying extreme weather shocks over a decade will compel sufficient policy actions to peak global emission(1) . However, this is too late for the world to keep within the 1.5⁰C carbon budget. Global average temperature reaches ~ 2 to 3⁰C by the end of the century. GIC decided to explore this highly disruptive scenario because, as investors, they need to contemplate a world of insufficient policy actions as a potential outcome. In the 2022 UN Climate Gap Report , based on current committed policies, the expected 2100 temperature outcome ranges from 2.4⁰C to 2.8⁰C. This is also a scenario that examines a world with both rising and disruptive transition and physical risks which GIC believes investors should prepare for.
Failed Transition (FT): Sourced from Ortec Finance’s ClimateMAPS 2022 standard set of climate scenarios, this scenario assumes only currently implemented policies. Climate change-related physical impacts, both chronic and acute, are extremely severe as the average global temperature increases to over 4⁰C above pre-industrial levels by 2100. In this scenario, markets price in physical risks including those occurring in the post-2050 period so that financial impacts are felt even before the physical risks manifest.
(1) Each “extreme weather shock – policy actions – and market reaction and pricing-in” cycle is more severe than the one before.
(2) Source: UN Emissions Gap Report 2022 by UNEP.