Extending the lens on climate change: Beyond investment strategies to investment policy and capital market assumptions

With many investors continuing to reassess the broader implications of rising temperatures, Ortec Finance recently hosted an online panel to discuss the perspectives and approaches industry leaders including USS Investment Management, KLP, D.A. Carlin & Company and Nuveen (a TIAA company) on the considerations, particularly for capital market assumptions (CMAs), within this evolving landscape.

The thought-provoking discussion, held under Chatham house rule, highlighted a number of key points drawn from diverse angles and experiences, summarized below.

Integrating climate into CMAs is difficult with perspectives varying on its necessity

Asset owner alignment is critical to establishing an essential climate-aware baseline

Establishing a climate-aware baseline for institutional investors is challenging due to fundamental uncertainty, muted impacts from long-term NGFS climate scenarios, and limited usefulness for short-term decision-making. Despite these challenges, asset owners have not been deterred from pursuing this goal. Many are actively undertaking alternative approaches, including creating their own short-term scenarios, incorporating bottom-up, climate-informed data across asset classes in both public and private markets; identifying initial use cases with available (albeit limited) data; and conducting external research to determine whether a broader consensus (if any) exists.

These efforts have further highlighted a ‘missing middle link’ between top-down and bottom-up approaches - limiting the ability to generate sufficient insights for short- to medium-term investment horizons and revealed significant divergence among market participants on the ‘most likely’ temperature outcome - despite most holding a view. In turn, it has also reinforced the pressing need to address this gap and to develop climate scenario outputs that are decision-useful.

Climate-aware baseline is unattainable – the shortcoming should be addressed with climate scenario analysis

Given the fundamental uncertainty and complexity of climate change, particularly how it will materialize and affect macroeconomic conditions in the long term (a key driver of CMAs), other asset owners believe it may remain infeasible to fully integrate climate into capital market assumptions. This reflects the challenge of balancing their core objective of developing robust CMAs that pragmatically capture all relevant drivers (including climate) alongside traditional factors such as economic growth, valuations, and interest rates over the full investment horizon.

Under this belief, efforts to sufficiently incorporate climate change into investment decision-making are addressed through short-term climate scenarios, which seek to understand interactions across macro drivers using academic models using narratives and models. These explore how and when the energy transition could unfold and incorporate related narratives such as geopolitics and technological developments over a 5–10 year horizon. The insights drawn from these interactions are then combined with results from stochastic analysis that include an outlook beyond the 10 year horizon, upholding a pension fund’s fiduciary obligations.

Inconsistent climate risk analysis outputs are also a barrier to its integration to CMAs

An agreed view that global markets will comparatively underperform in a higher-warming world without a low-carbon transition has prompted some asset owners to develop climate strategies to mitigate systemic impacts on economies and asset class returns, including within their own portfolios. While such view would typically lead these asset owners to integrate climate change into their CMAs, this has yet to occur, as uncertainty limits confident decisions on how to adjust CMAs in practice. Furthermore, such ‘insufficiently-informed’ decisions raises concerns about unnecessarily sacrificing short-term returns in order to maintain long-term portfolio resilience and achieve stable returns to meet liabilities.

This uncertainty is further compounded by the divergence of outcomes across different climate scenario modelling frameworks, which is more pronounced than the variation observed between scenarios with different temperature pathways and associated outcomes.

Building climate-aware processes that influence decisions will create more value than mitigation via separate structures

Establishing leadership appetite to address climate change and taking meaningful action through viable processes is the first and foremost step in overcoming the challenges of any integration. One approach is to acknowledge climate change’s radical uncertainty as comparable to other forms of uncertainty in financial markets and therefore integrate it within existing risk management frameworks.

Such frameworks would then manage the potential effects and uncertainty of climate risk in the same manner as other traditional investment risks, including how financial markets may respond to their perceived impact and potentially, uncovering opportunities.

Physical climate risk is now an immediate risk - requiring due consideration in near-term investment decisions despite its absence within CMAs

While physical risk is widely acknowledged as a long term material risk, a growing number of asset owners now firmly believe it has evolved into an immediate and significant risk - requiring it to be addressed in investment decisions made by pension funds, insurance companies, and asset managers today.

Asset owners seeking robust and granular physical risk insights – top-down and bottom-up

From an investment decision-making perspective, the challenge lies in robustly assessing how physical risk is specifically affecting geographies - across GDP growth, interest rates, and inflation - as well as sectors and asset classes. Another key consideration is the increasing risk of climate tipping points, such as an AMOC collapse.

Whilst the importance of this risk continues to rise, the inability to quantify the potential extreme impacts of physical risks - such as insured and non-insured losses from extreme weather events – constrains investment teams to effectively integrate it into CMAs.

However, by recognizing that this inability should not lead to ignoring the risk in investment decisions, many teams are turning to bottom-up insights. In particular, they are leveraging off the substantial improvements in data coverage, granularity and quality, in comparison to previous data that lacked appropriate damage functions to assess and address the issue at hand.

Other alternative and innovative approaches are being actively explored

Renewed active stakeholder engagement is an additional approach to addressing pressing physical risks, expanding on previous efforts that have predominantly focused on transition risks. These steps aim to reduce portfolio physical climate risk exposure and demonstrate financial impact.

Another innovative approach is developing climate scenarios that identify outcomes as the initial step, followed by the narrative required to achieve those outcomes - an inverse of traditional scenario modelling, where outcomes are derived from the underlying narrative. This approach enables users to analyze specific physical risk impacts on macroeconomies within their risk management frameworks.

Underestimation of climate’s impact on inflation should not be overlooked – higher inflation already included in CMAs

Insufficiently incorporating climate drivers into inflation could undermine the ability to meet future liabilities

Several modelling frameworks suggest climate change will have limited impact on inflation, a conclusion many asset owners view as unrealistic due to its reliance on monetary policy as the driver and limited to non-consideration of broader (and strong) economic transition-related drivers. These include changes to energy systems caused by low-carbon policy implementation and geopolitics, supply chain disruption, government stimulus to address slowing GDP growth from physical risk impacts as well as increasing demand for capital expenditure.

Overlooking the potential for substantial and persistent inflation in a higher warming scenario, driving higher-than-anticipated wage growth, puts financial institutions at real risk of being unable to meet their liabilities. Inflation would also erode real returns and real interest rates, reducing the value of current investments. While not directly due to climate change, a number of asset owners have already incorporated higher inflation into their current CMAs.

Increased inflation in the short-term could also be positive for the global community long-term

Another perspective offers while increased inflation is expected to create widespread downside effects in the short term for investors, economies as well as the wider society, it may also be beneficial across other aspects. This includes accelerating the low-carbon transition itself, preventing prolonged economic stagnation and ultimately, positioning pension and insurance portfolios for stronger performance over time.

Key takeaways

• Integrating climate into short-term investment decision-making and risk management frameworks is vital and beneficial with robust climate scenarios
• A climate-aware baseline and decision-useful climate scenario insights represent realistic, albeit not all yet fully realized, solutions to integrating climate change throughout the entire investment process
• Climate scenarios are essential to risk management frameworks but only add value if they are robust and plausible.
• Physical climate risks need to be addressed in the immediate future, despite overall inability to determine its systemic impacts at the preferred precision and granular level
• Higher (non-climate induced) inflation has already been incorporated by asset owners in CMAs, reflecting expectations of overall persistent and rising inflation, which may have both adverse impacts on real returns and potential upside for nominal returns over the long term.

Panelist overview

The perspectives summarized above are based on input from the following panelists who participated in our ‘Virtual panel discussion: Extending the lens on climate change: Beyond investment strategies to investment policy and capital market assumptions’ that took place on Wednesday March 24 under Chatham House Rule.