Top-down or bottom-up? How should institutional investors manage climate risk?

As investment teams across an organization grapple with climate risk from different perspectives, a fundamental question emerges: For investors seeking to make pragmatic and informed decisions today, should climate risk be addressed through a top-down or bottom-up approach?

Climate risk from an investor’s perspective

To answer this question, it is useful to first examine the characteristics of climate risks within the investment portfolio.

• Climate change is systemic. It affects macroeconomic conditions, market dynamics and asset valuations across all sectors, asset classes and geographies. As a result, climate risks are difficult to diversify through traditional asset allocation strategies.
• Climate risks are unevenly distributed – no asset will be immune to climate risk. However, impacts will vary not only across regions and sectors, but also within the same sector across different regions.
• Climate risks vary across individual holdings because these assets are rarely exposed to the same mix of sectors and regions, nor does the management have identical sustainability strategies. As a result, each holding company has a unique climate risk profile driven by differences in economic exposures.

What does this mean for institutional investors?

To move towards taking decisive informed action on climate risk, investors must evaluate their portfolio's overall climate risk exposure across two key dimensions by quantifying:

• Climate risk associated with sectors and regions from a top-down perspective by assessing how climate change is expected to affect investment returns but also specific sectors within specific geographies across different asset classes.
• Each asset's economic exposure to sectoral and regional risks from a bottom-up perspective by reflecting each holding’s unique mix of business activities and geographic exposures.

The intrinsic value of top-down climate risk analysis - and its limitations

Top-down climate scenario analysis assesses how systemic physical, transition, and market risks evolve under different climate scenarios and quantifies their impact on economies, sectors, and financial markets.

This systemic perspective makes top-down scenario modeling particularly valuable for strategic asset allocation and risk management in multi-asset portfolios. It provides a consistent and scalable framework to assess climate-related risks and opportunities across entire portfolios, capturing impacts on both financial markets and the real economy.

Despite the valuable insights provided by top-down analysis, translating these findings into investment decisions for portfolio managers remains challenging. Portfolio-level, asset-class, and sector-region assessments often fail to reflect the diverse economic exposures of individual securities. As a result, investors may struggle to derive actionable asset-level insights, limiting the practical application of top-down climate analytics in portfolio construction and security selection.

This gap between systemic climate insights and security-level decision-making creates a natural role for bottom-up climate analytics.

Where bottom-up analyses add value, but fails to capture some important parts of the picture

Bottom-up climate risk analysis evaluates climate risk by assessing physical and transition risks at the individual asset’s or holding level, aggregated up to portfolio-level exposure.

This approach is viewed as a useful solution because it produces granular, actionable insights that can be directly integrated into portfolio-level decisions. However, bottom-up models rely on the aggregation of siloed single-asset impacts which tend to underestimate the wider systemic nature of climate risk.

In addition, bottom-up climate risk analysis is challenging to implement across all asset classes in a consistent manner. Bottom-up assessments are often confined to publicly listed companies (equities and bonds), while other important exposures in large multi-asset portfolios – such as private market investments – remain unassessed.

Can investors solve the problem by using both approaches?

Many asset owners have sought to adopt both approaches, given the complementary strengths and limitations of top-down and bottom-up climate analytics, allowing them to develop a more complete view of climate risk exposures across their portfolios.

However, top-down and bottom-up models are built using different methodologies, climate narratives, and assumptions, and are often designed for different investment use cases. This creates inconsistencies where different teams within the same organization rely on different climate models and scenario frameworks to address the same climate risks.

For example, at strategic asset allocation level, teams may use Ortec Finance Climate Scenarios for top-down analysis, while portfolio construction teams use bottom-up models based on alternative scenarios, such as those developed by the NGFS. Because these frameworks are based on different modelling approaches, assumptions, and views of how climate risks may unfold, outputs are difficult to reconcile. This makes it challenging to maintain a consistent view of climate risks across the decision-making process and can undermine efforts to embed climate risks consistently from strategic asset allocation through to security selection.

Addressing this inconsistency requires top-down and bottom-up data to be aligned at the same level of aggregation. The sector and regional level provide a logical bridge, allowing top-down climate scenario assumptions to be integrated consistently with bottom-up company-level exposures. Without this alignment, it becomes difficult to translate system-wide climate risks into company-level impacts within a coherent investment framework.

Addressing systemic climate risk requires a combined top-down and bottom-up approach

Investors who recognize both the systemic nature of climate risk and the wide variation in climate risk exposure across holdings should move towards a combined top-down and bottom-up approach. Under this approach, it is essential to ensure a consistent view of climate risk can be established and used across different investment teams. This starts with aligning top-down and bottom-up assessments, enabling a coordinated approach to risk assessment and more informed investment decisions.