Towards more decision-useful climate risk insights

Many institutional investors recognize that rising temperatures will have a material impact on macroeconomic conditions, financial markets, and portfolio returns over the investment horizon. They are therefore increasingly directing capital towards the transition to a low-carbon economy, representing a significant step beyond ‘paper decarbonization’, which primarily focuses on meeting regulatory reporting obligations.

Despite the growing availability of climate risk modeling frameworks and data, many institutional investors continue to face significant challenges in translating the insights generated into concrete investment decisions that result in more climate-resilient portfolios.

This raises an important question:

We identified four key, interconnected approaches for enabling climate risk insights generated from top-down climate scenarios to more actively inform investment decisions

• Consider the relative scientific likelihood of temperature outcomes
• Assess the implications of climate risk for asset pricing and valuations
• Include climate risk insights into capital market assumptions to inform risk management and strategic decisions
• Translate consistent climate scenarios throughout top-down and bottom-up assessments.

Rank temperature outcomes by likelihood based on alignment with scientific expectations

While climate scenarios are not designed to predict the future, drawing on scientific studies and academic research to assess the relative plausibility of different temperature outcomes can help investors focus on the trends and dynamics that shape long-term investment risks and opportunities.

Recent scientific studies^1,2,3,4,5 indicate that warming of 2.5°C to 3°C is most likely. Other research draws on climate policy assessments, expert surveys, emissions modelling, and economic analysis generally suggests a high probability of exceeding 2°C warming by 2100.

For investors, this research provides a useful scientific benchmark to explore the investment implications of a future with higher temperatures. However, this ranking approach should not be interpreted as assigning probabilities to specific economic or financial outcomes. These outcomes should remain scenario-dependent, as similar levels of warming can lead to different macroeconomic and financial consequences. In practice, investors undertaking climate scenario analysis using a suite of deterministic scenarios could apply a probabilistic framing to assess the relative likelihood of each temperature outcome attached to a specific scenario within the suite, helping them better identify areas of focus despite the absence of explicit probabilities.

Use climate scenarios to thoroughly evaluate pricing-in implications

When assessing a portfolio’s climate risk exposure, investors should consider not only direct impacts but also the broader financial-market responses that climate risks can trigger. These include shifts in investor sentiment, climate-induced market-wide repricing, and the timing and velocity of systemic responses that can rapidly cascade across asset classes.

For example, a property does not need to be physically impacted or damaged to lose financial value. If risks increase, insurance premiums rise too and may eventually become unaffordable, unavailable, or unreliable, buyers, lenders, and investors are likely to reassess its value.

A realistic climate risk assessment that evaluates how the repricing of assets may occur at a more granular level across asset classes, benchmarks, regions and sectors will enable investors to identify concentrations of risk and make active decisions to adjust investment strategies accordingly.

Embed plausible climate impacts within the broader capital markets framework

While many of the world’s largest asset owners and asset managers have found it challenging to fully integrate climate change into capital market assumptions, there is broad consensus that climate risk should be embedded in robust risk management frameworks, underpinned by plausible climate scenarios.

By establishing climate risk as a core consideration alongside traditional investment risks, despite its inherent uncertainty, investors can address it more systematically across existing investment strategy and risk management processes. This starts with capturing climate considerations within stochastic economic scenarios for traditional risk analyses, then using insights from plausible deterministic climate scenarios for further assessment.

In this context, climate scenarios can serve different purposes. Scenarios aligned with the most likely climate pathways can help inform central expectations and support long-term investment decisions. More adverse and less likely climate futures can be used to stress test portfolios and assess resilience to severe transition and physical risk outcomes.

By combining both perspectives, investors can incorporate climate risk more systematically into decision-making while maintaining visibility of potential downside risks.

Generate systemic top-down and granular bottom-up climate analytics using a common set of climate scenario assumptions

Climate risks are systemic and unevenly distributed across sectors and regions, including among companies within the same sector, meaning that each holding has a distinct climate risk profile.

Investors seeking to address their portfolios’ exposure to climate risks therefore require a consistent view of climate risks, established from both top-down and bottom-up perspectives, that is subsequently applied across different investment teams throughout their organization.

Top-down climate scenarios provide insight into the portfolio-wide implications of climate change and capture systemic effects that can materially influence investment outcomes. Bottom-up assessments complement this by identifying the specific exposures, vulnerabilities and opportunities at the company level that contribute to those outcomes.

This approach requires top-down and bottom-up data to be aligned at the same level of aggregation, ideally at the sector and regional level, as this allows top-down climate scenario assumptions to be integrated consistently with bottom-up company-level exposures.

The right climate scenarios are key to generating decision-useful insights

Climate scenarios will remain vital within risk management frameworks for institutional investors. As modelling frameworks continue to improve across a broad range of available climate scenarios, investors seeking to take decisive action to address portfolio climate risks should broaden their focus, ensuring that their chosen scenarios generate plausible and realistic outputs that capture not only the implications for asset pricing and returns, but also how financial markets may respond as climate-related transition and physical risks materialize.

In addition, broadening the application of robust and plausible climate scenarios in capital market assumptions can help investors integrate climate-related risks and uncertainties into strategic decisions in a consistent manner.

Finally, choosing climate scenarios that can deliver top-down sector region outputs is essential to establishing a consistent view of climate risk that can be aligned with bottom-up assessments. Together, this will enable investment teams to take a coordinated approach to addressing climate risks at the strategic asset allocation, benchmark and portfolio construction levels.