Integrating Systemic Climate Risk in Investment Strategies

    Stockholm (NordSIP) – Coming with a strong data-focused mindset, Willemijn Verdegaal (pictured left) and Lisa Eichler (pictured right), Co-Heads Climate & ESG Solutions at Ortec Finance have designed an innovative solution to taking systemic climate risk into account in the investment decision making process. NordSIP met Verdegaal and Eichler at the Sustainable Investment Forum Europe (SInvEU) in Paris, where they shared their journey so far and outlined their future ambitions.

    Willemijn Verdegaal spent a number of years as policy advisor and UN negotiator on climate finance with the Ministry of Finance and the Ministry of Foreign Affairs in the Netherlands. She also spent  four years at the Dutch pension fiduciary MN as an advisor for responsible investment & governance. Armed with this expertise, Verdegaal joined forces with former policy advisor and climate science and biodiversity specialist Lisa Eichler to help the financial industry evaluate climate risk.

    “Given the ever more apparent effects of climate change, we wanted to be able to evaluate how, fundamentally, the economy would be impacted over time by climate risks,” says Verdegaal. The two founders wanted to develop a top-down research-based approach that investors would be able to use in the context of investment risk management.

    “The financial industry is missing out on the big picture, we thought. A lot of effort is spent on the microeconomic level of finance, not on the macroeconomic level,” Verdegaal explains. “The idea was not to develop a measurement tool at the company level, but to measure systemic effects on the economy and financial sector as a whole. Climate change is a mega trend, and therefore, it will impact our fundamental ability to generate returns.”

    Ortec finance, a specialised firm that provides independent research-based technology and solutions for investment risk and return management decided to onboard Eichler and Verdegaal. “Can you make our products ‘climate aware’? they asked us. They wanted to model in a forward looking way how investment portfolios may develop given the increasing climate risk prevalence, while integrating it into the Strategic Asset Allocation (SAA) and Asset and Liabilities Management (ALM) framework. ‘What is my solvency or funding ratio under a 4-degree scenario?’ is the type of questions Ortec clients are asking, or ‘Is my risk budget and investment strategy robust across different global warming pathways?’”.

    The model Verdgaal and Eichler have developed is based on scientific climate models, which are open source. The science-based climate output is then integrated into a GDP forecast. This climate-adjusted GDP is the link between environmental science and finance. Cambridge Econometrics turns scientific climate models and produces climate informed GDP forecasts.

    The difference in GDP from the so called ‘climate uninformed outlook’ is integrated into Ortec Finance’s stochastic scenario model where it translates the impact to other key economic and financial variables per region such as interest rates, inflations and equity returns. One of the main applications the team offers is a risk-aware SAA analysis and ALM study. “Anyone interested in our analysis can also purchase the underlying climate informed stochastic scenario sets per climate pathway. We cater to financial institutions who seek independent forward-looking scenario-based climate risk disclosure, in line with the TCFD’s strategy pillar. We focus on the on the systemic – undiversifiable – level of risk. This is the angle that counts from the position of an investor, but also for a regulator. Bottom up company risks and opportunities cancel each other out to a certain extent. The remaining net risk is of interest at the strategic risk management level, and that is what we capture,” Verdegaal explains.

    Both transition risk and physical risk are key to this analysis. “We perform real stress test scenarios. ‘What happens if the carbon bubble bursts?’ We look for the impact of stranded assets, for instance, as well as abrupt transitions.”

    Verdegaal emphasizes an important message: “Climate change represents a risk you cannot diversify out of. Even if you are very green, you might not do well if the market is impacted. This is a concept that the Swedish and Finnish markets were incredibly receptive about. Organisations understand the necessity of our product. They know that they have to get their head around it, they understand the use of our product, where it fits in the value chain and the added value.”

    Swedish state pension AP1 was one of Ortec Finance’s pilot clients. “They helped us develop our methodology. We found that their expertise and support were invaluable to making this innovation possible,” Verdegaal adds.

    Meanwhile, in other markets, clients still need some more explanation. “We have been talking to a variety of financial players: pensions, insurances and asset managers but also political parties and NGOs. We are working on getting in touch more with sovereign wealth funds, as they are inter-generational, and we believe that our analysis would be particularly valuable to them.”

    The team’s goal for 2019 is to mainly generate market awareness. “We just got our heads out of the research bubble,” admits Verdegaal. “We need to start building our commercial case, so we can re-invest in further research.” So far, the firm provides a range of solutions spanning from analysis to workshops, or underlying climate informed scenario sets.

    “We believe that asset owners and asset managers need to come to grips with climate change consequences and risks. They need to take in the full picture, and that’s what we need to show them,” Verdegaal concludes.

    Picture © NordSIP

    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA is Editor-in-Chief for NordSIP and Managing Director for Big Green Tree Media. She has 18 years of experience in the asset management industry in Stockholm, London and Geneva, including as a long/short equity hedge fund portfolio manager, and buy-side analyst, but also as CFO and COO in several asset management firms. Aline holds an MBA from Harvard Business School and a License in Economic Sciences from the University of Geneva.

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