Already pre-COP26, Climate risk had become too important to ignore for investors. Both physical and transition risks related to climate change are complex, however, and so are the solutions. For responsible investors, climate scenario analysis has become one of the indispensable tools helping them navigate this new risk environment. On 9 December, NordSIP hosted a webinar on the subject, inviting experts to share their valuable insights on the journey from designing and analysing climate scenarios to integrating the results in their investment decisions.
A quick poll of the audience reveals that the topic is relevant for all the attendees. And while 22% of those joining the webinar claim to be well-aware of the risks and 28% have already conducted scenario analysis, half of them admit to just getting started. All the more to benefit from the experience and expertise of the panellists: Valeria Dinershteyn, CFA, Director of Sustainable Investing Client Engagement at Northern Trust Asset Management (NTAM), Craig Mackenzie, Head of Strategic Asset Allocation and Climate Fund Manager at abrdn and Jan-Hein van den Akker, Head of Equity Europe & AMEA at Mercer Global Investments Europe.
“Different pockets of investors are moving at a very different pace when it comes to climate risk management and climate targets alignment,” Dinershteyn points out, kicking off the discussion. “Meeting our clients at the part of their journey that they are currently at and helping them marry their aspirations with operational implementation is what we strive to do,” she adds.
“We found some very weak methodologies and simplistic assumptions out there,” recalls Mackenzie about the time when abrdn started the journey of exploring climate scenario modelling. “Most scenarios we saw were quite extreme, basically stress tests. As a portfolio manager, you’d rather have a base-case scenario to guide your expectations,” he explains. After searching thoroughly, three years ago, they initiated cooperation with Planetrics, now part of McKinsey, to jointly develop some more sophisticated and useful scenarios.
Now that conducting climate scenario analysis is no longer just a nice-to-have exercise but also a regulatory requirement for some institutional investors, such as insurance and pension companies, it is evident that many of these institutions need help. “At Mercer, we see this as part of our fiduciary duty,” asserts van den Akker. “We have known for a while now that sustainability is a key theme for our clients, and climate risk is an integral part of this,” he adds.
Another quick poll reveals that 75% of the webinar attendees find measurement and data the biggest challenge of implementing a climate strategy. Among other difficulties, they quote the models themselves, the time frame, the availability of investment solutions, as well as portfolio construction and asset allocation. “You are not alone in struggling with these issues,” comments van den Akker. A recent survey that Mercer conducted among UK institutions showed that most schemes, especially the smaller ones with fewer resources, find these issues challenging. According to van den Akker, less than 10% of the surveyed institutions are currently looking at climate risk scenario modelling. “There is a lot of work to be done to bring them up to date, as most schemes are only at the very start,” he concludes.
Dinershteyn agrees that many institutions seem to be at a nascent phase of their journey on climate change. “The vague nature of the scenarios and the assumptions is something that a lot of our clients struggle with,” she adds. Data availability and quality are other significant thresholds, according to her. Yet interpreting and utilising all the reported data is even more challenging. However, the ongoing standardisation will level the playing field and make investors more comfortable with understanding the data and using it to assess their climate risk going forward, Dinershteyn hopes. “Having a sophisticated quantitative toolbox, like the one at NTAM, really helps to marry your financial objectives and factor exposures to your climate objectives,” she says. “Quants are well suited to optimise a portfolio given specific objectives and constraints,” she explains.
“I could go on for hours on all the problems with climate scenarios,” says Mackenzie before digging down into a few of these. He takes an issue, for instance, with the simplistic, one-size-fits-all scenarios, like the NGFS used by the central banks, that assume a uniform policy adjustment. “Scenarios like these simply don’t work for us as investors,” he says. “Clearly, India is going to move at a very different pace to Europe,” he adds. Hence the need to develop custom scenarios, considering that various parts of the world will develop at different speeds.
Another simplistic assumption, typical for many of the off-the-shelf models, according to Mackenzie, is using the cost of carbon as the driver of corporate climate risk. “If you are going to do a proper climate scenario, you need the sophistication of your modelling to project forward the energy and commodity markets for 30 years ahead. Very few providers out there have the economic modelling capabilities to do that,” he continues.
Tackling the issues, one by one
Given the multiple challenges and the complexity of modelling both the physical and the regulatory climate risks at hand, how should investors go about untangling and solving them? According to van den Akker, many of Mercer’s institutional clients decide to start by focusing on metrics and targets. “I am not sure if that is necessarily helpful,” he says. Figuring out the organisation’s beliefs and developing a policy around those is much more critical at the start of the journey, according to him. “Then you should ensure you have processes in place. Only once you’ve done all of the above are you ready to set up specific targets and metrics,” explains van den Akker. “Don’t just jump in, do it in stages. It’s a long journey,” is his advice.
From the perspective of a bottom-up security selector, Mackenzie and his colleagues tackle the challenges of climate risk measurement and management in a slightly different way. It is often an exercise of generating impairment estimates for individual securities, which can then be aggregated at sector, regional and asset class levels. “We find, for instance, that equity markets tend to be much more negatively impaired than credit markets,” he says. This is not surprising, given that bonds are more senior in the capital structure but also due to the maturity aspects of debt securities. A sophisticated scenario model should endeavour to capture the duration issue as well.
Physical risk also tends to be very small over the time horizon that most investors consider when allocating their assets, Mackenzie has found. “It’s only if you look 50 years ahead that physical risk becomes significant, and only in the most negative scenarios,” he says.
Dinershteyn concurs that physical risk is more of long-term concern, whereas transition risk has a significant short- to medium-term effect across asset classes and regions. She gives an example of how NTAM also integrates the temporal aspect of these risks. “We have created a methodology to look at government bonds, taking into consideration the countries’ climate commitments as well as assessing whether they have the right tools to reach these commitments,” she explains.
Factoring in stewardship
“There are whole sectors that at the moment don’t have 1.5-degree scenarios because the technology to decarbonise them simply is not there yet,” Dinershteyn adds. “Hopefully, between now and 2030, they will find a path to decarbonisation as well,” reminding us that sophisticated scenario analyses need to incorporate a notion of ‘hope’ when forward-looking assumptions are not entirely possible to forecast today.
Hope, however, is not enough, and investors can accelerate the net-zero transition of companies, sectors and regions by their systematic engagement and stewardship efforts. “Talking in a unified voice is very important,” points out Dinershteyn. NTAM, for one, is a member of the Climate Action 100+ initiative, where they engage actively with companies that currently are struggling to transition away from fossil-fuel-dependent business models.
Answers from the bottom up
In the security selection process, climate risk scenarios must become an integral part of the analyst’s toolbox. Mackenzie explains pedagogically how, thanks to this valuable tool, he and his colleagues can assess companies’ fair value. “Climate scenarios help us decide whether we should be buying at today’s prices or if we are in a green bubble and shouldn’t be buying,” he says. On average, the green technology companies are still cheap, according to him. “Tesla is no longer in our portfolio, though, and that says something,” he adds.
Managing a multi-asset climate opportunities fund, Mackenzie often finds himself pondering on one question: What kind of climate future am I pricing in? Scenarios help him answer this question. Scenarios that are constructed around a base case (of a 2.4°C increase, for example), inform the investment decision better than the extreme cases of zero change or 4°C increase, which are often those considered.
A few words of advice from van den Akker conclude the session. For one, investors should remember to approach climate change from a top-down asset allocation perspective as well, he urges. “Don’t forget the credit part of your investments as those can have a significant carbon footprint, having a bigger exposure to the old economy, than a diversified equity portfolio,” he reminds the audience. And finally, “you need to set realistic targets,” van den Akker concludes.