Climate change is becoming a key, high-level factor in the strategic asset allocation and risk management decisions of a growing number of the world’s institutional investment organizations, a group that includes the world’s largest pension funds.
More than half of the 14 “asset owner partners” participating in the Mercer Group’s “Climate Change Scenarios—Implications for Strategic Asset Allocation” now consider climate change in future risk management and/or strategic asset allocation decisions, including Calpers (California Public Employees Retirement System), the largest pension fund in the US.
Moving into a third year, Mercer is leading a global collaborative effort to develop a strategic risk management and asset allocation framework that institutional investors can use to evaluate the risks and opportunities global climate change presents for their portfolios, retirees, and investors.
“Collectively, large pension and sovereign funds (and other asset owners) have the power (and perhaps the resources) to determine objectives, fund vehicles and structure deals. Potentially, they may also have the capacity to create new entities to effectively deploy assets as necessary to fund (and profit from) a transition to a lower carbon economy,” write the authors of a project update report released January 12.
TIP Framework
Mercer has developed the three-point TIP framework to represent and assess the impacts of climate change on asset class returns.
- ‘T’ for Technology: Investments in carbon-efficient technologies could accumulate to $3 trillion – $5 trillion by 2030
- ‘I’ for Impacts: Costs of physical damage could accumulate to $4 trillion by 2030
- ‘P’ is for Policy: Costs of delayed, uncoordinated policy could accumulate to $8 trillion by 2030.
In addition to the three TIP factors, fundamental economic factors (economic cycle inflation) and market factors (ERP, for Energy Resource Price, Volatility) are key elements of Mercer’s climate change asset allocation and risk management framework.
Climate Change scenarios for asset allocation, risk management
In its latest project report update, Mercer analysts developed four climate change scenarios as a means “of understanding how asset classes may respond to the TIP factors under different conditions.” The four scenarios – Regional Divergence, Delayed Action, Stern Action and Climate Breakdown – were developed to indicate how climate change “might have an impact on a portfolio’s asset mix from now until 2030.”
Using the TIP model and four scenarios to examine each of these three key factors more closely, Mercer finds that the value of additional investments in technology assets (T) will grow between $180 billion and $260 billion per year for all climate mitigation scenarios.
Regarding the impacts of climate change on investment portfolios (I), the costs range between $70 billion and $80 billion per year in terms of adaptation and residual damage. In terms of climate policy (P), the increase in the cost of emissions from 2010-2030 ranges between $130 billion and $400 billion per annum, with costs highest under the model’s “Delayed Action” scenario.
Pension Funds Adapting to Climate Change
As Mercer has clearly recognized, mitigating and adapting to the risks associated with worldwide climate change requires comprehensive action on a global scale. The active engagement of private sector investment and investors is critical. Among the largest investment organizations in the world, the participation of pension funds and other institutional investors is likewise critical to making the transition to a more sustainable and clean energy economy.
The resources and research challenges required to realize the project’s objectives are enormous and virtually unprecedented. To carry it out, it will require consistent, coordinated, broad-based collaborative working relationships between supranational and national government agencies, investor and industry participants and associations, and other stakeholders. The Mercer Group’s groundbreaking Climate Program makes for an excellent, if belated, start.
“It will be no small task to accomplish this across regions, market segments and asset classes, but the stage has been set through membership organizations and established intermediaries to explore alternative investment structures, outsourcing opportunities and agreements on requirements. The focus should be put on developing these solutions and the associated deployment of assets – as a priority,” the authors of the latest project update report wrote.
