New Zealand government bonds are the most climate-sensitive in the developed world, according to a new Mercer report.
The ‘Investing in a time of climate change’ study – a sequel to Mercer’s inaugural 2011 report on the same subject – named New Zealand as the “most vulnerable of the developed market sovereign bonds”.
Mercer says global warming could damage the NZ government bond market “due to a higher proportion of the population living in low-lying areas, as well as the higher dependence of national GDP on the agriculture sector compared to other developed markets”.
On the plus side, “New Zealand’s expected ability to cope with the adverse effects of climate change helps to improve the overall ranking of New Zealand,” the Mercer report says.
However, the potential fate of New Zealand’s fixed income markets in a hotter world is not the central focus of the study, which extends the investigation into the investment implications of climate change first floated in Mercer’s 2011 report.
“In terms of investment risk, analytical work is increasingly being undertaken to quantify the potential damages from climate change to investors,” the report says. “A recent paper has estimated that, in a plausible worst-case climate change scenario (a 4°C-increase outcome), the value at risk of an equity portfolio in 2030 may be between 5% and 20% versus a no-warming scenario.”
Mercer says investors have “two key levers” to push in the portfolio decision-making processes around climate change: investment and engagement.
“From an investment perspective, resilience begins with an understanding that climate change risk can have an impact at the level of asset classes, of industry sectors and of sub-sectors,” the report says. “Climate-sensitive industry sectors should be the primary focus, as they will be significantly affected in certain scenarios.”
Furthermore, Mercer says investors can engage with fund managers and policy-makers to put climate change risk factors on the agenda.
From an investment perspective, the study says industry sector returns offer the “most meaningful” analysis. For instance, returns from the coal sector could decline by up to 74 per cent over the next 35 years, while renewable energy returns could rise by over 50 per cent during the same period.
“Asset class return impacts could also be material – varying widely by climate change scenario. For example, a 2°C scenario could see return benefits for emerging market equities, infrastructure, real estate, timber and agriculture,” the climate study says. “A 4°C scenario could negatively impact emerging market equities, real estate, timber and agriculture. Growth assets are more sensitive to climate risks than defensive assets.”
In the report foreword, Deb Clarke, Mercer global head of investment research, says updated scientific information and greater sector-level detail “enhances the first study significantly”.
This time around, too, Clarke says “a more dynamic modelling approach has been used… to incorporate four climate scenarios and four climate risk factors to estimate the impact on returns for portfolios, asset classes, and industry sectors between 2015 and 2050”.
Mercer’s climate risk factors covered technology, resource availability, impact, and, policy.
The four climate change models – dubbed transformation, coordination, fragmentation (lower damages), and, fragmentation (higher damages) – are based on global temperature increases of 2-4°C and varying levels of “mitigation action”.
Mercer says all investors will be affected to some extent whatever actual climate change scenario plays out.
“In this sense, they are all ‘future takers’ in the context of climate change, although investors will face this issue with different levels of resilience — with those investors that are unprepared for the minimum return impact expected to accompany any of the future scenarios effectively negating their best possible outcome,” the report says.
“On the other end of the spectrum is the emergence of a group of investors that we could term ‘future makers’. These investors feel compelled by the magnitude of the longer-term risk of climate change to seek to influence which scenario comes to pass.”