Mercer has laid out a new portfolio ‘stress test’ to model the short-term impact of climate change surprises – including regulatory change – on portfolios in the follow-up to its ground-breaking 2015 study.
The recently-published ‘Investing in a time of climate change – the sequel’ updates Mercer’s influential 2015 report with a swag of new data, strategies and tools including portfolio ‘stress testing’ of potential “sudden changes in return impacts” under global warming scenarios.
“Mercer’s stress tests consider the impact of a short-term market repricing event, where a catalyst of some sort (for example, new regulatory requirements, change of investor focus or a surprise election result) causes the market to change how it incorporates long-term climate change risk in asset pricing,” the study says.
Since the inaugural 2015 report, Mercer notes there have been two major global agreements on climate change targets as well as “many environmental, scientific, political and technological developments”.
Last week, for example, the NZ government tabled the Zero Carbon Bill aimed at drastically scaling back the country’s climate-sensitive emissions over the next 30 years.
According to Mercer, there is a greater probability of “increasing climate awareness in market pricing” than decreasing awareness, which could underpin a ‘low carbon transition’ (LCT) premium for investors.
The Mercer stress test models potential short-term opportunities across the three fundamental scenarios unveiled in the 2015 report, namely: global temperature rises of 2⁰C, 3⁰C and 4⁰C (or more) over different timeframes.
“Testing an increased probability of a 2⁰C scenario with increased market awareness can result in sector-level returns where renewables increase by more than 100% and coal decreases by nearly 50%,” the report says. “Positive asset class impacts include infrastructure at almost 23% and sustainable equity at more than 5%. Testing an increased probability of a 2°C scenario or a 4°C scenario with greater market awareness, even for the modeled diversified portfolios, results in +3% to -3% return impacts in less than a year.”
However, Mercer warns the LCT premium in “lower warming scenarios” is not comparable to standard investment risk factors or open to historical analysis given its reliance on “forward-looking assumptions”.
“Our assumptions suggest an asymmetric assessment of carbon-risk pricing — either it is priced in or it is mispriced, and fossil-fuel-exposed stocks will underperform over time,” the paper says. “…on balance, we think it is more likely that carbon risk is underpriced today than either fairly priced or overpriced.”
Both sustainability-themed specialist managers and passive strategies hinging on low-carbon indices are likely to garner support from investors as the climate change theme develops, Mercer says.
Low-carbon indices, the study says, are now “readily implementable in a passive-equity context, with some investors describing the low-carbon tilt as a ‘free hedge’ against climate change transition risk”.
The almost 100-page Mercer climate change sequel documents a number of other market changes since 2015 including a vast improvement in data across economic fundamentals, scientific scenario-modeling, more sophisticated risk factor analysis, better understanding of physical effects, and the potential impact for a wider range of assets.
The report says both governments and regulators are putting more pressure on businesses and investors to address climate change issues. Companies, institutional investors – such as pension funds – and even governments also face rising litigation risks, Mercer says.
“As signals from regulators become stronger and/or more investors take action, those that fail to consider, manage and disclose their potential portfolio-specific risks may be at risk of attracting legal challenges in the future,” the paper says.
The report says investors can help combat climate change by adopting the ‘future makers’ stance expressed through well thought-out portfolio settings.
In a statement, Deb Clarke, Mercer global head of investment research, says climate change is “clearly a fiduciary issue as it is about managing risk”.
“Asset owners should consider climate change at every stage
of the investment process, from investment beliefs, policy and process to portfolio construction decisions,” Clarke says.