17 February 2011 – FAVOURITES: A landmark study from leading investment analyst Mercer into climate change risk has recommended that  institutions shift up to 40 per cent of their investments into “climate sensitive” assets.

The study by consulting firm Mercer in collaboration with a group of 14 leading global investors, including VicSuper and AustralianSuper, with around $2 trillion said climate change could increase portfolio risk by 10 per cent over the next 20 years.

It also said that investing in climate friendly sectors would align to both serve their beneficiaries’ financial interests as well as helping to tackle climate change.

Low carbon investment opportunities could be as high as $5 trillion by 2030, it said.

Download the report, highlights and an executive summary from Mercer here

Following are segments of reports that appeared around the world’s leading financial media in the wake of the study.

From Responsible Investor: The study, which takes a novel look at the impact of climate change on asset allocation risks, defines climate sensitive assets as infrastructure, private equity, real estate, timberland, agriculture land, carbon, broad and sector focused sustainable equities and efficiency/renewable listed/unlisted assets.?“

The analysis suggests that under certain scenarios, a typical portfolio seeking a 7% return could manage the risk of climate change by ensuring around 40% of assets are held in climate-sensitive assets,” the report says. “To manage climate change risks, institutional investors need to think about diversification across sources of risks rather across traditional asset classes.”

“Mitigating climate change risks will require a new approach for investors,” states the 132-page report entitled Climate Change Scenarios: Implications for Strategic Asset Allocation. ?Mercer says the short-term horizon of traditional equity and bond investments means it will be more difficult for investors to price in long-term climate change risks in comparison with climate sensitive assets. It says the traditional way of managing risk, via a shift to a more conservative asset allocation, “may do little to offset climate risks”.

The report says it could even result in a decline in returns. Conversely, the report says investment opportunities in low carbon technology could be as high as $5trn by 2030.? Mercer says selected investments in climate-sensitive assets could reduce portfolio risk in some scenarios. ?Consequently, it says institutional investors’ interests could be aligned to both serve their beneficiaries’ financial interests as well as helping to tackle climate change.

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From Mercer: Trillions of dollars at stake from climate change over next 20 years
A collaborative study led by Mercer, United States ?New York, 15 February 2011

  • Climate change could contribute as much as 10% to portfolio risk over the next 20 years
  • Investors could benefit from increased allocation to infrastructure, real estate, private equity, agriculture land, timberland and sustainable assets
  • Investment opportunities in low carbon technology could be as high as $5 trillion by 2030
  • Institutional investors have numerous options for capitalising on opportunities and managing risks arising from climate change

Continued delay in climate change policy action and lack of international coordination could cost institutional investors trillions of dollars over the coming decades, according to research released by Mercer and a group of leading global investors representing around $2 trillion in assets under management1.

Andrew Kirton, Chief Investment Officer at Mercer, commented: “Climate change brings fundamental implications for investment patterns, risks and rewards. Institutional investors should be factoring long-term considerations, such as climate change, into their strategic planning. Mercer is pleased to have had the opportunity to kick start such strategic discussions with a group of leading global investors.”

The report Climate Change Scenarios – Implications for Strategic Asset Allocation analyses the potential financial impacts of climate change on investors’ portfolios, identified through a series of four climate change scenarios playing out to 2030. The report identifies a series of pragmatic steps for institutional investors to consider in their strategic asset allocation.

In the report, a framework is outlined that can be used by institutional investors to enhance their understanding of climate-related investment risks and opportunities across asset classes and regions. Mercer’s “TIP Framework” estimates the rate of investment into low carbon technologies (T), the impacts (I) on the physical environment and the implied cost of carbon resulting from global policy (P) developments across the four climate scenarios.

Some of the key findings show that by 2030:

  • Climate change increases uncertainty for long term institutional investors and as such, needs to be pro-actively managed.
  • Investment opportunities in low carbon technologies could reach $5 trillion.
  • The cost of impacts on the physical environment, health and food security could exceed $4 trillion.
  • Climate change related policy changes could increase the cost of carbon emissions by as much as $8 trillion.
  • Increasing allocation to “climate sensitive” assets will help to mitigate risks and capture new opportunities.
  • Engagement with policy makers is crucial for institutional investors to pro-actively manage the potential costs of delayed and poorly co-ordinated climate policy action.
  • Policy developments at the country level will produce new investment opportunities as well as risks that need to be constantly monitored.
  • The EU and China/East Asia are set to lead investment in low carbon technology and efficiency improvements over the coming decades.

The launch of the report and the Mercer TIP Framework represents a collaborative endeavour led by Mercer which involved 14 global institutional investors, and was supported by the International Finance Corporation, a member of the World Bank Group, and Carbon Trust. Grantham LSE/Vivid Economics were engaged to lead components of the research on the economic impacts of climate change scenarios and a research group comprised of industry practitioners and academics was consulted in the development of the model.

From Mercer, reactions of research partners:

“That climate change poses significant financial and economic risks has only been accentuated by the tens of billions of dollars in losses due to recent climate related natural disasters such as the floods in Australia and Pakistan and the wildfires in Russia. This study makes a significant contribution to our ability to measure the level of risk that climate change creates for investment portfolios. Managing that risk in a way that maintains the returns expected by beneficiaries is a crucial responsibility for the management of these investment portfolios. This report provides some practical steps that investors can take today to shift their asset allocation to manage climate change risks and finance the much needed infrastructure for a lower carbon future.”
Rachel Kyte, Vice President, IFC

“This report is unique and ground-breaking in quantifying the increased portfolio risk arising from global efforts to tackle climate change. It demonstrates that unless this risk is tackled intelligently by increasing exposure to climate sensitive assets, then long term rewards could fall. The findings undermine the notion of a conflict between ‘green’ investing ‘ and acting in beneficiaries long term financial interests. This will have profound implications for fiduciary duties and places a clear obligation to increase analysis of the consequences of climate change for portfolio management.”
Bruce Duguid, Head of Investor Engagement, The Carbon Trust

“Why does climate change matter to institutional investors like the Environment Agency pension fund? It matters because we know that we will need to be paying out pensions to our fund members well into the 21st century. We think all pension funds will need to adopt a climate change-proofed financial investment strategy in the future to enable them to fulfil their fiduciary duties. We also want our pensioners to retire into a similar environment than we enjoy today and not one that is affected by the extremes of climate change that could reduce their life expectancy.”
Howard Pearce, Head of Environmental Finance and Pension Fund Management, Environment Agency

“Climate change is a global risk factor that all long term investors should take into account when formulating investment strategy. This in-depth analysis will provide valuable input to our long term strategy reviews.”
Tom A. Fearnley, Investment Director, Norwegian Ministry of Finance, Asset Management Department

“In early 2010, we set a goal to better understand how climate change could be factored into our broad investment actions. For example, should the risk and return impacts of global warming modify our allocation between and within asset classes?  The Mercer study has helped clarify our thinking on some of these uncertainties. In our view, the report makes an original contribution by giving financial meaning to recognized climate science (Stern, IPCC) and provides ideas on constructing portfolios acknowledging climate trends. It also raises many more questions and hopefully will stimulate additional in-depth work around investment capital and climate change.” Doug Pearce, CEO/CIO for British Columbia Investment Management Corporation (bcIMC)

“CalPERS has been a leading advocate for environmental and climate change issues for many years and recognizes these to be key risks for long term investors. This opportunity to collaborate with institutional investors from around the world to look at the impact of climate change scenarios on investments helps us to shape our strategic thinking in this area and better integrate our programs, policies and risk management.”
Joe Dear, CIO, CalPERS

“This project has given us insight into the complexity of the effects climate change could have on the risk and return of our portfolio. Climate change proves to be a source of uncertainty. Although there is currently no straightforward answer to manage this uncertainty, we will continue to address this issue in our investments activities.”
Jaap van Dam, Managing Director Strategy, PGGM Investments

“Participating in this project has not only given us better insight of what impact climate change could have on asset classes and the long term performance of our portfolio. It has also given us enhanced tools for our strategic asset allocation analysis.”
Johan Magnusson, Managing Director of Första AP-fonden (AP1)

“VicSuper has taken an active position in integrating sustainability into its investment strategy. This has involved investing in low-carbon equity funds such as the Vanguard Carbon Aware International Shares Fund, as well as in venture capital clean technology which in turn invests in technology and products providing solutions to environmental challenges. Our participation in this Climate Change Scenarios report has assisted our thinking in how to integrate climate change risk and opportunity into our investment strategy, and also in ways to access a robust and defensible methodology to assess the possible risk and return implications of climate change. We do this for the benefit of our more than 250,000 members.”
Peter Lunt, Head of Investment Research, VicSuper

Footnote: Whilst the UN climate change talks in Cancun produced some agreement on reforms that failed to materialise during preceding discussions at Copenhagen, the absence to the future of market based mechanisms post 2012 when the Kyoto Protocol expires creates a cloud of uncertainty over investors’ heads.

From Mercer – Media release

It is widely acknowledged that climate change will have a broad-ranging impact on economies and financial markets. What is less certain is what climate change will mean for institutional investors and how they can best prepare for this challenge, both from a risk and return perspective.

To help manage these uncertainties, Mercer, together with 14 institutional asset owners and investors from around the world, the Carbon Trust and IFC, a member of the World Bank Group, recently launched a climate change strategic asset allocation study (the “study”) exploring the potential impact of climate change scenarios on asset allocation. The Grantham Research Institute on Climate Change and the Environment, together with Vivid Economics, have been engaged to lead components of the research on the economic and financial impact of climate change scenarios.

Some of the investor partners include AP1, APG, AustralianSuper, British Columbia Investment Management Corporation (bcIMC), CalPERS, CalSTRS, the Environment Agency Pension Scheme, the Maryland State Retirement and Pension System, the Norwegian Government Pension Fund, the Ontario Municipal Employees Retirement System (OMERS), PGGM and VicSuper Pty Ltd.

The study has been structured using a scenario based framework to identify potential new investment opportunities and possible future risks related to climate change. Accordingly, it will consider a variety of climate change scenarios and map the potential risks and opportunities of these outcomes for returns on asset classes in different regions over the periods until 2030 and 2050. The research will explore volatility and correlations among asset classes, regions, and sectors under each scenario and consider each scenario’s impact on strategic asset allocation.

The study will culminate in a publicly available report, which will launch in the fourth quarter of 2010. Each study partner will also receive their own tailored report assessing the effects of the scenarios on its asset mix, highlighting both the investment risks and opportunities.

The release of the study findings should encourage financial intermediaries, such as investment managers, consultants and research firms, to develop tools, products and services that facilitate appropriate responses to climate risk scenarios.

Furthermore, the report will consider recommendations for policy-makers and industry bodies. Although financing arrangements did not feature prominently during the Copenhagen Summit discussions, they will be crucial for mobilising capital to help meet government targets to reduce emissions and provide the funding required for adaptation to the physical impacts of climate change.

Greg Radford, IFC Director for Environment and Social Development emphasised the role of the private sector in combating climate change.

“The importance of private sector capital cannot be understated in the fight against climate change. Yet, mobilising those funds requires clear understanding of the climate risks and opportunities to help pension funds allocate capital appropriately.”

“We are very excited and proud to undertake this important climate change scenario analysis project together with our valued partners,” said Andrew Kirton, president of Mercer’s investment consulting business. “Institutional investors will be better placed, in our opinion, to consider the implications of climate change for investment risk and returns at the total portfolio level as a result of this project. A scenario based approach will provide new insight into current thinking among our project partners, many of whom are leading the charge in responding to the challenges presented by climate change.”

Helga Birgden, Mercer’s Acting Global Head of Responsible Investment, said the research would assist strategic investment decision-making among investors.

“This research is an exciting example of how our research partners are actively collaborating to ‘stress test’ their portfolios for the impact of various climate change scenarios in a sophisticated way,” she said.

AustralianSuper Chief Investment Officer, Mark Delaney described how this is an important opportunity to understand how different climate change scenarios will impact future investment returns.

“Whilst no one knows precisely how climate change will evolve, by considering the impact of a number of scenarios on our fund, we will be better prepared for what eventuates. Working with global pension funds and other large investors will promote valuable dialogue and exchange of ideas.”

Norway’s Finance Minister, Mr. Sigbjorn Johnsen, noted, “Climate change poses major socioeconomic and financial risks worldwide. The Norwegian government takes these risks seriously, also in the management of the Government Pension Fund. The climate scenario study is an important element in our effort to gain a deeper understanding of the robustness and sustainability of our long term investment strategy.”

“I think we can all agree that climate change will have significant impacts on the global community. The big challenge is translating the impact of climate change into consistent effects on strategic asset allocation,” said Jaap Van Dam, Chief Strategist at PGGM.

“This project is a natural successor to work by the Carbon Trust demonstrating that climate change is a key driver of value across different sectors,” said Bruce Duguid, Head of Investor Engagement at the Carbon Trust. “This focus on asset classes, combined with previous work on sector impacts, should enable investors to reward opportunities that will thrive in a low carbon economy and help avoid fuelling further high carbon growth.”

“It is of utmost importance for a large global pension fund like ours to assess the possible implications of climate change on the long term returns of our assets. This project gives us a unique opportunity to join forces with peers and climate experts to discuss this important issue and analyse how it could possibly affect our strategic asset allocation, the core in our asset management model,” said Johan Magnusson, Managing Director of Första AP-fonden (AP1).

“APG attaches great importance to understanding the strategic implications of climate change for the pension assets it manages. We are therefore very pleased to be working with other leading investors from around the world on this project,” said Angelien Kemna, Chief Executive of APG Asset Management.

“Although we acknowledge that global warming will have wide-ranging impacts on economies and financial markets, long-term investors like bcIMC are uncertain what this will mean for our global investment strategy and how we can best prepare for this challenge, both from a risk and a return perspective. Our goal with this research project is to develop a better understanding of how to manage these uncertainties,” said Doug Pearce, CEO/CIO of BC Investment Management Corporation (bcIMC).

“We aim to use this project to directly feed into our investment strategy, fulfilling our fiduciary duty to manage the financial impact of climate change,” said Howard Pearce, of the Environment Agency Pension Fund.