If you think climate change is a real and present danger, your asset allocation should reflect that outlook, according to a new study from Mercer, the consulting firm. That’s sure to be a controversial recommendation in some quarters. Anything related to climate change tends to stir debate of one kind or another, and so reviewing the topic as it relates to investing promises no less. Ready or not, it’s time to take a hard look at the implications of climate change for designing and managing portfolios, Mercer explains in “Climate Change Scenarios—Implications For Strategic Asset Allocation”
The paper argues that climate change increases investment risk and so asset allocation strategies should adjust accordingly. The uncertainty surrounding policy regulations and the economic impact of climate change inspire “new approaches” for building portfolios. The analysis is a joint effort by Mercer and more than a dozen institutions, including the California Public Employees’ Retirement System (CalPERS) and the International Finance Corporation.
Written for an institutional audience, the report introduces a new investment framework based on three key variables, which are summarized as:
● Technology: the rate of development and opportunities for investment into low carbon technologies
● Impacts: the extent that changes in the physical environment influence investments
● Policy: the implied cost of carbon and emissions levels due to policy changes
These so-called TIP variables “could contribute as much as 10% to overall portfolio risk,” the Mercer analysis predicts. Even so, the equity risk premium is still expected to dominate most institutional portfolios. Mercer estimates that nearly three-quarters of the risk contribution in the “default” portfolio will come from equity markets.
The study advises that in order to properly manage climate change risks, “institutional investors need to think about diversification across sources of risk rather than across traditional asset classes.” That’s an increasingly familiar refrain, of course, via so-called factor analysis. For instance, it’s now common to view equity risk in terms of three factors comprised of broad market, style (growth vs. value), and size (capitalization) betas. There, of course, many more factors to consider, and the new Mercer paper argues in favor of analyzing risk across yet another dimension.
The practical result, according to the paper, is raising portfolio allocations to TIP factors. As one example, the study notes:
…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 (this includes opportunities across a range of assets including infrastructure, real estate, private equity, agriculture land, timberland and sustainable listed/unlisted assets)…. Some of these climate sensitive investments might be traditionally deemed as more risk on a standalone basis, but the report shows that selected investments in climate-sensitive assets, with an emphasis on those that can adapt to a low-carbon environment, could actually reduce portfolio risk in some scenarios.