Past performance isn’t a guide to the future
Transition risks (technology or policy changes that help move us to a low carbon economy)
Physical risks (physical damages like droughts, floods and wildfires, resource scarcity such as water scarcity, reduced productivity due to heat)
When we talk about the impact of climate-related risks in the context of pension schemes, we are looking to understand the potential financial impact2 of those risks. In particular, what warming scenario, or event, could significantly reduce the value of assets, impairing returns, and when could that happen? Climate scenario analysis is a tool that allows us to quantify the potential impact.
Unlike the history of financial markets, there is no historical data set that can be used to quantify the impact of climate change on financial markets. Climate is incredibly complex and there are many possible pathways we may go down depending on how governments, policymakers, businesses, and consumers respond to climate change.
To help with this, climate scenario analysis focuses on a range of plausible descriptive scenario narratives.
The IFoA and University of Exeter’s paper highlighted a potential disconnect between climate science and the economic models because they fail to allow for climate “tipping points”: events that, when triggered, could lead to runaway events. These could include feedback loops accelerating the increase in global temperatures. For example, melting permafrost is a feedback loop and tipping point that is challenging to model, particularly around the timing of such an event and the rate of acceleration.
While scenarios can and do3 use “non-linear” damage functions that aim to capture the acceleration of damage in high emissions scenarios, there is a reasonable likelihood that most climate scenario models underestimate physical impacts.
Financial stability and insurance “breakdown” are also not modelled. A systemic failure may be caused by either an “uninsurable” physical environment, or due to the scale of mitigation and adaption required to avoid the effects of material warming of the planet.
Know your limits
It is better to be roughly right than precisely wrong
Climate scenario analysis is a valuable tool to better understand the financial risks pension schemes may face under a range of different climate scenarios. New and emerging risks, such as the impact of climate change on biodiversity loss, will be integrated into climate scenario modelling over time once the supporting science and impact on econometrics and finance is better understood.
This space is moving fast. UK occupational pension schemes that fall under the statutory requirement to produce an annual Taskforce for Climate-Related Financial Disclosures (TCFD) report need to update their climate scenario analysis at least every three years and earlier if there is a material change to the funding or investment strategy, or if there are new or improved scenarios or modelling capabilities. Similar requirements are expected to be introduced for the Local Government Pension Scheme soon.
As a final thought, scenarios are not the only tool in an investor’s climate change box. Investors should also utilise carbon footprinting and transition assessments to identify the risks of climate change on their underlying assets; considering measures to reduce the impact of these risks if they arise; ensuring their advisers are up to date with the latest developments in climate change consulting; and staying on top of their own training and governance requirements.
Mercer has been providing quantitative climate scenario analysis for pension schemes since 2010 and we introduced longevity climate scenario analysis in 2023. If you are interested in finding out more, please speak to your usual Mercer consultant or complete the contact form to speak to a Mercer specialist.
1 'The Emperor’s New Climate Scenarios'
2 Defined benefit schemes should also consider the impacts of climate change on liabilities, funding and covenant.
3 Mercer’s latest Failed Transition scenario includes around a 25% reduction in GDP by 2062 compared to a scenario with no climate impacts.
4 How trustees can help make climate scenario analysis decision useful
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