Preparing portfolios for climate change 

The impact of climate change is increasingly seen as the most serious global challenge of the 21st century. Average global temperatures have already increased by 1°C on pre-industrial averages, and current science suggests that, in as few as 30 years, we could be facing a 2°C increase, a climate humans have never experienced and one that hasn’t occurred on earth for millions of years.

The urgency of the climate crisis is driving the need to transition to a zero-emission economy, and investor and corporate awareness has been increasing rapidly in recent years. In particular, many companies and investors want to align with the targets of the 2015 Paris Agreement, helping to ensure temperatures do not increase past the 1.5°C threshold.

A growing cohort of governments, companies and investors are now actively focused on the net-zero transition and the emissions reductions required. Given different climate scenarios using target dates of 2030 and beyond, there is no single approach to achieving net-zero emissions. Within the finance industry, backed by global initiatives such as the ‘United Nations Environment Programme Finance Initiative’, investor support is gathering momentum in the ‘race to Zero’.

Institutional investors such as pension funds, financial institutions, insurers, wealth managers, and endowments and foundations, hold trillions of dollars in assets in their portfolios that are highly exposed to climate transition risk in a decarbonising economy. If they do nothing to address this issue today, climate change could significantly reduce their ability to deliver on investment promises such as pension payments. At the same time, they are increasingly keen to identify and capitalise on any opportunities they have to allocate to companies generating sustainable and green revenues.

It's important for investors to try and assess an organisations ability or willingness to transition toward limiting global temperature increases and how well-positioned they are for the low-carbon economy. Investors should also consider and understand the downside risks associated with a transition.

It's time for investors to consider repositioning their portfolios for the transition to a zero-emission economy. For investors at the beginning of their climate change transition, the sustainable investing landscape is rapidly evolving and can be complex. It's critical to understand the climate impact of their existing portfolio, to establish their capacity for future transition and, ultimately, to identify their long-term transition goals.

Devising and implementing climate transition strategies requires a top-down scenario analysis, forward-looking portfolio analytics and bottom-up assessment of holdings. These assessments help investors identify the “grey” assets — those that generate high emissions and have limited capacity for transition; the “green” companies — those with low emissions, including the solutions to the net-zero transition; and everything in-between, where the capacity for transition in the future needs to be understood.

Addressing climate change means we need data and analytics translated by practitioners to help institutional investors identify key risks and work to eliminate them. The data we have access to today, though far from perfect, indicates investors can support the transition to a 1.5°C scenario and still meet investment objectives.

Although a 1.5°C scenario presents transition risk (especially for portfolios aligned to a 3°C or 4°C+ world), data suggests investors can still target investment in the many mitigation and adaptation solutions required for an orderly transition. Although there is an active debate about timing, methodology and portfolio implications for institutional investors, one starting point is generally agreed — understanding where emissions are generated now and what capacity companies have to transition and keep ahead of industry changes.

A transition action plan is a natural next step for investors that have undertaken climate scenario analysis. Numerous industry studies show that it’s in investors’ best interests to transition from our current 3°C temperature increase trajectory, ideally to a 1.5°C scenario. Strategic transition planning should also recognise short-term flexibility, where needed, to address investment considerations such as market pricing and market timing.

With trillions of dollars of assets, institutional investors are uniquely well placed to bring about positive change by transitioning their portfolios and executing their action plans. The data, tools and processes will no doubt evolve, but they already exist in forms which can enable useful decisions. Above all, there is a compelling reason to transition: the damage ahead if we don’t reduce emissions and minimise the impact of climate change.

Our advice and analytics enable investors to assess and rank emissions intensity, transition capacity and green revenues in the portfolio. Central to this assessment is portfolio-wide consideration of the transition capacity to align to a 1.5°C global warming target. We believe, it’s best to combine a top-down, total-portfolio view with forward-looking bottom-up portfolio analytics such as sector and company exposures. This allows investors to identify next steps and where investments could be allocated in the future so they can engage with managers.

Our Analytics for Climate Transition (ACT) assessment draw on multiple data providers and metrics to assess portfolios across a spectrum from grey to green investments. Because many companies lie in the middle, their capacity for transition in the future needs to be fully assessed and ranked by investors.

The analysis is designed to provide investors with a portfolio-wide view of the emissions reduction needed to meet a net zero target and to plan the changes required to the portfolio in order to transition.

The analysis covers geographic, sector, manager and selected stock drivers. The results are intended to aid investors in assessing where emissions reductions could come from, compare different strategies, engage with asset managers and plan for and make portfolio changes to reduce emissions. The goal is to reduce the greys in a portfolio where there is high stranded asset risk, grow the green solutions, and steward the assets that are in-between.

The purpose of such work is to help investors engage with their asset managers on how best to position their portfolios for the low-carbon transition. We work with investors to set annual emissions reduction targets aimed at key milestones aligned with IPCC guidelines and based on what’s possible for their portfolios — keeping in mind that some asset classes will take longer to transition than others.

ACT helps investors use this analysis to identify not just the losers of today but the potential winners of tomorrow, enabling them to engage with their managers and capitalise on the transition ahead.

We offer ACT across our clients worldwide. These services will help support climate transition strategies across our global assets under management on behalf of Mercer’s Investment Solutions clients.