Climate Change Scenarios – Implications for Strategic Asset Allocation

Abstract

Climate change was described by Nicholas Stern as ‘the greatest market failure the world has seen’ (Stern Review, 2007). But relatively little research has focused on the investment implications of climate change at the total-portfolio level, and how institutional investors might respond. That is the purpose of this paper.Uncertainty is a key stumbling block in climate-change research. Every link in the chain of man-made greenhouse gas emissions, physical changes in the climate system and their socio-economic impacts is highly uncertain. Therefore, investors cannot simply rely on a best guess as to how the future will unfold when planning their investments. Moreover, because many of these uncertainties emanate from complex systems that are poorly understood and difficult to model, climate change has been called a problem of ‘deep uncertainty’ (Lempert, Groves et al. 2006). In this context, deep uncertainty implies that probabilities cannot be assigned to future states with high confidence. This calls into question the appropriateness of relying too heavily on quantitative modelling tools, for which investors must specify probability distributions to underpin the parameters of their investment models. Institutional investors must develop new tools to more effectively model systemic risks such as climate change. These tools require an expansion of the way we think about portfolio risk, looking beyond mere volatility. Describing probable scenarios, identifying the potential sources of risks, measuring and monitoring them over time are the components of an improved risk management strategy that seeks to protect the long-term assets that institutional investors oversee on behalf of their stakeholders. It is in this context that the collaborative group came together to look at the implications of climate change for strategic asset allocation. Led by Mercer, fourteen global institutional investors, IFC and the Carbon Trust all joined forces to examine what climate change might mean for the underlying drivers of the major asset classes and regions around the world. Grantham LSE/Vivid Economics and a research group comprised of specialist practitioners and academics were also involved in parts of the process along the way.