A new report from Mercer modelling the potential impact of climate change on investments, has found investors cannot ignore the implications for investment returns.

The research reveals investors can manage the risk most effectively by looking ‘under the hood’ of their portfolios and factoring climate change into their risk modelling, which requires a significant behavioral shift for most.

This study helps address the following investor questions:

• How big a risk/return impact could climate change have on a portfolio, and when might that happen?

• What are the key downside risks and upside opportunities, and how do we manage these considerations to fit within the current investment process?

• What plan of action can ensure an investor is best positioned for resilience to climate change?

The report, titled “Investing in a time of climate change.” outlines actions for investors to manage key downside risks and access opportunities. It is the culmination of a research project that began in September 2014 launched in London ahead of negotiations for a new global climate agreement at the end of 2015 in Paris.

The investment modelling in Mercer’s report estimates the potential impact of climate change on returns for portfolios, asset classes and industry sectors between 2015 and 2050, based on four climate change scenarios and four climate risk factors. The four scenarios represent a rise in global temperature above pre-industrial era temperatures of 2°C, 3°C and two 4°C scenarios (with different levels of potential physical impacts).

Mercer collaborated with 16 investment partners, collectively responsible for more than US$1.5 trillion, to produce the report. It was supported by IFC, the private sector arm of the World Bank Group, in partnership with Federal Ministry for Economic Cooperation and Development, Germany, and the UK Department for International Development (DFID). The study was also supported with contributions from Mercer’s sister companies NERA Economic Consulting and Guy Carpenter, and input from 13 advisory group members.

Risks and Opportunities

Downside Risks: Key downside risks come either from structural change during the transition to a low-carbon economy, where investors are unprepared for change, or from higher physical damages.In the first instance, under a 2°C, or Transformation scenario, investors could see a negative impact on returns from developed market equity and private equity, especially in the most affected sectors.

On the flip side, this scenario would be likely to lead to gains in infrastructure, emerging market equity, and low-carbon industry sectors.

The investment modelling supports the following key findings:

Climate change will give rise to investment winners and losers

Based on the scenarios modeled, climate change is expected to have an impact on investment returns; investors need to take action to understand and mitigate the risks and maximize value at the asset, industry sector and portfolio level.

The biggest risk is at the industry level

Differentiation between winners and losers is most apparent at the industry level – For example, depending on the climate scenario which plays out, the average annual returns from the coal sub-sector could fall by anywhere between 18% and 74% over the next 35 years, with effects being more pronounced over the coming decade (eroding between 26% and 138% of average annual returns over the next 10 years).

Conversely, the renewables sub-sector could see average annual returns increase by between 6% and 54% over a 35 year time horizon (or between 4% and 97% over a 10-year period) depending on the climate scenario.

Asset-class return impacts will be material, but vary widely by climate change scenario

Growth assets are more sensitive to climate risks than defensive assets.

A 2°C scenario could see return benefits for emerging market equities, infrastructure, real estate, timber and agriculture. A 4°C scenario could negatively impact emerging market equities, real estate, timber and agriculture.

A 2°C scenario does not have negative return implications for long-term diversified investors at a total portfolio level over the period modelled (to 2050), and is expected to better protect long-term returns beyond this timeframe.

So what? What should investors do?

Investors have two key levers in their portfolio decisions — investment and engagement. From an investment perspective, resilience begins with an understanding that climate change risk can have an impact at the level of asset classes, of industry sectors and of sub-sectors.

Climate-sensitive industry sectors should be the primary focus, as they will be significantly affected in certain scenarios. Investors also have numerous engagement options. They can engage with investment managers and the companies in their portfolio to ensure appropriate climate risk management and associated reporting. They can also engage with policymakers to help shape regulations.

Chair of Mercer’s Responsible Investment team, Jane Ambachtsheer, said, “Whilst it is challenging, we have attempted to quantify the potential investment impacts of climate change. We recognise that markets do not always price in change; they are notoriously poor at anticipating incremental structural change and long-term downside risk until it is upon us.”

“Our report identifies the ‘what?’ the ‘so what?’, and the ‘now what?’ in terms of the impact of climate change on investment returns. These insights enable investors to build resilience into their portfolios under an uncertain future.

“This report can act as a guide to creating an action plan. Whether it is setting portfolio de-carbonisation targets, investing in solutions that address risks and opportunities, or increasing engagement with managers and companies, our report shows investors how they might take action. Engaging with policy makers is also crucial and helps empower investors in their role as ‘future makers’,” said Ms Ambachtsheer.

Mercer’s Global CIO for Mainstream Assets, Russell Clarke, added a portfolio construction perspective, saying, “This study helps us better prepare to navigate the changes that such a structural and systemic issue as climate change may represent. We believe it’s a significant investment risk that investors should be aware of and able to act upon in close collaboration with investment managers.”