Integrate climate considerations across whole asset allocation process

Don't just add climate needs at the end after an allocation has been made

A recurring question in the asset management industry is whether there is a “greenium” or some type of risk-adjusted excess return that investors should expect to earn from being exposed to climate change.

This can be thought of in terms of diversifiable and undiversifiable risks. Basic asset pricing theory says investors should only be compensated for undiversifiable risks. Some climate change risk is systemic and undiversifiable, but a lot of it can be diversifiable, especially at the security-specific level. Different companies may be on the right side of change while others aren’t. Similarly, some countries are better situated for change than others.

Based on temperature data and asset class returns going back to the 1960s, temperature deviations from historical trends correlated with lower economic growth. There is already a wide range of literature on the topic of temperature deviations and economic growth, so this result isn’t too surprising.

What may be more surprising is that the historical record shows investors might not have properly priced in that risk of temperature swings. Furthermore, larger swings in temperatures correlated with lower equity returns and more market volatility in general.

At least for now, it looks like climate change risk is at least partially an uncompensated risk in the markets. That could change over time and bears monitoring, but a basic question an investor should ask is, “Why be exposed to a risk if I’m not compensated for the exposure?”

The cost of ignoring climate change risk will depend entirely on the climate change scenarios that play out and over what timeframe. Under a baseline model of a two degree Celsius temperature increase over the next few decades, the annual effects could look like noise initially, but eventually indicate a change in the trend of returns and volatility. The errors around the forecasts are wide, highlighting the uncertainty.

Climate allocation

Climate change is a distinction that makes a significant difference for asset allocation. Different countries will likely be differentially affected by climate change. Different sectors, industries, and companies will be differentially impacted.

When it comes to managing risks, we like to look for resilience. Which countries and which companies are better situated to manage and adapt to the risks? Our Climate Risk Resilience framework helps answer that question at the country level and various index providers have broad ranging assessments of company specific resilience. A lot of the risks can best be assessed with boots on the ground, with analysts who do due diligence on the investments to cross-check the quantitative assessments provided by data providers.

By incorporating a top-down asset and country allocation view of climate change resilience with a bottom-up security-specific evaluation of investment opportunities, asset managers can create a more efficient portfolio for clients in achieving their climate-related goals.

Climate change assessment extends beyond just creating a more efficient portfolio, though. Some clients have very specific views they want reflected in their portfolios. These could be due to preferences or due to a desire to hedge other risks they may be exposed to outside of their portfolios. In this way, climate change isn’t just a distinction that makes a difference for asset allocation, it’s a distinction that makes a difference for clients.

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Natasha Turner

Natasha was global editor at ESG Clarity, part of Mark Allen Financial, and a financial journalist for seven years. She has been shortlisted for Story of the Year and Investment Journalist of the Year...