Where climate change scenario planning sits in investment
Many of the world’s major economies are working towards a 1.5°C Paris Agreement-aligned future, but investors must prepare portfolios for the climate change outcome – whatever this ends up being.
Like any macro trend, investors have to consider how climate change could impact their portfolios. The Paris Agreement set a deadline for many of the world’s economies to meet and – several years on – various scientists and policymakers are unsure about this being met.
This is placing a requirement upon investors to ensure their portfolios are prepared for whatever the climate change outcome is. Peter Michaelis, head of the sustainable investment team at Liontrust Asset Management, uses climate change scenario planning in his work and says other investors need to recognise the importance of this.
“We believe the market continues to underestimate both the rate of change needed to decarbonise and the magnitude of the positive impact on companies helping this transition, as well as the structural decline in businesses continuing with carbon-intensive products and services where there are lower-carbon alternatives,” says Michaelis.
Some firms are already taking this into consideration. Investment consultancy Redington is seeing this with many clients. Specifically in the UK, the Department for Work and Pensions has provided guidance for pension schemes to conduct scenario analysis and choose a baseline scenario – to monitor portfolio activity against on an annual basis.
“We have found the ‘disorderly transition’ scenario to be a popular baseline amongst our own clients,” says Redington global head of sustainable investment Anastasia Guha.
“Those who have set decarbonisation targets typically look at their portfolio at an asset class level, identifying the most pragmatic way to decarbonise without impacting portfolio returns. Scenario analysis can provide useful insights to help prioritise asset classes and issuers that need attention.”
We believe the market continues to underestimate both the rate of change needed to decarbonise and the magnitude of the positive impact on companies helping this transition.
Putting scenario analysis into practice
With it obviously yet to be seen what happens with climate change, some firms are preparing options for various outcomes. Isobel Edwards, a green, social and impact bond analyst at NN Investment Partners, is viewing debt securities through this filter, and separating these based on what climate change outcome they are aligned with.
“For the past couple of years, we were monitoring the 2°C alignment of the issuers in the portfolio and then decided to track the net-zero-by-2050 commitments of the issuers through published plans and/or external verification,” says Edwards. “We were able to see with current emissions data who was falling out of line with the 2°C scenario and with net-zero plan data we were able to see who was planning for the 1.5°C scenario in the future.”
Emissions data can be a crucial part of this. Though data is a well-documented challenge for net-zero conscious investors, Edwards will often try and make her own assumption by analysing other metrics.
“It’s important to have a monitoring process in place to make sure that the plans which issuers make are coming to fruition,” says Edwards. “Ideally, they publish interim plans, like 2025, 2030, etc. so that when the time comes, you can go to the issuer and check if they are where they need to be according to their published plan. It’s an important accountability tool.”
At Liontrust, Michaelis and his team follow a three-step approach to implementing scenario planning within decision-making processes. This starts with identifying companies reducing emissions regardless of the outcome: “Of our 20 sustainable themes, all those associated with increasing resource efficiency will benefit from, and contribute to, the shift towards an ultra-low carbon economy.”
"Second, we want to ensure the companies we own understand the magnitude of the energy transition and are managing their businesses in a proactive way that protects them from inevitably tightening regulations,” adds Michaelis who explains the third step is to omit investment in sectors with carbon-intensive characteristics.
Scenario planning has a key role to play in investment for the long term and it is clear there are both physical and transitional risks for portfolio managers to navigate as the situation worsens. However, there is still a need to be flexible, as Guha explains: “Scenarios are not forecasts. They measure how much risk the portfolio is exposed to from the transition to a low-carbon economy. While asset allocation decisions shouldn’t be based solely on climate scenarios, they can help guide portfolio construction.”
