How climate scenarios can help investors build portfolio resilience

The stark warning of the United Nations’ Intergovernmental Panel on Climate Change (IPCC) in its recent report was clear: While many climate mitigation and adaption solutions are available now, the window of opportunity to meet the Paris Agreement targets to limit global warming well below 2ºC is closing rapidly.

Without drastic and immediate cuts in emissions, we risk irreversible damage to our planet, as well as the communities and biodiversity inhabiting it.

As long-term investors, we recognize the material impact of climate change on investment portfolios. Yet, the process of determining the right strategy to increase portfolio resilience to climate change is not straightforward. Uncertainty over how climate risks evolve and their implications for macroeconomic and market conditions complicate the picture.

Climate scenario analysis provides long-term investors with a systematic approach to navigate this uncertainty. We at GIC have partnered with Ortec Finance and Cambridge Econometrics to develop a set of climate scenarios to map out and stress test our portfolio against potential future pathways.

Other than the two scenarios which reflect the binary outcomes of an either successful net zero or a failed transition, we designed two bespoke scenarios to account for the nuances associated with climate policy-making and market responses to climate risks.

Our custom scenarios go one step further compared to how most conventional climate scenarios work, by looking at whether markets price in future climate risks disruptively and by incorporating the potential for markets to over-react, resulting in sentiment shocks.

In addition, we created a set of climate signposts to assess the likelihood of the different scenarios. Our analysis based on the most recent scenario sets and signposts is clear: expect greater volatility, continued uncertainty, heightened transition and physical risks, and disruptive change on the horizon.

Our two bookend scenarios include the optimistic Net Zero scenario where climate policies are introduced in an early and orderly manner, enabling the world to reach net zero by 2050. The more pessimistic Failed Transition scenario instead foresees no further policy actions and severe climate-related physical impacts, as the average global temperature increases to over 4ºC above pre-industrial levels by 2100.

The Delayed Disorderly Transition describes a world that is slow to implement climate policies until a surge in extreme weather shocks causes public pressures to rise, compelling governments to act. Due to the delay, much more drastic measures are executed within a much shorter time period. While global warming is kept below 2ºC, markets overreact to these extreme weather and policy shocks before the sentiment shock dissipates and markets recover.

Under Too Little Too Late, policy-makers similarly stall on enacting climate policies and only respond to public pressure following a series of extreme weather shocks. Unlike in Delayed Disorderly Transition, these policy responses are not made in time or of sufficient magnitude, resulting in a global warming outcome of 2-3ºC by 2100. This scenario also sees increased market volatility as a result of multiple abrupt extreme weather shocks and policy changes.

Net Zero, Delayed Disorderly Transition and Failed Transition align with the scenarios developed by the Network for Greening the Financial System (NGFS). However, while the benefits of Too Little Too Late has been discussed by NGFS, GIC is the first to develop it into a scenario for portfolio analysis.

We decided to explore this highly disruptive scenario because of our belief that investors should consider a potential future world of insufficient policy actions and rising physical risks. This is especially relevant as the latest UN Emissions Gap Report expects the 2100 temperature outcome to range from 2.4ºC to 2.8ºC based on current committed policies.

After calibrating the various factors with the potential to shape climate change, we then used Ortec Finance’s ClimateMAPS model to assess the impact on macro indicators such as gross domestic product (GDP) growth, inflation and financial asset returns.

In addition to examining the plausible economic and investment environments under each of the scenarios, we created a set of climate signposts to provide an appraisal of the relative likelihoods of these scenarios.

The signposts systematically incorporate a range of historical and forward-looking indicators such as government and corporate commitments and measures on climate change, technology, and existing carbon emission levels.

Our most recent signposts point towards Too Little Too Late as the most likely scenario followed by Failed Transition, Delayed Disorderly Transition and Net Zero. Importantly, however, none of the scenarios have a more than 50% probability, which highlights the highly uncertain outlook that investors need to navigate.

Investors should thus prepare for more macro and market volatility as physical, transition and market risks might evolve in a disruptive manner. For example, in the Delayed Disorderly Transition and Too Little Too Late scenarios, sharp policy responses to the onset of extreme weather shocks will see both GDP and inflation fluctuate widely.

Second, investors must take a balanced approach to managing both transition and physical risks given the considerable uncertainty over which scenario would eventually materalize. It is also important not to optimize only for one particular scenario due to the range of possible outcomes.

Third, market beta is likely to be negatively affected by climate-related drivers, especially physical risks, over the long term. However, the growth and returns impacts vary widely across scenarios, countries and sectors.

A hypothetical global portfolio consisting of 60% equities and 40% bonds will continue to generate positive returns over a 40-year period. But the underperformance is stark: climate change will reduce returns by roughly 10 to nearly 40%.

Yet there is potential upside as well: equity markets with low exposures to low-carbon utilities, such as those in emerging markets, have the potential to outperform.

One of the limitations of most current climate-related financial models is that they are not able to fully capture the upside from decarbonization solutions, as companies with the required climate technologies may not exist yet or are in early stages of development.

Spending on climate adaptation and the resultant investment opportunities is an additional area that climate models have not fully incorporated yet.

Investors must ultimately manage their portfolios nimbly and integrate both climate risks and opportunities in the investment process, from top-down asset allocation and risk management to bottom-up security selection.

These climate scenarios and signposts are not meant to predict the future, but they will help us prepare for the transition that will come to bear. We just hope it is not too little, too late.