Five years from now, it is very possible that we will acknowledge that the new Mercer climate change report was a line in the sand for the way mainstream investors think about investment risk. It states that the risk to investment portfolios from climate change is so significant that traditional portfolio management strategies are not well placed to deal with it.
In a sector known for its conservatism and herd mentality, to flag that all portfolios should be restructured, not by means of re-weighting traditional asset classes such as equity and debt, but by the degree of climate change risk, is a powerful statement. If embraced by the market, the resulting 40 per cent capital flows will lead to some very rapid investment revaluations that will be quite disruptive.
To put it in context, a 5 per cent change in strategic asset allocation for a fund would be a big event. For the industry at large to contemplate 40 per cent is mind-blowing. According to management consulting firm McKinsey, large institutional investors, such as pension and mutual funds, control about $65 trillion in financial assets. To conclude that 40 per cent of this amount may be in assets that add systemic risk is extraordinary.
How did this happen so swiftly and ‘unexpectedly’? To some of us it was not unexpected; of more interest is why it took so long for a major industry participant to come up with such a piece of research that veered away from more traditional portfolio construction methods – where risk analysis is based on historical data – towards a scenario-based approach that tests future possibilities. The global financial crisis taught us a nasty lesson about the limitations of historical data and we have seen that progress in addressing systemic risk in the finance industry has been painfully slow.
Climate change is not a risk that oscillates over a business cycle – it is a structural change; a one way street and we’ll be travelling on it for decades. A scenario-based approach is the most effective way of examining the implications of the risk. Scenarios are able to capture the uncertainties that exist in the market and therefore give insight into the types of investment actions that can be used to mitigate – or hedge – this systemic and structural risk. The hedging approach to the uncertainty of the risk is a cornerstone of Mercer’s new investment paradigm.
We also know that carbon-exposed company valuations are in for a rocky ride unless companies themselves produce their own operational hedges. Carbon intensive firms run the risk of having their projected earnings discounted by the market at a higher rate, leading to lower valuations, especially the capital-intensive ones, invested in long-term assets whose ‘tail end’ risk is starting to look severe. Conversely, sectors such as cleantech, renewable energy and timberland will attract capital and discount rates will fall, leading to higher valuations. We may be setting the scene for the next boom/bust.
Despite the fanfare of the report’s release, we do not know how the industry will react. When a leading asset consultant breaks ranks and discredits their own and their peers previous work, how will their clients, regulators, competitors and even their own professionals’ deal with it? Based on past experience it will take time to play out. Mercer’s competitors have remained relatively inactive in this area for a long time and they will have to spring into action to catch up. If they thought this research was going to be an ‘add on’ to existing asset allocation theory, their worst fears have been confirmed – it is a rewrite, and their clients will know it.
Disclosure will be key to moving forward and the Climate Institute’s initiative, the Asset Owner Disclosure Project, has aggressively pushed the boundaries of how asset owners such as superannuation funds manage climate risk. In fact, the data sought has been beyond what many have the capability or willingness to produce, but it is data that now seems mandatory.
Now that the asset owners’ own advisers are telling them how risky climate change is, the fund trustees, on behalf of their members, should be taking a keener interest in how their funds are dealing with it. A new level of accountability has been thrust onto investment committees. They, in turn, need to question the validity of their traditional approaches and of their internally- and externally-sourced recommendations, while the challenge for fund trustees is to see the broader picture.
Members would have good reason to ask the ‘if not, why not’ question about the management of this risk. In other words, if a fund is not ascribing a heavy weighting to either the ‘respond early’ or ‘respond late’ climate change scenarios, what scenarios it does use to formulate its investment strategy? There is no ‘do nothing’ option anymore.
Only time will tell whether the industry accepts or rejects this guidance; however when we look back, this may well be a defining moment in the pricing of carbon exposed assets. At a minimum, procrastination is no longer an option. And as the American writer, Don Marquis, once said: “procrastination is the art of keeping up with yesterday.”
Phil Preston is the principal of Seacliff Consulting, a firm offering specialised consulting services in the financial and responsible investment fields. His prior work includes 17 years of financial research and portfolio management in the funds management industry.
Julian Poulter is business director of the Climate Institute and a director of the Asset Owners Disclosure Project.