A climate of change driving SAA
A new research project by Mercer will look at the opportunities and risks inherent in climate change by region and asset class. Nina Röhrbein reports
Some pension funds already deal with the risks and opportunities presented by climate change by investing in renewable energy or screening companies and sectors, but adapting the whole portfolio is an entirely different matter. Strategic asset allocation (SAA) is often described as the most important factor driving long-term portfolio returns, with academic research* concluding that it accounts for over 90% of portfolio returns, and overshadowing the effect of market timing and stock selection.
"This means we need to devote more time and effort to thinking about strategic issues, including systemic risks that might change the investment landscape, such as climate change," says Danyelle Guyatt, principal at Mercer's responsible investment team. "To date, some pension funds have started to consider the implications of climate change in terms of stock picking and thematic investment strategies, but the overall implications for the risk/return profile of different asset classes deserves attention."
There is a need for research on this link, and this is why Mercer is about to launch a research project to assess the implications of climate change for strategic asset allocation decisions. The project is a collaborative endeavour led by the firm's responsible investment and financial strategy groups, together with international asset owners, a climate change think-tank and industry bodies with a specialist interest in sustainable investment. It will take a scenario-based approach and set out a series of signposts to guide pension funds as to the changing likelihood and course of events as new information becomes available.
The two-part report will consist of a public report to share the broad findings with the industry, as well as a tailored report for each asset owner that commits to the project, benchmarked against the other project partners. The project aims to produce a qualitative framework that outlines risks and opportunities by region and asset class, as well as considering the sector effects, which can then be used as an overlay to strategic asset allocation decisions.
"Some regions are at much higher risk from the physical impacts of climate change than others," says Guyatt. "The Intergovernmental Panel of Climate Change (IPCC) 2007 report highlighted that it is likely to be the developing economies that will be the hardest hit, particularly southeast Asia and Africa. There is also a risk that parts of the southern European belt will in the worst-case scenario be hit by severe drought, while Northern Europe is expected to experience extreme flooding risk. One aspect of the research is to consider what these possibilities could mean for different asset classes, such as property and equity investments and how countries will redress these risks through mitigation efforts."
"Traditional strategic asset allocation modelling approaches have not taken climate risks or opportunities sufficiently into account," adds Anders Lande, senior adviser at the Norwegian Ministry of Finance's information unit. "This project seeks to address that gap and it is an ambitious and complex task, which is more efficiently undertaken in collaboration with others. Together we need to develop the tools and critical thinking that is required to understand the financial implications of climate change."
Part of the challenge in considering the implications of climate change for strategic asset allocation lies in distilling the vast amounts of scientific research and new policy announcements, according to Guyatt. "Pension funds will need to be aware of the global policy response to climate change," she says. "In addition to the policy measures, the likelihood of successful implementation of these policies is crucial for evaluating the investment implications, both from a risk and an opportunity perspective.
Between now and 2030 the most important development for pension funds will be related to government policy announcements and their successful implementation, according to Guyatt, as this will have a direct bearing on capital flows and asset class performance. From 2030-50 and beyond it is much more about the physical risks of climate change and adaptation, she says.
Norway's Government Pension Fund - Global has already signed up to the project. APG Asset Management, the fiduciary manager of several pension funds including that of the Dutch civil servants pension scheme ABP, has also joined.
"We have looked at the implications of climate change for individual companies and industries for some time and will continue to do that," says Rob Lake, head of sustainability at APG Asset Management, which has assets under management of €180.5bn. "We have also analysed specific investment opportunities generated by climate change and are already investing
€1.5-2bn in renewable energy and energy efficiency. So the logical progression was to start exploring whether climate change has any implications not just at the level of individual investments but for strategic asset allocation."
But Lake says it is challenging because the forces that drive strategic allocation are by definition strategic forces, such as the expectations they have about economic growth rates, inflation, demographic changes and mortality rates. "Given that our collective ability to predict the detailed economic impacts of climate change is still relatively limited, it is difficult to see what implications it might have in the context of strategic asset allocation as a whole," he says. "But we think it is important to at least start to ask those questions, which is why we have joined Mercer to see what progress we can make in understanding these issues a bit better."
The project will look top-down at all asset classes and the overall split within the portfolio and find out to what extent climate change is going to be one of the big strategic driving forces.APG Asset Management is in the process of setting up all the details of the project, with the first phase expected to take around six months.
"As it develops, it will feed into our thinking and the practicalities of how we do strategic asset allocation over the course of the next year," adds Lake. "We do not know exactly what might need to be done until we find out what the nature of the issue is. But if it turns out to be a big driving force, we will ensure that the pension fund adapts its portfolio and can continue to match its liabilities. Because our portfolio is so large we basically invest in the whole of the economy and the performance of the portfolio is principally driven by the performance of the global economy. In other words, if the performance of the global economy were to suffer as a result of climate change, our portfolio, our clients and their beneficiaries would suffer too."
Another issue that needs to be addressed, says Guyatt, is the decision-making process around allocating to thematic or lower carbon risk investment opportunities such as clean tech, green bonds or sustainable property.
Guyatt believes that pension funds' awareness about climate change has steadily risen. "But a lot of pension funds are still unsure what they can do beyond investing a few per cent in a clean tech fund," she says. "And so we have a long way to go. There is still a limited number of pension funds globally that have taken strong action in terms of engaging with governments, companies or investing their money in ways that position for a shift towards a lower carbon economy. In addition, few pension funds probe their active fund managers on climate change and convey what they expect from them, which means that fund managers tend to be left to their own devices.
"But as we reported in the Carbon Risks in UK Equity Funds research - a WWF sponsored project we were involved in with Trucost - fund managers are largely not pro-active about climate change. There are also options for passive investors to consider. For example, pension funds can encourage higher standards of voting and engagement by their passive managers on climate change issues. They can also start to look at some of the new lower carbon indexes and passive products that are emerging."
The project is expected to start in September with some early results at the end of the year.
* Financial Analysts Journal, Brinson et al. 1986 & 1991