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Short-term climate change repricing ‘could add or take 3%’ from portfolios

Increased market awareness of climate change impacts could add as much as 3% to investor returns in “less than a year”, according to a report from Mercer.

In a follow-up to its acclaimed 2015 climate change report, the consultancy said new short-term stress-test analyses – requested by its investor clients – had demonstrated how “longer-term return impacts could manifest as shorter-term climate-related market repricing events”.

If markets priced in global temperatures rising by 2⁰C above pre-industrial levels – the scenario central to the 2015 Paris Agreement on climate change – this could result in a positive repricing of as much as 3% in less than 12 months, Mercer’s analysis found.

However, if markets priced in a temperature rise of 4°C, the consultancy said the repricing could be negative by as much as 3%.

“Testing an increased probability of a 2°C scenario or a 4°C scenario with greater market awareness, even for the modelled diversified portfolios, results in +3% to -3% return impacts in less than a year,” said Mercer.

According to the consultancy, it was important to overlay such analysis with an opinion on the likelihood of such developments.

The consultancy said that, for a variety of reasons, it did not believe markets were fully pricing in climate change, but that it viewed increasing climate awareness in market pricing to be more likely than decreasing awareness.

This, it added, supported the idea of a premium that could be harnessed from a transition to a low-carbon economy.

“Although a 2⁰C scenario definitely still presents transition risk – especially for portfolios aligned to a 3⁰C or 4⁰C [scenario] – opportunistic investors can target investment in the many mitigation and adaptation solutions required for a transformative transition,” said Mercer.

In two sample portfolios used by Mercer, the sustainability-themed version was almost 0.2% a year better off between now and 2030.

2⁰C scenario ‘most beneficial’ for investors

Mercer said its updated climate scenario investment modelling strengthened the case for investors working to keep average warming to below 2°C.

In the report – dubbed ’Investing in a Time of Climate Change - the Sequel’ – the consultancy modelled three climate change scenarios: 2°C, 3°C and 4°C average global temperature increases over pre-industrial levels. These were each modelled over three timeframes: to 2030, 2050, and 2100.

Mercer said the results of its analysis emphasised why a scenario in which average warming was kept to below 2°C was “most beneficial” for long-term investors.

The current trajectory, according to Climate Action Tracker, is for warming of 3.3°C above pre-industrial levels. A separate climate change monitoring tool operated by asset manager Schroders reported that the predicted temperature rise was 3.9°C as of the end of 2018.

Mercer said its findings “strengthen the argument for investor action on climate change and suggest greater attention is required on how investors will actively support the transition to a 2°C scenario”.

Investing for a 2°C world was “both an imperative and an opportunity,” the consultancy said. For nearly all asset classes, regions and timeframes, a 2°C scenario lead to enhanced projected returns compared with higher forecast temperatures.

Mercer added that there were “many notable investment opportunities enabled in a low-carbon transition”.

Testing the scenarios

The consultancy applied its modelling to two sample asset allocations: a diversified growth allocation, and a similar portfolio with explicit allocations to sustainability-themed investments in multiple asset classes.

“In the two sample portfolios, there is a return opportunity to 2030 of between 0.1% and 0.3% [per year] in a 2°C scenario, compared to -0.07% [a year] in a 4⁰C scenario,” said Mercer. “To 2100, a 4⁰C scenario leaves each portfolio down more than 0.1% [a year] compared to a 2⁰C scenario.”

Helga Birgden, global business leader for responsible investment at Mercer, added: “The modelling shows that greater inclusion of sustainable assets into portfolios can enhance returns. The evidence is compelling and reinforces the findings made in Mercer’s 2015 climate change report, supporting greater urgency for action to achieve a well-below 2°C scenario.”

The report can be downloaded here.

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