Nina Röhrbein looks at Mercer's project to help institutional investors tailor their investment portfolios to manage the risks as well as exploit the opportunities thrown up by climate change

As a key component of the portfolio management process, strategic asset allocation
has sometimes been estimated to contribute to more than 90% of the variation in portfolio returns over time. This is why, in September 2009, Mercer together with 14 global investors representing around $2trn (€1.4trn) assets under management launched a research project on the implications of one of today's key risks - climate change - for strategic asset allocations.

The ‘Climate Change Scenarios - Implications for Strategic Asset Allocation' report has found that climate change could contribute as much as 10% to portfolio risk over the next 20 years. Continued delay in climate change policy action and lack of international co-ordination could cost institutional investors trillions of dollars over the coming decades.

But they also have many options for capitalising on opportunities and managing risks arising from climate change, with investment opportunities in low carbon technology possibly amounting to as much as $5trn (€3.6trn) by 2030.

The short-term versus long-term focus has, so far, prevented the majority of pension funds from evaluating and consequently responding to the risk of climate change, according to Danyelle Guyatt, global head of responsible investment research at Mercer and author of the report. "The financial crisis has absorbed a huge amount of trustees' time over the past two years, which is why they might not necessarily consider it top priority," she says. "Our study highlights the extent of the material climate-related risks at the portfolio level and suggests some actions investors can take."

The report urges institutional investors to take a three-stage approach to integrating climate change in their asset allocation. They first need to enhance their approach to asset allocation by discussing climate change both at the investment and the specialist level so that trustees and investment committees are fully aware of all dimensions of the risk.

They should also change their strategic asset allocation and increase their exposure - up to 40% - to climate-sensitive assets such as infrastructure, private equity, real estate, timberland, agriculture land, carbon, green bonds, broad and sector-focused sustainable equities and efficient or renewable listed and unlisted assets to help capture the upside and protect against the downside risk of climate change at the total portfolio level, as the short-term horizon of traditional equity and bond investment makes it more difficult for investors to price in these long-term risks.

Thirdly, investors should engage with policymakers because policy developments at the country level will produce new investment opportunities and risks that need to be constantly monitored.

"Smaller pension funds could just focus on improving the sustainability of their existing portfolio with their existing active managers rather than change the asset mix," says Guyatt. "Investing in passive sustainability equity tracker funds is also a very accessible low-cost option to make portfolios more robust in terms of climate risk. Green bonds are becoming more available and investors do not need a large allocation to build exposure to those. Green or environmental infrastructure funds are increasingly becoming available, as trillions of dollars need to be spent on rebuilding either existing infrastructure or investing in new infrastructure over the coming decades, making it a potential growth area for institutional investors.

"There are plenty of opportunities in property portfolios, either in bringing existing holdings up to the highest energy efficiency standards, which in itself makes the portfolio more climate sensitive, or by transferring this task to a product or manager," continues Guyatt. Private equity already has an excess supply of investment opportunities, with more funds trying to raise capital than people willing to invest in them. On the commodity side, agricultural land and timberland present a number of ways in which to access the sustainability theme.

"While our study focused on beta as opposed to alpha, investors can tackle the challenge from both ends. On the alpha side they could ask fund managers, for example, to run a scenario analysis on the impacts of high carbon prices on their portfolio and ask them how they might tilt their portfolio or capture more sustainable assets."

The report analyses the potential financial impacts of climate change on investors' portfolios, based on four climate change scenarios playing out to 2030, in order of descending likelihood.

The report also outlines a framework that can be used by institutional investors to identify and manage the systemic risks and investment opportunities arising from climate change across all asset classes and regions. The ‘TIP framework' estimates the rate of investment into low carbon technologies (T), the impacts (I) on the physical environment and the implied cost of carbon resulting from global policy (P) developments across the four climate scenarios.

Actions for institutional investors to consider, according to Mercer, are to: understand the risks associated with climate change and embed these into asset allocation policies; evolve and transform the portfolio mix; allocate to sustainable assets; consider a wider pool of passive options; engage with active fund managers, companies and policymakers; and support ongoing research.