Short-term shifts in market sentiment induced by awareness of future, as yet unrealized, climate risks could lead to economic shocks, causing substantial losses in financial portfolio value within timescales that are relevant to all investors.
Factors, including climate change policy, technological change, asset stranding, weather events and longer-term physical impacts may lead to financial tipping points for which investors are not presently prepared. This research shows that changing asset allocations among various asset classes and regions, combined with investing in sectors exhibiting low climate risk, can offset only half of the negative impacts on financial portfolios brought about by climate change. Climate change thus entails “unhedgeable risk” for investment portfolios.
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While the response to action aimed at limiting warming below 2°C is shown to be negative in its short-term economic and financial impacts, the benefits of early action lead to significantly higher economic growth rates and returns over the long run, especially when compared to a worst-case scenario of inaction. The present study shows that certain types of portfolio benefit more than others.
Even in the short run, the perception of climate change represents an aggregate risk driver that must be taken into consideration when assessing the performance of asset portfolios. Our analysis provides investors with a general guide to minimising their exposure to climate sentiment risk and has the potential to stimulate a constructive dialogue between investors, governments and regulators to examine the conditions necessary to build more resilient financial markets under unprecedented environmental change.
Commissioned by the University of Cambridge Institute for Sustainability Leadership (CISL) and the Investment Leaders Group (ILG), this report looks at the economic and financial impacts of climate risk over the next five years in order to identify opportunities for reducing climate-related investment risks through portfolio construction and diversification across different asset classes, regions and portfolios.
While the most significant physical impacts of climate change will probably be seen in the second half of this century, financial markets could be affected much sooner, driven by the projections of likely future impacts, changing regulations and shifting market sentiment. This study employs a unique approach to address these short-term implications of our long-term climate problem in relation to portfolio risk. The complex analysis presented here is the fruit of a collaborative effort between three research entities within the University of Cambridge, namely the Cambridge Centre for Risk Studies (CRS), the Cambridge Centre for Climate Change Mitigation Research (4CMR) and the Cambridge Judge Business School.
Both regulators and financial markets react in light of new information about climate change, including major events such as storms, floods and droughts; policy decisions; and the success and failure of companies. While such changes are partly visible in the present, they are likely to accelerate as the physical impacts of climate change become deeper and more regular. This will influence financial market behaviour gradually in the first instance (led by the most informed investors) and then, potentially, in a more disorderly fashion as markets seek to shed at-risk assets. Some of the economic losses incurred by investors in this transition can be avoided or hedged through mere reallocation strategies, while others require system-level intervention in the form of policy or regulatory action. While we cannot model the psycho-social dynamics of financial markets despite the ready availability of risk information, we can model physical impacts and consequences for the macroeconomy under different scenarios of climate change mitigation identified by the Intergovernmental Panel on Climate Change (IPCC) climate science. In doing so, our study characterises in detail the multi-faceted impact of climate change on different asset classes and geographies.
The results of this analysis show that, on a worst-case No Mitigation basis, 47 per cent of the negative impacts of climate change across industry sectors can be hedged through industrial sector diversification and investment in industries that exhibit few climate-related risks. Similarly, shifting from an aggressive equity portfolio to one with a higher percentage of fixed-income assets makes it possible to hedge 49 per cent of the risk associated with equities. However, these two “halves” are not cumulative, such that no strategy will offer more than 50 per cent coverage. This gives rise to the conjecture that, even in the short run, climate change will constitute an aggregate risk system-wide action in order to mitigate its economy- wide effects.
We adopt an approach that – as far as we are aware – has not been applied to analysis of the financial implications of climate change: stress testing representative portfolios using economic and market confidence shocks derived from climate change sentiment scenarios. This study quantifies the potential financial impacts of a shift in market sentiment driven by significant changes in investor and consumer beliefs about the future effects of climate change, modelling the impact of three market sentiment scenarios on four portfolios with different asset allocations.
The scenarios reflect differing beliefs about the likelihood of government action to limit warming to 2°C, as recommended by the IPCC, the actual emission levels anticipated, as well as physical climate change impacts, the probable stringency of regulation and levels of investment, including the types of technology likely to be developed. The scenarios, aptly named Two Degrees, No Mitigation, and Baseline, were developed according to well-recognized risk modelling techniques, drawing on the latest IPCC climate change projections and employing analysis of historical market shocks that offer meaningful parallels to interpret and model parameters within a climate risk framework.
The asset allocations employed are representative of pension funds (Conservative, Balanced and Aggressive) and insurance companies (High Fixed Income). Portfolios were stress tested by applying shocks based on different levels of carbon taxation, energy investment, green investment, energy and food prices, energy demand, market confidence, bond market stress and housing prices. Impacts are modelled over five years at the portfolio, asset class, sector and regional levels. This analysis enables the quantification of impacts for each scenario across different asset classes, industrial sectors, countries and portfolio structures.
The macroeconomic analysis shows that the transition to a low-carbon economy carries increased economic costs in the short term, but that longer term discounted benefits make a transition more than worthwhile. The sheer scale of structural change required for the global economy to shift away from a future dominated by fossil fuels towards a low-carbon economy requires tremendous investment in new capital infrastructure, in research and development, and in new business models. This transition period lasting years will be costly to the global economy. However, the alternative may well be worse: results from the macroeconomic analysis show that the No Mitigation scenario triggers a global recession for three consecutive quarters, shrinking the global economy by as much as 0.1 per cent each quarter.
By comparison, the Two Degrees scenario grows at just 0.3 per cent per quarter, whereas the Baseline model offers the fastest near-term growth, reaching 0.7 per cent per quarter. Over a longer time horizon (2015-2050), however, the Two Degrees scenario is shown to outperform the Baseline by 4.5 per cent with a discount rate of 3.5 per cent. While the degree of benefit varies by portfolio type, all portfolios experienced short-term losses and long-term benefits in this scenario. Clearly, it is only after the learning process, technological progress and construction of new infrastructure systems are complete that the positive benefits of the new low- carbon economy begin to accrue. Again, this process contrasts with the No Mitigation scenario, where economic output never recovers, but is suppressed indefinitely below Baseline.
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