In this Q&A, Willemijn Slingenberg-Verdegaal and Lisa Eichler, Co-Heads of Climate & ESG Solutions at Ortec Finance, explain why climate change risk has become such a priority and how climate, macroeconomic, and financial modelling can be tied together to produce a more complete ALM and inform strategic investment decisions.

Climate change is increasingly recognised as a key systemic risk, meaning that the risks and opportunities are unlikely to only effect the valuations of directly impacted companies.

There will likely be knock-on effects between companies, through supply chains, which affect consumers and the economic system as a whole.  A disorderly transition to a more sustainable economy has the potential to be highly value-destructive for investors – even if they are diversified and invest sustainably. The challenge they face is how to understand the pathways climate change might take, and to incorporate these systemic considerations alongside company specific considerations into their portfolio management.

To develop a solution to this climate integration puzzle, Ortec Finance is collaborating with Lombard Odier Investment Managers and Carbon Delta. This state-of-the-art climate portfolio management solution combines systemic climate risk informed asset liability management (ALM) with strategic decision-making and active portfolio construction, using a forward-looking, quantifiable measure of climate risk and opportunity. This solution is designed to help investors influence the probability of extreme climate scenarios, increase their resilience and performance in the face of climate change, and to diminish the underlying risk drivers associated with this megatrend.

 

What has happened to make climate risk a priority?

We are witnessing a perfect storm in terms of public demand for action, together with the fact that climate risk is now explicitly recognised by many regulators as a financial risk.

Today, there is far more pressure on governments and companies alike to recognise the risks associated with climate change and plan accordingly. Preparing for the transition to a low-carbon economy is also a far more feasible prospect as a result of technological advancements both in industry and finance.  

We are now seeing progress on the global stage, which is, in part, due to a growing social awareness of the need for change. In 2015, the world came together to sign the Paris Agreement, which aims to limit any rise in global temperatures this century to well below 2°C above pre-industrial levels. This significant agreement marked out a new set of global ambitions.

These kinds of high-profile agreements have the effect of making people more conscious of climate risk and gives us, as a society, goals to work towards. It also creates more pressure on the public and private sectors to transition towards a low-carbon economy.

The next step is all about implementation.

Pension funds and other asset owners, in turn, are increasingly expected to manage climate-related risks. They can no longer get away with choosing to turn a blind eye to this. Societal pressures and technological advancements have come together at a very opportune time.

 

What has changed from a regulatory perspective?

There has been definitive progress on this front, such as that recently demonstrated by, for example, the Dutch government. A climate law recently passed in the Netherlands has quite strict decarbonisation goals. This law aims to cut emissions 49% by 2030, and 95% by 2050. It also outlined proposals to make electricity production entirely carbon neutral by 2050. Also Sweden has announced it want to become the world’s first fossil free welfare state.

Elsewhere, there are plenty of encouraging signs of progress. The European Parliament, the Council of the EU and the European Commission, have recently reached a political agreement to adopt the draft regulation on ESG disclosures which affects institutional investors. The Institutions for Occupational Retirement Provision (IORPs) II Directive came into effect earlier this year and requires pension funds to take ESG factors into consideration in their risk management processes.

In 2018, the European Commission’s High-Level Expert Group (HLEG) on Sustainable Finance released its final report, which mapped out the challenges and opportunities that the EU faces in developing a sustainable finance policy.

Looking ahead and signatories of the Principles for Responsible Investment (PRI) will be required to adopt the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) in 2020. This will have the welcome effect of increasing the amount of reliable information on financial institutions’ exposure to climate-related risks and opportunities available.

 

What do you mean by a ‘disorderly transition’?

This refers to the timeframe outlined by the Paris Agreement. The central aim of this agreement is to strengthen the global response to the threat of climate change by keeping the global average temperature rise this century well below 2°C above pre-industrial levels, and ideally try and keep at 1.5°C.

This is actually a very tight timeframe in which to enact global structural change and it gets tighter with each passing day. The shorter the timeframe, the greater the probability of a ‘disorderly’ transition, which would be characterised by significant volatility and value destruction for investors.

We see three global warming paths. In the first, we achieve 1.5°C, but we expect this could result in a disorderly transition given the tight time constraints. The second sees a 2°C change, which is still very ambitious and may well still be accompanied with shocks. Lastly, there could be a 4°C if we assume a ‘business-as-usual approach’, enacting a very delayed transition.

Importantly, however, we believe a disorderly transition that keeps us to 1.5°C is economically preferable to any scenario which leads to a 4°C. Any under 2°C scenario represents a period of transition followed by a return to relatively ‘normal’ growth trajectories. However, higher warming pathways fundamentally – and without any clear road for recovery - undermine the ability of natural systems to support current levels of GDP, let alone growth. This this would be highly value destructive.

Based on our analysis, a 4°C scenario would result in a cumulative difference in climate-adjusted GDP growth for Europe, for example, of over -35% by the end of the century compared to climate-neutral market expectations. This is closer to -3% for a 1.5°C scenario.

It’s worth noting, however, that an orderly transition towards the Paris goals could be highly value-generative for investors, particularly as it relates to energy. Fast-paced energy transition is expected to increase world equity returns by 6 percentage points over the next ten years compared to a current market outlook that assumes no energy transition. For a fast-paced global energy transition to happen, it is assumed that companies, governments and consumers reduce their carbon emissions in an orderly manner so that average global warming is limited to 1.5°C.  Drastically lowering emissions requires vast investments in new technologies, green infrastructure, energy efficiency, and human capital development. These are all strong fundamental drivers of economic growth and investment return.

 

Should we expect a disorderly transition?

There are tentative, early signs of a potentially disorderly transition. The debate has never been so fierce and many governments are under extraordinary pressure to confirm a decarbonisation strategy. In Holland, the government has outlined some very ambitious climate goals, but a perceived lack of action regarding implantation has sparked student & school children protests in the Hague recently.

The very fact that the debate is so heated shows there are going to be clear winners and losers as a result of this transition, and that the likelihood of aggressive policy or technological change has increased significantly.

It is important for an investor to understand how, at the strategic level, they will be impacted. Change brings opportunity, as well as risk, so it is important that investors have the tools they need to identify both in advance. After all, missing opportunity is also a risk.

 

What is different about your approach?

We focus on modelling systemic climate risk. What makes our approach so unique is that for the first time individual long-standing modelling traditions from the climate, economic and financial space are now connected and able to communicate.

State of the art climate modelling, based on Intergovernmental Panel on Climate Change (IPCC) research is fed through the macro-economic model of our partner Cambridge Econometrics. We then receive a climate-informed GDP shock that is fed into our stochastic econometric financial model. In this way an investor can, for example, see in a quantified way how regional or global equities and credits perform in different global warming scenarios. It also provides insights into how coverage ratios and purchasing power develops. The modelling provides very concrete and actionable insights that allow for climate to be integrated into strategic investment decision making.

At the asset-liability modelling (ALM) level, our approach means we are able to tie climate, macroeconomic, and financial modelling together so that information from the climate models can be expressed in financial metrics that can then be used to shape the strategic asset allocation and portfolio management.

Because climate change is a systemic risk, it is extremely hard to diversify your way out of it. A transition risk will not only impact the big emitters; it may impact the entire economy because of the knock-on effects. This is where the complementarity with Carbon Delta’s more granular, metrics are crucial. They allow investors to embed forward-looking data around climate risk at the company and security level.

We are currently working on enabling the ALM to also ‘read’ this more bottom up data in order to quantitatively express that investing in more ‘transition proof’ companies and technologies, under a low-carbon scenario, improves the risk/return profile at the ALM level. That way, there is a consistent feedback loop from the ALM, to the benchmark choice and back up. The result is a consistent integration of climate-related risks and opportunities throughout the whole investment process. It also enables asset owners to engage in much more informed conversations with their asset managers to produce outcomes that are more resilient to climate change risk.

This holistic approach to embedding climate risk into portfolio management is new. And it’s why we are so excited to be working in partnership with Lombard Odier Investment Managers and Carbon Delta.

 

about the authors.

 

Willemijn Slingenberg-Verdegaal Co-head Strategic Climate Solutions at Ortec Finance Willemijn studied economics at the University of Utrecht and the London School of Economics. Together with Lisa Eichler she drives the integration of climate risk and sustainability across Ortec Finance’s investment decision tooling, especially in forward looking scenario based strategic modelling tools (ALM/SAA analysis). Before joining Ortec Finance, she was a member of the Responsible Investment team at MN services. She has also held a role as senior policy advisor on climate finance at the ministry of finance where she was responsible for mobilising the Dutch contribution to international climate finance.

Lisa Eichler Co-head Strategic Climate Solutions at Ortec Finance Lisa Eichler’s (Msc Environmental Management, MA Global Public Policy, Duke University, USA) main expertise centers on policy, economic and financial analysis of topics relevant for the transition towards a low-carbon, climate-resilient economy. In particular, Lisa’s main interest and experience over the past 10 years focuses on climate change adaptation and its interlinkages with disaster risk and resilience, as well as biodiversity / natural capital. Lisa also managed an innovative modelling approach (using IO and CGE models) for assessing the direct and indirect economic, social and environmental impacts of climate extremes.