Climate change has the potential to be highly value destructive, but also highly value generative as companies innovate and adapt to a low-carbon future. The implications of this highly complex and multi-layered issue are profound for investors, especially as the systemic nature of the risk cannot be diversified away.

In recognition of this, the need for a holistic approach to managing climate risk and opportunity across the investment value chain is now paramount. This is the objective of a new collaboration in the investment industry between Ortec Finance, Cambridge Econometrics, Carbon Delta and Lombard Odier Investment Managers. These independent parties are working together as a ‘coalition of the willing’ driven by an intrinsic joint sense of urgency to move the dial on this issue.

The working group met for the first time in April to bring together its combined expertise to discuss an initial framework for embedding climate risk within the spectrum of portfolio management from econometric modelling, asset-liability modelling, and investment management, all based on forward-looking data on climate risk and opportunity. Achmea IM, PME and MN also joined the discussion.

 

Climate: an undiversifiable systemic risk

The physical and transition risks associated with climate change will affect companies and sectors, but it will also fundamentally impact the global economy. Research conducted by Ortec Finance and Cambridge Econometrics revealed that a failure to transition to a low carbon economy could result in a 4°C rise in global temperatures, with a significant negative effect on global equity returns. By contrast, if an orderly and rapid transition occurs, their model shows world equity returns could be boosted significantly upwards.

Embedding climate change in the macro-economic risk analysis that feeds into asset liability modelling (ALM) and strategic asset allocation (SAA) decisions is therefore an important factor in ensuring investment portfolios are managed in a climate-informed way.

The dominant approach to managing climate risk and opportunity in portfolios is at the company-specific level, for example by looking at carbon foot-printing. However, this fails to address the systemic nature of the risks associated with different global warming pathways.

Lisa Eichler, Co-head Strategic Climate Solutions at Ortec Finance, commented: “Climate change is now recognised as a key systemic risk, which will affect investors’ performance, and there is no way to diversify this away. We believe it is critical to reflect this reality in the assumptions and economic models underlying the asset liability modelling and strategic asset allocation to ensure pension funds can manage their funding ratios in a climate-informed way.”

Ortec Finance and Cambridge Econometrics worked in partnership to develop a new methodology for embedding systemic climate risk into top-down macro-economic modelling and scenario sets. Ortec Finance integrates this information into their systemic climate risk-aware ALM, showing how different global warming scenarios affect strategic investment parameters, including funding ratios. This, in turn, should educate an investors’ strategic asset allocation decisions to help them make climate-informed decisions about their optimal SAA to address and mitigate climate risk drivers over the long term.

“Accounting for climate risk at the bottom-up portfolio implementation stage can help improve your game,” says Willemijn Verdegaal, Co-Head Climate & ESG Solutions, at Ortec Finance. “But integrating climate at the strategic asset allocation level means you’re playing the game on a different field. And that field is climate-aware.

“But even that is not enough,” Verdegaal continues. “We need to build climate risk and opportunity into the whole portfolio management process in order to provide the best outcomes for investors. This means using cutting-edge data on climate risk and opportunity, and embedding that information throughout the investment process.”

 

Data: understanding climate risk and opportunity

Data is a key aspect of understanding the implications of climate risk and opportunity for the ALM, SAA and integrating it into portfolio construction. Both the scenarios generated in the ALM and the constructed portfolios need to rely on advanced forward-looking climate-related risk and opportunities metrics.

Carbon Delta’s Climate Value-at-Risk^® (CVaR) aggregates the estimated forward-looking costs to companies, and their associated financial instruments, resulting from physical and transition risks and opportunities at the country, sector and facility level. In addition, Carbon Delta’s CVaR accounts for technology opportunities, calculating the future revenue a company is likely to generate from low-carbon technology patents. In this collaboration, Carbon Delta’s CVaR is integrated into both the ALM and the portfolio construction process.

David Lunsford, Co-founder and Head of Development for Carbon Delta, said: “Companies with a higher technology CVaR, who have high-quality patents related to high-emitting sectors, for example, will therefore be more resilient to climate risk over the long-term.

“The idea behind our CVaR,” Lunsford continues, “is to aggregate the risks and opportunities arising from climate change between now and the end of the century so investors and their asset managers can use that information in their analysis of the financial performance of the companies they are investing in for the foreseeable future.”

One of the key innovations the collaboration is focusing on is integrating the sector level into Ortec Finance’s Systemic Climate Risk Scenario Solution. The innovation will be developed and trialled using  Carbon Delta’s CVaR data. In future iterations, other bottom up data sets could also be considered in order to match client preferences.

 

Portfolio management

According to Foort Hamelink, responsible for integrating ESG in bespoke portfolios at Lombard Odier Investment Managers (LOIM): “Climate change presents a major and growing risk to investors, but it also creates significant opportunities as companies innovate and transition to a low-carbon economy. We believe embedding climate risk and opportunity into the valuation of companies and assets means we can make more informed decisions and ensure investment portfolios are sustainable over the long-term. In our view, this issue needs to be reflected across the whole portfolio, including passively-managed strategies across all asset classes.”

To integrate climate risks and opportunities into portfolio management, LOIM have developed a solution for implementing low-tracking error portfolios that ‘tilt’ portfolio holdings using LOIM’s proprietary ESG/CAR approach (which differentiates between companies that are ‘talkers’, ‘doers’ and those achieving actual results in improving their business practices), and on carbon metrics, including Carbon Delta’s forward-looking CVaR data.

 

Closing the loop

To ‘close the loop’, Ortec Finance, Carbon Delta and LOIM, then carry out analysis of how the new portfolio diminishes exposure to the underlying risk drivers identified in the ALM. This captures improvements at the implementation level in the ALM output parameters. Because climate risks are better managed at the level of the asset mix and the level of implementation, i.e. sector and holdings, the climate-related risks are reduced in a consistent manner throughout the investment chain. Consistency is achieved as all parties are working from the same, independent macro-economic, sectoral and company level data points. As a result, risk parameters at the ALM level, such as funding ratio outcomes, should improve. Additionally, having such a consistent state-of-the art approach across the full investment chain will greatly enhance reporting under the TCFD’s pillar three on strategy.

Anna de Jong-Wakley, Head of Sales and Solutions for Benelux, at Lombard Odier Investment Managers, says: “The main goal of our collaboration is to give our clients a solid framework to work within in order to mitigate climate risk. By creating a toolset for each step in the decision making process, we have created a transparent way to measure and impact the level of climate risk within portfolios. Our collaboration is key to help the transition to mitigate climate risk and create resilient portfolios. By reducing the probability of extreme climate scenarios unfolding, we can also ensure that our collaboration results in a positive impact for investors, and for society as a whole.”

 

This collaboration is open in nature and other potential participants would be very welcome to join. If you would like further information, please contact Anna de Jong-Wakley at LOIM, Willemijn Verdegaal and Lisa Eichler at Ortec Finance, and David Lunsford at Carbon Delta.

 

Join us for the opportunity to hear more about our approach to integrating sustainability at the whole-portfolio level at our seminar, “the sustainability storm”, at Kasteel Woerden in July on 4 July. Click here for more information.

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