Our ongoing climate research shows that various global regions and asset classes will face significant and growing climate risks in the coming years. We hold the view that asset allocators seeking optimal long-term results should thoughtfully factor climate change into their structural investment planning. In fact, we believe allocators can build climate resilience into their portfolios today to pursue the potential return opportunities arising from climate change.
Mounting risks and implications of climate change
While some of the risks associated with climate change may seem too far off to matter right now, many of the environmental, social, and economic ramifications are already apparent. We believe now is the time for allocators to begin thinking about how to incorporate climate change and related considerations into their strategic asset allocation (SAA) plans.
Record-setting heat, floods, wildfires, and hurricanes have repeatedly wrought massive, costly destruction and ensuing business disruptions, higher capital spending needs, rising insurance costs, and greater risks of impaired and/or stranded assets. These trends are expected to persist in the decades ahead: According to our climate-science partners at Woodwell Climate Research Center, climate change risks will become more severe and widespread over the next 10 to 30 years, with material implications for investment performance.
We believe climate change could have lasting effects on an SAA plan’s risk and return profile by creating increased volatility and dispersion within and across asset classes, market sectors, and geographies — the traditional building blocks of an SAA. Allocators should therefore anticipate and plan for a broader range of potential investment outcomes going forward, particularly in more climate-sensitive assets and likely at the overall portfolio level as well.
Building a climate-aware SAA framework
Building a “climate-aware SAA framework” might seem like a tall order, as historical data on carbon emissions is rather limited, capital market assumptions based on climate risks are nascent, and standards for tracking and measuring carbon emissions across asset classes are still being developed. However, there are proactive steps allocators can take toward building climate resilience into their SAA plans. We propose a three-pronged approach to manage the investment risks and potentially capture the opportunities stemming from climate change:
1. Prepare for greater uncertainty: Assume a wider range of potential investment outcomes for both long-term portfolio risks and returns. This is especially important in asset classes and market segments that may be more exposed to physical climate risks, such as emerging markets (EM) equity and debt, municipal bonds, commodities, infrastructure, and real estate.
2. “Decarbonize” core portfolio exposures: Consider transitioning a portfolio’s largest asset allocations — particularly within equities and corporate fixed income, for which emissions data is more readily available — toward “Paris Agreement-aligned” mandates whereby underlying asset managers have committed to reducing portfolio-level carbon emissions.
3. Invest in climate-focused solutions: Consider establishing “satellite” portfolio allocations to dedicate some public and private capital to nonconcessionary, climate-focused investment strategies.
Putting a plan together
Figure 1 is one hypothetical example of how an investor might approach structuring a climate-aware asset allocation plan.
We recognize that building a climate-aware SAA framework is easier said than done. To learn more, including some suggested ways to start implementing such a plan, please see my full white paper on this topic, Building climate resilience within a strategic asset allocation framework.