Will Climate Change Cost Pensions Trillions?

Schemes must factor in climate change risk to their asset allocation strategies over the next two decades or face losing trillions of pounds, Mercer warns.

Research from the consultant - commissioned by a group leading schemes including BT Pension Scheme - anticipated climate change policy will account for 10% of a pension fund's portfolio risk by 2030, with costs hitting about £5trn by 2030.

Mercer said funds could combat the growing policy risk headache by diversifying their portfolios away from equities and bonds into "climate sensitive" assets.

These include infrastructure, real estate, private equity, agriculture land, timberland and sustainable assets. Mercer forecasts a portfolio trying for a 7% return could cancel out the climate change risk by allocating 40% of its funds to these assets.

The Environment Agency, participants in the research, welcomed the switch to a policy-led asset allocation strategy.

Environment Agency head of environmental finance and pension fund management Howard Pearce said: "We think all pension funds will need to adopt a climate change-proofed financial investment strategy in the future to enable them to fulfil their fiduciary duties.

"We also want our pensioners to retire into a similar environment than we enjoy today and not one that is affected by the extremes of climate change that could reduce their life expectancy."

Mercer also predicted the increased investment in low carbon technology would increase portfolio risk by 1% but be offset by a predicted investment of about £2.5trn by 2030 in this area.

Mercer chief investment officer Andrew Kirton said: "Institutional investors should be factoring long-term considerations, such as climate change, into their strategic planning.

"Mercer is pleased to have had the opportunity to kick start such strategic discussions with a group of leading global investors."

Mercer used its ‘TIP' framework to judge the impact of climate change, a formula allowing pension funds to manage risk based on low carbon technology (T), physical impacts (I) and climate policy (P).

Emma Boyde of the FT reports, Pension funds plan action on climate change risks:

At least two pension fund sponsors of a research project into the risks for investors of climate change intend to change or advise changes in their asset allocation as a result of the findings.

The collaborative project*, led by Mercer, the investment consultants, found that climate change policy could contribute as much as 10 per cent to portfolio risk over the next 20 years and identified asset classes that could be beneficiaries as well as those that were likely to be negatively affected.

“The risk numbers indicate this is a very real risk,” said Helene Winch, director, head of policy at BT Pension Scheme Management, adding that she intended to pass the information back to BT's risk management teams.

BT's pension scheme is one of 14 global insitutional investors that supported the research, which also received the backing of the International Finance Corporation and Carbon Trust.

Speaking afer the launch on Tuesday, Howard Pearce, head of environmental finance and pension fund management at the UK's Environment Agency, another of the partners, said the Agency's scheme would change its strategy as a result of the findings.

The research team, led by academics from the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Vivid Economics, an economics consultancy, examined four scenarios that could take place in the next 20 years. The two most likely scenarios, the research team decided, were that there would be a regional divergence in response to climate change issues, or worse, there would be a delayed response leading to harsh policy measures in perhaps a decade. The two least likely scenarios, it concluded, were that strong internationally co-ordinated action would take place or that there would be significant climate breakdown in the next 20 years.

It looked at those four scenarios and considered three broad risks to portfolios: technology (investment flows into new technology); impact (real physical impact of climate change); and policy (international and domestic agreements and regulatory responses). The team concluded that continued delay in climate change policy action and lack of international co-ordination could cost institutional investors thousands of billions of dollars over the coming decades.

It found investors could benefit under most scenarios from increased allocation to infrastructure, real estate, private equity, agricultural land, timberland and sustainable assets. Under certain scenarios, even the likely scenario of delayed action, certain asset allocations were found to have a negative likely outcome.

The modelling was applied to a hypothetical “typical” portfolio with 34 per cent in developed large-cap equities, 13 per cent in emerging market equities, 18 per cent in global government bonds, 26 per cent in investment grade credit and 9 per cent in property.

*Climate change scenarios - implications for strategic asset allocation, (Feb 2011)

You can read the Mercer report by clicking here. It provides a thorough discussion on climate change and its potential impact on various asset classes. There is a lot of uncertainty surrounding climate change but pensions should be thinking hard about how it and other secular trends will impact their portfolio. Will climate change cost pensions trillions? I doubt it. Moreover, it will present pensions with new opportunities. In fact, I firmly believe that pensions stand to make very profitable investments in both private and public markets if they play this theme wisely.