Investment portfolios could lose up to 45% of their value by 2020 through economic shocks caused by shifts in investor sentiment on climate change, and only half of those losses can be offset by a change in asset allocation, a new report warns.
“Unhedgeable Risk: How climate change sentiment impacts investment,” by the University of Cambridge Institute for Sustainability Leadership, studied the effects of three climate change scenarios on four notional portfolios, mimicking typical institutional investor allocations.
An “aggressive” portfolio, mimicking pension fund portfolios with 60% allocated to equities, 35% to fixed income and 5% to commodities, is set to lose up to 45% of value in a “no mitigation” scenario where no consideration is given by governments and markets around the world to environmental challenges over the next five years, due to the impact of climate change on equities and certain sectors to which this portfolio would be heavily exposed, such as energy.
Under a “two degrees” scenario — if governments move toward limiting the average global temperature increase to 2 degrees Celsius by transitioning to a low-carbon economy, for example — the aggressive portfolio would suffer short-term losses, but it would recover sharply to gains of 25% after five years.
At the other extreme, an insurance company-like “high fixed-income” strategy — with an 84% fixed income allocation, 12% equities and 4% cash — would lose 4% in a no-mitigation scenario and 3% in a 2-degrees situation, but it would gain 4% if no major changes are made by governments under a baseline setting.
“This new research indicates that no investor is immune from the risks posed by climate change, even in the short run,” said Jake Reynolds, director, sustainable economy at the CISL, in a statement accompanying the report. “However, it is surprisingly difficult to distinguish between risks that can be addressed by an individual investor through smart hedging strategies, and ones that are systemic and require much deeper transformations in the economy to deal with. That's what this report attempts to do.”
The report said about 53% of the climate change risks in a portfolio can be hedged, through reallocation of assets. Regarding the unhedgeable 47% of climate risk, Scott Kelly, research associate at the Centre for Risk Studies at the University of Cambridge Judge Business School, said “systemwide action is necessary to deal with this in the long-term interest of savers.”
The report was commissioned by the Investment Leaders Group, a group of asset owners and money managers representing more than $5 trillion in assets, which is aiming to promote sustainability in the investment chain.