GIC, Singapore's sovereign wealth fund, updated its climate scenario analysis to include a fourth scenario of a 2-3 degrees Celsius outcome and the impact of climate risks on inflation that is the first of its kind.
The fund developed the update, which was published April 22, with support from Ortec Finance, a technology and solutions provider based in the Netherlands that it first engaged in 2021 to develop its climate analysis.
In the update, GIC added a fourth scenario titled Too Little Too Late, where climate policies are delayed and are implemented only after a series of extreme weather events. The scenario assumes high transition and physical risks, and, as a result of the delay and insufficient scale, considers a global warming outcome of 2-3 degrees Celsius by 2100, a GIC spokeswoman said. The inclusion of this scenario is the first of its kind. "While the value of a TLTL scenario has been discussed by the Network for Greening the Financial System (NGFS), it has not yet been included in any climate scenario sets currently in the market," the spokeswoman said.
"GIC thus decided to examine this bespoke scenario to offer a more extensive and nuanced narrative that reflects our concerns as a long-term investor over a potential future pathway of insufficient policy actions, severe physical risks as well as greater market volatility," she said.
It is also reflective of the latest Emissions Gap Report by the UN Environment Programme, she said. The report, released in October, said that current policies will likely result in a 2.8 degree Celsius rise by the end of the century — far behind the Paris Agreement goal of limiting global warming to below 2 degrees Celsius, with the hopes of keeping it below 1.5 degrees Celsius.
Portfolio incorporation
Climate scenarios are incorporated into GIC's asset allocation process from both a top-down and bottom-up approach by analyzing plausible outcomes such as upside and downside effects on the portfolio over an investment horizon of 20 years, the GIC spokeswoman said.
"At another level, we explore a wider range of potential future environments that the rest of the world may not currently be paying attention to. This involves identifying nascent, high-impact drivers and possibilities of how the world may fundamentally change before these are recognized and priced by the markets. Climate change is one such example," she said.
"These scenarios and impacts are shared internally across the asset groups, and where relevant, are incorporated in the bottom-up underwriting process and stress-testing of investments," she added.
The analysis took a granular approach to climate change, considering four scenarios in total that detailed different pathways the world might take in the energy transition and the impact they might have on the investment portfolio. On top of the new Too Little Too Late outcome, the other scenarios comprise an optimistic Net Zero pathway, a Delayed Disorderly Transition and the worst case scenario of a Failed Transition.
The analysis found that annualized nominal returns over a 40-year period for a global 60-40 portfolio were 3.4% in the event of a Failed Transition, 3.8% in a Too Little Too Late scenario, 4.2% in a Delayed Disorderly Transition and 4.3% in a Net-Zero outcome, compared with a 4.6% baseline.
Inflation impact
The update to the analysis also included the impact of physical climate risks on inflation, which rendered a variety of results depending on the situation.
"Climate scenario modeling is a little challenging in that there are all these moving pieces that even something like inflation can move up or down, depending on the time horizon, region, or sector," said Willemijn Verdegaal, managing director of Ortec Finance's Climate & ESG Solutions, who is based in the Netherlands.
According to the modeling, higher temperatures lead to higher physical risks, which in turn lead to slower GDP growth rates. This tends to make inflation go down, she said.
At the same time, physical risk can have negative effects on agriculture productivity and "significantly hurt food production," she added.
"So if you are in regions where people spend a large portion of their monthly income on buying food, and when food prices go up, that has a large inflationary impact in those regions," she said.
Transition risks were also taken into account, where transitioning economies from high to low carbon will require high levels of investment to build up renewable energies and clean infrastructure, which could lead to a short-term rise in inflation.
But after these initial investments, since renewable energies tend to have high capital expenditures but low running costs, prices will come down again in the medium term, Ms. Verdegaal said.
"Definitely what our models really show is that every 0.1 degree makes a difference in terms of economic impact. And even though the transition may cause significant upheaval, in the longer term it is always much better in terms of economic (growth), economic impact, and impact on investors… The global investor community stands to lose most when temperatures increase," she said.
She also cautioned that the tweaks to these scenarios are not an indication of the likelihood of any situation. "It's more ensuring that we are in line with global regulation (and) global targets. I stay away from giving any probabilities. Our job is really just to sketch what would need to happen if the world were to go there," she said.
