Institutional investors urged to include sustainable assets to ‘enhance returns’

Institutional investors are again being urged to include a greater amount of sustainable assets in their portfolios to enhance returns.

Mercer’s latest climate change report has identified short and long-term actions that investors can consider to mitigate risks and access opportunities.

The model it has used in the report is consistent with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations and enables investors to assess climate-related financial risk for a total portfolio, across all asset classes and industry sectors, to quantify a forward-looking ‘climate impact on return’ over multiple decades.

It has modelled three climate change scenarios, a 2°C, 3°C and 4°C average warming increase on preindustrial levels, over three timeframes – 2030, 2050 and 2100. The longer timeframe (Mercer’s 2015 report was modelled to 2050) provides greater visibility into the expected impacts of natural catastrophes and resource availability for each temperature increase.

A new stress-testing addition to the model enables investors to assess how a sudden change in view on the likelihood of a scenario, market awareness (how much climate risk is priced in by the markets) and/or environmental damages could impact investment returns in the near term.

Commenting, Mercer global business leader, responsible investment, Helga Birgden, said: “A key conclusion is that investing for a 2°C scenario is both an imperative and an opportunity. It’s an imperative, since for nearly all asset classes, regions and timeframes, a 2°C scenario leads to enhanced projected returns versus 3°C or 4°C and therefore a better outcome for investors. It’s an opportunity, since although incumbent industries can suffer losses in a 2°C scenario, there are many notable investment opportunities enabled in a low-carbon transition.

“The modelling shows that greater inclusion of sustainable assets into portfolios can enhance returns. The evidence is compelling and reinforces the findings made in Mercer’s 2015 climate change report, supporting greater urgency for action to achieve a well-below 2°C scenario.”

Furthermore, the report said investors should also focus on the potential short-term implications of investing in a time of climate change. Sudden changes in return impacts are more likely than neat, annual averages, so stress testing is an important tool, Mercer said.

“Testing an increased probability of a 2°C scenario or a 4°C scenario with greater market awareness results in market re-pricing events that could impact the modelled diversified portfolios by between +3% to -3% in less than a year.” added Birgden.

The report provides investors with a clear framework to start actively taking on a future maker approach and implementing the transition to a 2°C scenario. Future makers, as defined in Mercer’s 2015 climate change report, advocate for 2°C-aligned business plans from companies exposed to transition risk and press governments to take urgent action in implementing the Paris Agreement, including an increase in commitments to address climate change.

Mercer global head of investment research, Deb Clarke, said: “This is clearly a fiduciary issue as it is about managing risk as set out in the World Economic Forum 2019 report. Asset owners should consider climate change at every stage of the investment process, from investment beliefs, policy and process to portfolio construction decisions.”

There is further regulatory pressure on asset owners to consider climate risk. In the UK, the Department for Work and Pensions’ investment regulations come into force in October 2019. The regulations require trustees of pension schemes to include a statement in their Statement of Investment Principles setting out how they take account of financially material considerations, including environmental, social and governance (ESG) factors, and explicitly climate change.

The UK Parliament Green Finance committee wrote to 25 largest asset owners in the UK about their sustainable finance activities as a way to prompt debate and study the market. It is likely they will focus on the next largest asset owners in due course.

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