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ESG Megatrends: Climate Change

ESG Megatrends: Climate Change
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ARTICLE TYPE
Insights
TOPIC
Responsible Investing,Climate
PUBLISHED
April 12,2022
READ TIME
10 mins
AUTHOR
Gertjan Medendorp
Anna Czylok
SHARE
Back
ARTICLE TYPE Insights
TOPIC Responsible Investing,Climate
PUBLISHED April 12,2022
READ TIME 10 mins read
AUTHOR Gertjan Medendorp
AUTHOR Anna Czylok
SHARE

Understanding the potential impact of climate change and the interaction between different stakeholders, initiatives, metrics, and tools presents challenges. There is a growing need for investors to understand the risks and opportunities that come with climate change and their impact on investment portfolios. Supervisory bodies across Europe are raising the bar and expect institutional investors to assess and understand whether and to what extent they are exposed to these types of upcoming risks. As a fiduciary manager we help our clients to further integrate climate-related considerations into the investment processes. Our approach is forward looking, transparent and comes with a high degree of flexibility. We support clients by putting things into the right perspective, interpreting outputs, and designing a path to improve portfolios’ resilience.

This paper is part of the ESG Megatrends: Implications for Strategic Asset Allocation (SAA) series in which we discuss the consequences of key ESG developments across the global economy that we believe will affect investors’ portfolios.

 

Written by Gertjan Medendorp and Anna Czylok, Aegon Asset Management.

 

In this paper we argue that although the actual pathway that the economy will follow is unknown, we know with certainty that there is no ‘business as usual’ scenario where climate does not play a role eventually.

 

Transition and physical risks are relevant and will result in varying degrees of risk. The physical risks caused by climate change arise due to real-world environmental hazards, such as an increase in severity and frequency of extreme weather events. These physical risks have both real-world and financial implications due to, for example, supply chain disruptions, changes in commodity prices, and physical damage to assets. Most likely climate change is already affecting the financial sector in many ways and the effects could increase significantly. Transitioning away from fossil fuels and carbon-intensive production and consumption requires a significant shift towards zero -emission alternatives across the globe. This gives rise to transition risks for the economy and financial markets.

 

An important consideration for investors when weighting up transition risk against physical risks is that physical risk resulting from climate change cannot be reversed. It will keep increasing in magnitude if the transition towards a net-zero economy is not timely and the results would be disastrous.

 

Climate risks are complex and there are many dimensions to consider, such as time horizon and loss metrics. Besides, projecting the impact of events that are historically unknown is challenging.  Scenario analysis can be helpful in gaining understanding of how different asset classes, countries and sectors are impacted by climate-related financial risk.

 

We have been servicing multiple clients in their endeavours to understand the potential impact of climate change on their investment portfolio. In this journey we have developed our own proprietary methodology supplemented with tooling from external vendors and data providers. The box below summarizes some key observations from our research.

 

 

Transition risks
  • The transition will likely lead to large differences across and within industries. Investors should not forget that it could bring significant opportunities too.
  • The cumulative projected impact of transition risks can be significant on a 20 to 30 year horizon.
  • Year on year, investors can still expect to earn a positive return on their investments.
  • A disorderly transition could offset the expected additional return of risky assets, particularly when climate policy implementation is unanticipated. This is especially true if climate risks are not correctly priced into the financial markets.
  • It seems that emerging markets are more exposed to transition risks than developed markets. On the other hand, the expected additional profit growth in emerging markets versus developed markets provides quite some room to offset the potential negative aggregated impact of transition risks.

Physical risks
  • Financial impacts from physical climate risk could arise from both an increase in the frequency and severity of extreme weather events, and gradual rising temperatures.
  • Another aspect to consider is the uncertainty that extreme weather events bring about and its effect on (real) interest rates and risk premia. Given a greater unpredictability with respect to future (economic) outcomes and depending on the risk aversion, people might increase their saving rate in anticipation of more dire conditions in the times ahead. This implies lower current consumption and demand for credit, and results in a downward pressure on interest rates.
  • From an investor perspective, companies’ exposure to physical risk and subsequently long-term valuation will necessarily be subject to larger margins of error giving a rise to higher required compensation for risk.
  • Particularly at risk are those companies with locations in climate-sensitive regions, or with long-lived fixed assets. Fixed-income investors are better positioned to bear the risks of capital destruction and climate costs caused by extreme weather events based on the capital structure of the companies. 

ESG Megatrends - Climate Change.pdf

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More about the authors

Gertjan Medendorp Investment Strategist

Gertjan Medendorp CFA, is a senior investment strategist within the Fiduciary Services & Investment Solutions team.

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Anna Czylok Investment Strategist

Anna Czylok is an investment strategist within the Fiduciary Services & Investment Solutions team.

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