As the momentum behind decarbonisation and net-zero objectives builds around the world, asset owners are increasingly engaged in addressing the investment implications of climate change. The focus thus far has largely been on implementation at the security- and manager-selection levels, but there is a growing recognition of the need to factor climate change into broader investment policy and asset allocation decisions. To help with this process, our Investment Strategy Team, in partnership with our Climate and ESG teams, recently completed a comprehensive effort to integrate climate risks into our capital market assumptions (CMAs).
Finding a way to measure transition and physical risk
Our CMA process follows a classic building-block approach in which the components of total return — income, growth and valuation — are forecast independently. At the heart of the approach is an assumption that macro variables (e.g., GDP, inflation) and fundamental variables (e.g., EPS growth, credit losses) each have a bearing on total return.
With this as our starting point, we needed a framework for thinking about the climate inputs that should be incorporated into the CMA process. We chose to focus on two areas of climate risk:
- Transition risk includes risks arising from the decarbonisation of the economy, such as the impact of policy/regulatory changes (carbon pricing, subsidies, etc.), technological disruption (the move to renewables, electric vehicles, etc.) and societal pressure and behaviour.
- Physical risk concerns changes to the physical environment brought on by climate change, including chronic risks (long-term shifts in climate patterns, temperatures, sea level, etc.) and acute risks (risks that are event-driven and increasing in severity, such as floods, hurricanes and wildfires).
Given the complexities and variations in the categories of climate risk, we employed two distinct approaches to estimate their impact on macro variables. For transition risk and chronic physical risk, we followed a scenario-based approach that draws on policy scenarios designed by the Network for Greening the Financial System (NGFS), a group of central banks and supervisors. The output from three different integrated assessment models is available for each of the scenarios, providing some model-risk diversification in estimating potential paths for real GDP and inflation. Figure 1 shows 12 of these paths for US real GDP (left) and 12 for inflation (right). We can see that there is a wide dispersion of outcomes, but generally speaking, real GDP is expected to be lower than baseline and inflation is expected to be higher than baseline, driven by transition risk.