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Introduction to climate resiliency
While some of the risks of climate change may seem far off, the social, economic, geopolitical, and environmental disruptions of climate change are already apparent, and we believe allocators should incorporate these considerations into strategic asset allocation (SAA) plans today. Record-setting heat, flooding, wildfires, and hurricanes have repeatedly caused massive, costly destruction and are leading to business disruptions, higher capital spending needs, higher insurance costs, and greater potential for impaired and/or stranded assets. These trends are widely expected to continue. According to our climate-science partners at Woodwell Climate Research Center, the risks of climate change will become more severe and widespread over the next 10 to 30 years, with material implications for investment performance.
We believe climate change could have lasting effects on a plan’s risk and return profile by creating increased volatility and dispersion within and across asset classes, sectors, and geographies — the traditional building blocks of an SAA. We take the view that allocators need to factor climate change into their structural planning, and in this paper, we propose a climate-aware SAA framework to help them do so.
Working with Woodwell, Wellington has studied physical climate variables and their long-term impact on capital markets. The tools and models we have developed with Woodwell indicate a rapid progression of climate change within the next three decades. Many parts of the world will experience dangerous temperatures; stronger and more frequent hurricanes; more frequent floods and wildfires; longer droughts; water scarcity challenges, and rising sea levels. Our research on physical climate risks is also the foundation for how we think about climate transition risks, including the importance of mitigating those risks and researching opportunities associated with the energy transition.
Many climate-related risks and opportunities will be idiosyncratic, materializing from company-level revenues and expenses associated with the low-carbon transition and physical climate events. However, our work with Woodwell indicates that some regions carry inherently more climate-risk exposure. For example, countries along the earth’s equatorial zone are projected to experience greater increases in temperatures and more extreme weather events than regions farther from the equator. Certain sectors also carry more risk. High-emitting industries, for example, will likely incur much higher costs to reduce greenhouse gas (GHG) emissions. Importantly, while allocators need to understand these differences, even within these higher climate-risk market segments, dispersion across companies and countries will be high, creating climate “winners” and “losers.”
Building a climate-aware strategic asset allocation framework
Building a climate-aware SAA might seem like a tall task, as historical carbon data is limited, long-term capital market assumptions that incorporate climate risks are nascent, and standards for tracking and measuring carbon emissions across asset classes are still being developed. But we believe allocators can take proactive steps to building resiliency…
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