How climate change affects capital market assumptions

Thomas Mucha, Geopolitical Strategist
Supriya Menon, Head of Multi-Asset Strategy – EMEA
2024-06-20T12:00:00-04:00  | S3:E6  | 29:53

The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.

Episode notes

Head of Multi-Asset Strategy for EMEA, Supriya Menon, explores her team's latest research on how climate change affects capital market assumptions.

Key topics:
2:05 – Supriya’s investment background
3:25 – Climate research from an allocator’s perspective
6:10 – New research framework: Three pillars
8:20 – Collaborating with internal climate experts
9:50 – Key research findings
12:30 – Implementing a climate framework
14:45 – Climate risk, geopolitics, and transition scenarios
18:20 – Integrating climate across asset classes
22:05 – Insurers approach to climate
23:30 – Next steps for climate research

The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.


COLD OPEN (SUPRIYA MENON): When we think about capital market assumptions, one of the main takeaways is that climate change -- that’s both physical and transition risks -- worsened the growth/inflation mix, so you get a bit less growth and a bit more inflation, and, absent further action, reduces risk-adjusted return, so lowers that efficient frontier.

THOMAS MUCHA: Long-term investment planning requires the integration of capital market assumptions. Without these CMAs, asset allocators would have nothing on which to base strategic plans. Now, CMAs can and do change, given secular dynamics like deglobalization, new macro regimes, geopolitical shifts, of course, and climate change. Today we’re discussing just that: the effects of climate change on capital markets; in short, why asset allocators should be paying attention, and what they can do to prepare for an investment future shaped by climate change. My guest today has been spearheading research on this topic. She’s Wellington’s head of Multi-Asset Strategy EMEA, Supriya Menon. Supriya, thanks for joining me, and welcome to WellSaid.

SUPRIYA MENON: Thanks for having me, Thomas. It’s wonderful to be here.

THOMAS MUCHA: So before we get into today’s topic, which is, of course, critical to the future of markets, to say nothing of the planet, I’m curious about your professional background, Supriya. So what’s been your career path to now leading the Multi-Asset Team for Wellington’s Europe, Middle East, and Africa Team?

SUPRIYA MENON: Thanks for that question. So I started my career at the tail end of the dotcom boom, so in 1999, in Morgan Stanley in New York. So in terms of my career path, I’ve always been someone who likes looking at the world from the top-down perspective, and since we’re focusing here on climate you might say looking at the wood rather than the trees. I spent time analyzing emerging markets as an equity strategist for a while, as a hedge fund analyst, and since about 2009 I’ve been working in various roles within multi-asset strategy and portfolio management. So I’ve always had an interest in thinking about long-term strategic themes, even ones not directly front and center for markets right away, and doing the work on how they might influence how we invest and allocate over the long term. So I started working on sustainability themes within a multi-asset context about five or six years ago, and joined Wellington in early 2022. I’ve also lived and worked in many countries, grew up in India, but since then I’ve lived in the US, Switzerland, and in the UK, I call London home.

THOMAS MUCHA: Excellent, so a wide background, putting all of those skills to use, no doubt. But very quickly, Supriya, remind our listeners what the remit of the Investment Strategy Team is.

SUPRIYA MENON: So Investment Strategy, which we call iStrat, is a strategy and solutions platform within Wellington. We like to say that most investors at Wellington really have to focus on one thing, which is managing their portfolios to exceed client objectives, but we have the privilege of doing three things. So as a head of Multi-Asset Strategy for EMEA, I build customized solutions for clients; I help manage products and solutions; and also use research-driven insights, and I work on the research myself together with others on the team, to help clients address their investment challenges, of which climate is one among many. So an important thing to remember about the research that we do within iStrat -- and it’s a critical part of how we deliver our solutions -- is that we deliver that research from an allocator’s perspective, and it really comes from managing portfolios ourselves, and it helps us engage in these discussions with our clients as peer allocators. So examples of the research, it’s really quite wide-ranging -- and how we think about market regimes, to how you generate income in a diversified multi-asset framework, or how to approach currency hedging. I always like to say to clients, if you have a thorny problem you’re grappling with, it’s quite likely we’ve done the research on it.

THOMAS MUCHA: Okay, well, speaking of thorny problems, let’s unpack the work your team has done to help asset owners who want to incorporate climate considerations into their strategic asset allocation plans. So, first, what was the genesis of this effort, and why did you undertake this project?

SUPRIYA MENON: The starting point is really our belief -- and it’s really an investment belief -- that climate change affects investment outcomes, and that really underpinned our decision a couple years ago to integrate climate into our asset allocation process. The other thing I’d say is that Wellington has deep client relationships, with a range of asset owners across channels, and clients see their long-term portfolios challenged by climate change. They know things are getting worse, but they often struggle with this question of, well, how do you make your portfolios more resilient, whether that implies taking a risk-based perspective or, indeed, taking advantage of opportunities in the transition, as well as in adaptation. And, at the same time, we have the opportunity at Wellington to gain insights through our partnerships with some leading organizations in the scientific area.

THOMAS MUCHA: Yes, in particular the Woodwell Climate Research Center, is an important part of my research process, as well. I get to take the analysis and the expertise of these great climate scientists, and incorporate it into my own research, so that works across firms; it works across teams; it works across individuals. I know this can get complex quickly, but let’s give an overview here of the framework and the pillars that this most recent research is built on.

SUPRIYA MENON: So you mentioned the word “pillars,” and we do think of our work as sort of being a framework that’s constructed on three pillars. So the first one is really the top-down one. It’s focused on incorporating climate-related inputs, including transition and physical risks, into our ten-year capital market assumptions, our CMAs, that really underpin and anchor our strategic asset allocation. Now, we take a scenario-based approach that range between sort of slower and faster paces of transition, and we do this because we know that the future is going to be a little bit different from the past in this respect, and the pace of transition is difficult to anticipate, so scenarios give us a bit of a framework for doing so. And it’s important also to know that these underpin the SAA, strategic asset allocation, for all of our multi-asset portfolios, so we don’t have climate-aware and non-climate-aware SAAs; we just have one set of climate-aware capital market assumptions. Now, the second pillar, which we worked on last year, is our effort to add relevant climate metrics to an asset allocation optimization process that we use to construct portfolios, so in doing so, once you integrate those objectives, what are the tradeoffs you have to face in portfolio construction? And we also, then, decided to extend the research into a third pillar, which focuses on the bottom-up piece of this implementation, and the choice of specific climate-aware building blocks and strategies to express a desired asset allocation for example, how do you think about passive versus active strategies, growth versus value orientation and other aspects of portfolio construction. Now, these three pillars help give us this sense of a kind of total portfolio approach to integrating climate into multi-asset portfolios. The goal of this was to come up with a blueprint, so it’s a seven-step blueprint that we hope can serve as a guide to our clients, either its individual components or as a whole.

THOMAS MUCHA: Supriya, you mentioned the Woodwell Climate Research Center. Who are some of the internal partners that helped to collaborate on this project?

SUPRIYA MENON: Yes, so we have a really collaborative culture at Wellington, and this research has really been a testament to that. So we leaned into not just those external folks that I mentioned, but also internally, our Climate team helped us with the research in many ways, and I’d like to mention Chris Goolgasian, who’s the Head of Climate Research, but also Julie Delongchamp, who’s our climate transition risk analyst. The co-authors on these pieces were: Tim Antonelli, who’s the strategist covering insurance; Lilia Chobanova, who’s within our Fundamental Factor Team; and Patrick Wattiau. And it’s important to note here that for the first piece of research, it’s Patrick who really did all of the digging on the different sources for scenarios and macro assumptions, so a special shoutout to him, but all of these folks helped get the research to a better place. We conducted 20 or 25 interviews with investors and experts across the firm, really to integrate their insights on how they invest with climate change as a key parameter. And here it really enabled us to come to this rich understanding of the diversity of approaches we have at Wellington, which then allowed us to do this research on portfolio construction, incorporating these strategies.

THOMAS MUCHA: Okay, so what has the research revealed, and, to you, what are some of the key findings?

SUPRIYA MENON: So when we think about the capital market assumptions, one of the main takeaways is that climate change -- that’s both physical and transition risks -- worsened the growth/inflation mix, so you get a bit less growth and a bit more inflation, and, absent further action, reduces risk-adjusted return, so lowers that efficient frontier. This is because you have to think about higher carbon prices as a tax, so the more you undertake mitigation, the higher the price of doing so in the short run, but over the long term you do develop technologies that enable those costs to come down with increased scale. So you can think of the costs going up over a shorter period and coming down over a longer period, in those sort of higher-mitigation scenarios.

THOMAS MUCHA: What’s that timeframe for that tradeoff?

SUPRIYA MENON: Yeah, so if you think about the next 10, 20 years, in the orderly net zero scenario -- so that’s the most orderly and upfront of the mitigation scenarios that, that we’ve incorporated -- that’s when it ends up being the most costly, and those costs come down with scale over the long term. This varies between technologies, of course. But if we think about physical climate risk, there is an impact that is longer term, and it worsens the further out you go if you don’t take stringent actions on mitigation. That’s because acute events become more frequent, more impactful. This adds to pressure on supply chains, and chronic physical risk can also depress productivity, so that increases inflation, reduces growth.

THOMAS MUCHA: So we have a more inflationary world. We’ve got lower growth. We have a wider set of potential outcomes, in terms of climate outcomes and climate impacts. What else?

SUPRIYA MENON: Yeah, so there are ways to improve upon this. You can reduce your risks and expose yourself to the opportunities in this transition, as well as in adaptation. So I spoke about pillar two, and one of the ways you can do this is to optimize your portfolios using climate metrics. Of course, in getting to a portfolio that is more climate aware, more resilient, there are also significant tradeoffs in the form of high turnover, high tracking risk in your portfolio, for example. So a preferred approach is really what we explore in pillar three, which is focused on implementation: how do you undertake more thoughtful portfolio construction? How do you think about active management helping you solve some of your tradeoffs in getting you to a better place? And we really believe that this implementation piece plays the most significant role in building a climate-aware multi-asset portfolio.

THOMAS MUCHA: Well, what are some of the considerations clients should be thinking about as they implement this framework?

SUPRIYA MENON: This really goes to the heart of the seven-step blueprint I mentioned earlier, and we really recommend that clients take a look at it if you have the chance. I won’t go through all of it, but a couple of considerations I’d like to highlight. The beta piece is important on the climate-aware CMAs, and, as I mentioned, it does change your inflation and growth assumptions, but ultimately it represents a more realistic baseline from which you can take actions to reduce some of the negative drag. Another piece that we explore, and that we recommend that clients do, is to incorporate physical climate risks at the top-down, and also, ideally, at the single-security level. We also take a view that adaptation is complementary to mitigation and offers a rich opportunity set for solutions. So most asset owners are multi-asset allocators, first and foremost, and while they are keen to make sure that portfolios integrate sustainability as a critical way to achieve resilience, they also need to balance that against other risks coming from, say, style factors or sectors. And while there is likely to be some tradeoff between meeting climate targets and achieving diversification, the work that we do suggests that an active, diversified set of approaches are better suited ultimately to the pursuit of those climate objectives, while also allowing for a reduction in portfolio biases. We suggest that clients lean into heterogeneity in their portfolios. The other point I’d make is that sectors are a bit more complicated. When you integrate climate, you do end up with a portfolio that ends up being tilted towards specific sectors. But also traditional sector or industry classifications may not be as useful when framing the climate opportunity set. Also, some sectors thought of as problem sectors, or part of the problem here -- so thinking about materials or utilities -- are also part of the solutions, so that’s another area where we have to be quite thoughtful in constructing the right type of exposure.

THOMAS MUCHA: Well, congrats on getting it to seven steps. Sounds like there should be 17 or 18 steps here. You did mention adaptation and, you know, from my perspective as the geopolitical strategist at Wellington, obviously there is a direct connection here with the national security environment, the geopolitical environment. The policymakers that I speak to, you know, do view climate change through this national security lens. It’s further stressing already an already complex geopolitical environment, particularly in the Equator and tropical regions, where many of the geopolitical hotspots sit. So they view adaptation as the best insurance policy, you know, for warding off many, many national security problems that are coming as a result of climate change, from climate migration, to more resource wars, to food and water scarcity issues, and on and on. So I’m wondering, Supriya: as governments increasingly work to build resilience to physical climate change risks, and, of course, at the same time try to transition to a low-carbon economy, how do you see capital market assumptions evolving over time, particularly in this very challenging geopolitical backdrop?

SUPRIYA MENON: Yeah, so you brought up the geopolitical piece, and this is an important consideration in how we think about our scenarios. So let me just touch on the transition scenarios, and I’ll get to physical risk. Our scenarios are now more disorderly and delayed, so these reflect the impact of policy delays in some countries, a lack of coordination, or certain actions which can make things worse, at least on the affordability front. So I’m thinking, for example -- it’s just one example -- tariffs on Chinese electric vehicles. So, because these increase costs, they can potentially delay the transition by introducing more resistance to it from the point of view of consumers. So governments do act, and are acting on the transition, but those scenarios which you can think of as too little, too late, and too disorderly, end up being more probable. So that is something we consider in terms of the probabilities we place on these scenarios, and how we think about the scenarios individually. The other point I’d make -- and I completely agree that physical risk and building adaptation strategies are really important, especially for emerging markets, and more governments are including it in their sort of policy mix, but the other point I’d like to make is that the slower the transition, the more onerous the adaptation to physical climate change can be, so the relationship between the two isn’t linear but exponential. So once you get a transition that’s incredibly slow and incredibly disorderly. Your adaptation costs also increase significantly, in an exponential fashion. And all of that really feeds back through to the politics of it, and we are in a situation where the direction of travel is a little bit more disorderly.

THOMAS MUCHA: Yeah, I would say the geopolitical conflict and geopolitical competition is a negative in a lot of ways for decarbonization, because these are such strategic industries. You mentioned EVs that governments are trying to protect. There’s also increasing competition for critical minerals that are necessary for decarbonization, and all of this is wrapped up into this great power competition with the US, China, and their allies on each side. And so the geopolitics is running squarely through the adaptation versus mitigation debate, and it’s a tough time to be a policymaker, and to try to balance all of these different variables.

SUPRIYA MENON: Absolutely, it is and from the point of view of an asset allocator, things like commodities are important because they are critical to how you build inflation-resilient portfolios, so we have to get back to this point on how you balance your more traditional portfolio objectives -- for example, wanting to have some inflation sensitivity built into your portfolio to make yourself more resilient from that perspective -- and how that works with also making sure you integrate climate. So really thinking about critical minerals and commodity supply chains, and which commodities you want to be exposed to, and being quite active in terms of the mix of commodities you might have, is one example of approaches that have resonated with some of the clients we speak to, and it goes also to this point of clients wanting to consider how to integrate climate across asset classes. So while the initial work was done within equities, and then to corporate bonds, we’re now speaking to clients more about, well, how does it work across asset classes, things like the carbon intensity of commodities, or how you evaluate climate risk in sovereigns. Do you place different weights on different factors in emerging market sovereigns and developed market sovereigns? So these are questions and points of engagement we have quite frequently.

THOMAS MUCHA: Well, that’s a complex backdrop among asset owners. So among those who are interested in incorporating climate change into their assumptions, I imagine that some are more concerned about financial risks. Others might be more excited about the evolving investment opportunities that are clearly here. So, from your perspective, Supriya, what’s been the overall reception to this research, and what aspects this have clients been most engaged with so far?

SUPRIYA MENON: That’s a great question, and I’d say that the general feedback has been very positive across channels, and the three pieces I referred to, the three pillars, in a way, have been among the most highly read and engaged with among the research that we produce, and we’ve engaged with institutions all the way from very large sovereign wealth funds to pension funds, wealth managers, insurers, among others. And on the one hand, you have these really large institutions who consider themselves sort of universal owners, so they’re focused on the beta side of things, the financial returns, which can be generated over the long term, from within capital markets as a whole. They really think about that beta piece, and the capital market assumptions, and from their perspective, the impacts of climate change permeate quite broadly. But a lot of clients actually went about this in reverse order, so while we started with the top-down, sort of reflecting our general bias, perhaps, and then moved down to the bottom-up, most clients went about this the other way around, so they started with implementation, more of sort of a satellite type of approach, and are now thinking about that top-down asset allocation piece. One piece, in addition, which has really resonated, is a physical risk aspect. You and I talked about it a bit, but it’s really difficult to do because of the paucity of information there, so thinking about security level analysis, for example, and inputs, it’s something we can help clients with, because we built the tools that enable us to do that, but understanding physical risk is a really essential part of building resilience to climate change, so while portfolios can go only so far, in a way, given where capital markets sit currently, you need to have that extra piece of physical risk, whether that’s adaptation or understanding the risk side of it, in order to really take a holistic approach towards resilience in your portfolios.

THOMAS MUCHA: You mentioned insurers, Supriya, and I speak to a lot of our insurance clients, as well. I can attest that they’re definitely ahead of the curve in incorporating climate change into their capital market assumptions, and how they think about the world. So what have you learned from their feedback?

SUPRIYA MENON: So you’re absolutely right, Thomas, in that insurers are certainly among the most affected, so that’s on the liability side, for sure, but also thinking about their assets. And when I speak to my colleague, Tim Antonelli, who is one of the co-authors of the piece, he makes the observation that they are surprisingly still siloed, and that there’s a disconnect between the climate impact on liabilities and on assets. So they need more consistency across functions. So P&Cs, or property and casualty insurers, think a lot about climate, given their underwriting, but there are other areas like health and life insurers, for example, who are further behind, where the liability modeling doesn’t reflect significant changes from climate. So there is sort of a range here. We’d also expect the global demand for regulation on the insurance side to become more friendly to incentivize climate-related investments. So we’ve seen recently Hong Kong implementing reduced capital charges for green bonds, for example. That’s one among many.

THOMAS MUCHA: All right, so what comes next? I mean, how do you plan to hone this research over time?

SUPRIYA MENON: Yeah, the possibilities are endless, but we have to focus. So an important part of how we do this is that we need to revisit our scenarios and assumptions at regular intervals, as this is an evolving field. So we do this as a team on an annual basis. The other issue is that there are a lot of subjects that we haven’t cracked, or we haven’t delved into in as much detail as we would have liked to have, for example, the valuations piece and the horizons piece. So in our capital market assumptions, we explore the impact on earnings, for example, or on credit losses, but not on valuations, so we don’t have the level of conviction that we need to really build in assumptions on how climate change impacts the valuations of specific assets. In terms of horizons, it’s really this question of what is a right horizon. So we use a ten-year horizon for our capital market assumptions, but we know that results can vary over shorter periods, so should you undertake some shorter-term analyses, as well? Stress tests, for instance. We also know that climate change represents a tragedy of the horizons not my words; I believe it’s Marconi’s, but may have been somebody else’s as well. And it’s this question of whether we’re underestimating the long-term cost of inaction. For example, we know there are tipping points in climate science, and how do you think about, as a financial analyst, the right long-term discount rate if the cost of acting late is orders of magnitude higher than that of acting early. So it’s really about what is the right horizon. There’s no easy answer there. And we also want to use that research practically for example, things that we’ve really delved into in pillar three: how do you align meeting portfolio objectives, be they income or total return, with allocating to sustainable investments? So that’s also an area of focus for us.

THOMAS MUCHA: Yeah, the one thing that I’d add to that is, in my own experience, really steering into the science has been an effective tool in coming up with effective strategies. And that science, as you say, is changing all the time, so I think it’s really important to have these close relationships with climate scientists and other experts in the field. But last question: are you reading any good books, that help you see the world more clearly?

SUPRIYA MENON: That’s a good one, and I feel like I’m stretched between a lot of book clubs at the moment, but it’s a good way to spend one’s time. So, in terms of climate specifically, actually, I recently joined our internal book club. It was organized by the Sustainable Investment team. And one book we had to read quite recently was Kim Stanley Robinson’s Ministry of the Future. So, in some senses, it’s an uncomfortably realistic future state of the world, where we sort of reach the brink of the precipice, we sort of fall off it momentarily, but, in a sense, we pull ourselves back. So it touches on everything from heat domes and geo-engineering, and even climate quantitative easing, as potential solutions. So it’s uncomfortably realistic science fiction is how I would put it, but very, very interesting.

THOMAS MUCHA: Speculative fiction is the way that I characterize Kim Stanley Robinson.

SUPRIYA MENON: Did you read it yourself, Thomas?

THOMAS MUCHA: Yes, I would also highly recommend that book. I think he delves into the science properly, but what that book does so well, I think, is incorporates the political and social aspects of climate change, which you don’t always get with the science, so it’s a really nice blend.

SUPRIYA MENON: Agreed. And the other one which I read recently, which is sort of very different -- it’s incredibly pragmatic, and practical, and interesting in a very different way is Hannah Ritchie’s book -- Not the End of the World. It’s sort of a view of where we can have the most impact when it comes to environmental challenges, so a very kind of dispassionate view of it, in a way, busting some myths along the way, offering solutions, practical ways in which we can make a difference. So, those are a couple of books which come to mind, and I’d recommend to listeners.

THOMAS MUCHA: All right, well, let’s end on that relatively positive note. Once again, Supriya Menon, Head of Multi-Asset Strategy EMEA. Thanks for joining me on WellSaid.

SUPRIYA MENON: Thanks for having me. It was fun.

Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced June 2024.

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Supriya Menon
Head of Multi-Asset Strategy – EMEA