The purpose of this paper is to provide an overview of climate change investment risks and opportunities for US public pension trustees, and introduce both quantitative and governance frameworks that trustees can use to approach climate change as an investment risk (as opposed to a nebulous uncertainty) and inform related tangible actions.
Assessing Climate Change Risk for US Public Pensions
Although climate change is a significant environmental, social and economic risk that is expected to have its greatest impact on the physical environment in the long term, we must change our behaviors now to address it and avoid dangerous temperature increases.
The rapidly evolving political, regulatory and economic landscape elevates the importance of climate change as a potentially material investment risk. To help investors quantify this risk, Mercer recently led a collaborative research project with 16 institutional investors, the key findings of which were:
- Climate change — and related human actions to curb it — will give rise to investment winners and losers.
- Sector impacts will be the most meaningful.
- Regional equity return impacts will be material, but vary by climate change scenario.
- A 2°C scenario need not harm overall returns out to 2050.
For this paper, we ran an illustrative US public pension portfolio through our proprietary, forward-looking climate change investment risk modeling framework (the “TRIP framework”) to produce a set of quantitative results. This illustrates what the financial impacts may be on a portfolio, and can inform related risk management decisions under potential future climate scenarios.
Overall we find the typical US public pension portfolio would experience a 33-basis-point (bps) average annual shortfall over 10 years under a Transformation scenario, which is aligned with a 2°C temperature outcome, the baseline goal of the Paris Agreement. This equates to a 3% cumulative loss, which on a $1 billion portfolio equals nearly $60 million of foregone returns. Though the return difference between the Transformation and base case scenarios narrows to 19 bps across a 35-year period, the cumulative impact doubles to nearly 6%, which on the same $1 billion invested today would equate to nearly $740 million in foregone returns.
Portfolio Impacts: Transformation (Average Annual Return Impact Over 10 Years)
Notably, this portfolio contains both winners and losers at the asset-class level under a Transformation (2°C) scenario. Real assets and emerging market equity/debt post substantial gains, whereas all other classes are neutrally or negatively affected. The negative effect is most pronounced in the portfolio’s 46% exposure to US and developed market equities.
Based on these findings and others highlighted in this paper, climate change is a potentially material investment risk that presents public plan fiduciaries with a distinct risk management challenge. This paper further describes a set of concrete governance processes, risk assessment methods and risk management decisions that public pension boards can use to address climate change as an investment risk.
Based on the sample climate-change asset-allocation analysis highlighted, the average US public pension portfolio is most vulnerable to a 2°C Transformation scenario — meaning the average portfolio is meaningfully exposed to risks associated with the transition to a low-carbon economy precipitated by policy action and/or technological advancement. The trustees of US public pensions should review these risks to determine if they are tolerable and, if not, what actions to take to minimize them.
This paper is a companion piece to the Center for International Environmental Law’s concurrently released report Trillion Dollar Transformation: Fiduciary Duty, Divestment, and Fossil Fuels in an Era of Climate Risk.