Pension schemes: managing the impact of climate risk on investment portfolios

Financial institutions are under increasing regulatory pressure to embed climate risk into their general risk management processes. This is an important development for institutional investors, such as defined benefit pension schemes and their asset managers, and it seems certain that climate risk will eventually be priced into assets.

Trustees of pension schemes need to understand and manage the impact of climate risk on their investment portfolios.

With climate risk set to become a financial consideration in the investment and risk management process, this article introduces several concepts which underpin climate risk models.

Pension schemes: climate risk and investment duties

Environmental, social and governance (ESG) factors, especially climate risk, alongside the exercise of fiduciary investment duties, continue to attract considerable attention. For now, the legal view is largely settled: in short, trustees of defined benefit pension schemes should consider ESG as a financial factor when making investment decisions.

This is still largely seen as a question of whether trustees should invest, for example, in solar farms and disinvest from fossil fuels.

The public debate about climate risk and pension scheme investments has morphed into an argument about social impact investment. As a result, important developments in other parts of the financial sector, with potentially significant consequences for pension schemes, have not received the necessary attention.

Financial markets: understanding and managing climate risk

Prudential regulators have started asking banks to think about the impact of climate risk on their balance sheets. The UK Prudential Regulation Authority, the Central Bank of the United Arab Emirates and the Bank of Canada have made it clear that financial institutions must undergo stress-testing for climate risk and for the results to be made public.

Firms will be required to adopt a proactive approach to managing climate-related financial risks. Potential consequences cannot be underestimated. Once climate risk is embedded in risk management processes and regulatory capital calculations, it will impact lending costs and asset values.

Such regulations promote advances in the understanding and modelling of climate risk, which is important for trustees and shifts the debate from "solar good, coal bad" to a more granular and quantitative assessment of existing portfolios.

Building a climate risk model: conceptual challenges

The business impact of transitioning to a carbon-neutral economy, known as transition risk, is a critical component in assessing climate risk.

Modelling for transition and physical risk is a complex conceptual and quantitative exercise.

This article only focuses on conceptual matters to illustrate the challenges without diving into numerical models. Interdependent variables must be considered when building a holistic understanding and running effective stress tests.

These include:

• Identifying stress transmission channels: This is critical. Firms are exposed to numerous transitional climate-related financial stresses. Transmission channels include carbon prices lowering EBITDA, loss of market share due to changing client preferences, investments in green technology absent corresponding revenues and regulatory changes causing stranded assets.

• Projecting action pathway sources: These could include local and international regulatory reforms and climate-related economic trends. For example, global banks could stop funding coal-fired power plants, restricting access to liquidity for affected companies.

• Corporate emission-reduction initiatives.

While companies can run stress tests reflecting status quo emission-reduction efforts, doing so would be impractical. It is fair to assume that firms will undertake numerous steps to lower emissions, each with its own financial implications.

Several avenues are available. For example:

• A company can borrow more funds to advance carbon footprint reduction initiatives. This can increase leverage and raise the probability of default.

• Acquiring a company specialising in green practices can lower the carbon-to-revenue ratio. This often involves more borrowing, which means more leverage and a deteriorating probability of default.

• A company that restructures to improve its environmental credentials, such as selling high-emission supply chain businesses, may still need the output of those businesses but will have less control.

• Regulatory change could force companies to offset their emissions by purchasing credits, which can increase costs and reduce profitability.

Like all other stress tests, the impact of climate risk will need to be assessed under different scenarios, which typically reflect different action pathways for transitioning to carbon neutrality.

The ultimate objective of these stress tests is to quantify the impact of transition risks on the balance sheet and in asset portfolios. Done at scale and throughout the financial market, this will drive asset returns and prices. Financial firms, institutional investors and asset managers need to understand this and make it part of their strategies.

This article was first published on Thomson Reuters Regulatory Intelligence.