skip to primary navigationskip to content
 

Unhedgeable risk: How climate change sentiment impacts investment

Unhedgeable risk: How climate change sentiment impacts investment

Dr Jake Reynolds, Director, Sustainable Economy

12 November 2015


In an article for ESG Magazine, Dr Jake Reynolds explains why financial markets are not immune to the impacts of climate change in the short term.

Climate change poses a grave threat to humanity in the 21st century, with significant implications for the investment industry. The risk is generally assumed to be long term, but new research from the University of Cambridge Institute for Sustainability Leadership (CISL) and the investor platform it convenes, the Investment Leaders Group, shows that financial markets may not be immune in the short-term.

The report Unhedgeable Risk: How climate change sentiment impacts investment reveals that short-term shifts in market sentiment induced by awareness of future climate risks could lead to economic shocks and losses of up to 45 per cent in a typical equity investment portfolio. Around half (53 per cent) of this decline would be ‘hedgeable’ if investments are reallocated effectively, with the other half (47 per cent) ‘unhedgeable’, meaning that investors and asset owners would be exposed without system-wide action to address the underlying drivers of risk.

Though asset prices are not only made up of fundamental analysis, until now no studies have quantified how changes in investor sentiment on climate change could impact financial markets in the short term.

The Investment Leaders Group brings together 11 large asset owners and fund managers with the mission to help shift the investment chain towards responsible, long-term value creation. It commissioned this research to explore how shifts in market sentiment, driven by changes in investor concerns about the future effects of climate change, could impact the value of equity and fixed income portfolios over the next three to five years.

The study sheds light on the exposure of different asset classes, regions and sectors and, ultimately, investment portfolios, to shifts in climate change-related sentiment, which can be triggered by new technologies, extreme weather events, and policy commitments such as may emerge from the upcoming climate negotiations in Paris. The study, undertaken by the University of Cambridge’s Centre for Risk Studies (CRS), Centre for Climate Change Mitigation Research (4CMR) and the Judge Business School, modelled the impact of three plausible sentiment scenarios on four different types of investment portfolios:

Sentiment scenarios

Portfolio structures

  1. Two Degrees: limiting average temperature increase to two degrees Celsius as recommended by the United Nation's Intergovernmental Panel on Climate Change (IPCC) [five per cent probability]
  2. Baseline: where past trends continue (i.e. business-as-usual) with no significant change in the willingness of governments to step up actions on climate change
  3. No Mitigation: oriented towards economic growth without any special consideration of climate challenges [five per cent probability]
  1. High Fixed Income: mostly fixed income, mimicking the strategies of insurance companies
  2. Conservative: 60 per cent fixed income, 40 per cent equity; mimicking certain pension funds
  3. Balanced: 50 per cent fixed income, 50 per cent equity; mimicking certain pension funds
  4. Aggressive: 35 per cent fixed income, 60 per cent equity, five per cent commodities; mimicking certain pension funds

The study suggests that the investment industry should begin to see climate change as a risk factor in the short term, as well as the better studied risks from physical impacts arising from changing temperatures in the medium to long term. It shows that short-term shifts in market sentiment created by growing awareness of future climate risks could lead to a loss of value of up to 45 per cent across an aggressive equity investment portfolio. At 23 per cent, the losses in a typical fixed income portfolio may be lower, but still considerable.

Unhedgeable Risk
Table: Summary of portfolio performance measured by the five per cent value at risk. Source: Unhedgeable Risk: Stress testing sentiment in a changing climate (CISL, 2015)

 

With more than half of potential losses ‘unhedgeable’, the study points to a market failure requiring system-based action to secure the long-term interests of investment funds and their beneficiaries such as pension holders. As the Governor of the Bank of England and Chairman of the Financial Stability Board Mark Carney recognised in his recent speech at Lloyd’s of London, Breaking the Tragedy of the Horizon – climate change and financial stability, while carbon-related policy is for governments to decide, financial policymakers have an interest, if not a responsibility, to ensure that the financial system is resilient to any transition hastened by those decisions. Whether the world adopts a ‘Two Degree’ or ‘No Mitigation’ scenario there will be implications for investors, spearheaded by sentiment shifts in financial markets. As world leaders converge in Paris for the UN’s latest round of climate negotiations, this finding is timely.

At the macroeconomic level, the study shows that shifts in market sentiment cause global economic growth to reduce in both scenarios over a 5–10 year period as a result of economic adjustment. In the longer term, however, the study shows that economic growth picks up most quickly along a low carbon pathway (Two Degrees), with annual growth rates of 3.5 per cent versus 2.9 per cent for the No Mitigation scenario.

The report calls for collaborative action from business, government and finance institutions to work together to ensure the economy moves on to a low carbon pathway. Asset owners and fund managers can play a leadership role in this respect and, in doing so, secure the interests of their savers and wider beneficiaries. Many have started managing the carbon intensity of their portfolios and others actively invest in technologies offering strong financial returns while enabling the transition to a low carbon pathway.

In the aftermath of the 2008 financial crisis, the concept of stress testing gained strength in the banking sector and this study shows that the same is also possible, and valuable, for the investment industry. Stress testing investment portfolios against a broad range of sustainability risks can provide insights into potential short-term losses and gains. Further research of an interdisciplinary nature is necessary to formulate the scenarios and their effects on the financial system with greater precision, but these early results are already clear.

Investors can act to reduce their exposure to short-term climate sentiment risks, but not eliminate them. System-wide action is required to protect savers’ long-term financial interests against the systematic components of climate risk. Most importantly, the study shows that investors should concern themselves with the immediate risks posed to their portfolios by sentiment shifts, and not only the fundamentals of climate change itself in the long term.

 


Dr Jake Reynolds is Director of Sustainable Economy at the University of Cambridge Institute for Sustainability Leadership, with oversight of the Investment Leaders Group.

This article will appear in the December 2015 issue of ESG Magazine.

About the author

Dr Jake Reynolds

Dr Jake Reynolds leads our efforts with business, government and finance leaders to build a sustainable economy. Architect of the Rewiring the Economy vision, he is responsible for CISL’s business platforms enabling leaders to find system-level solutions to sustainability problems, and put them into practice with partners and peers.

Share this

Disclaimer

Articles on the blog written by employees of the University of Cambridge Institute for Sustainability Leadership (CISL) do not necessarily represent the views of, or endorsement by, the Institute or the wider University of Cambridge.