Understand the risks and opportunities for investors as climate change drives the need for a transition towards a zero-emission economy.
Climate change is driving the need to transition to a zero-emission economy,1 and investor and corporate awareness is increasing rapidly. Investors want to understand the downside risks they face as a result of the transition — as well as any opportunities they have to allocate to companies generating sustainable and green revenues. In particular, many companies and investors want to align with the targets of the 2015 Paris Agreement, including ensuring temperatures do not increase past the 1.5°C threshold.
To align with this goal, investors need to develop a climate transition plan: a plan that defines clear targets and trajectories; a plan that encompasses the entire portfolio since climate transition will impact entire economies; a plan that lays out actions for the next 10 years and beyond — but, critically, identifies what can and needs to be done today.
Mercer’s new climate transition analytics and advice are now being offered to its consulting clients worldwide. These services will help support climate transition strategies across its US$304.5 billion in global assets under management2 on behalf of Mercer’s Investment Solutions clients.
Supporting climate transition strategies requires top-down scenario analysis, forward-looking portfolio analytics and bottom-up assessment of holdings. These assessments are crucial to help investors identify the “grey” assets — those that generate high emissions and have limited capacity for transition; the “green” companies — those with low emissions, including the solutions to the net-zero transition; and everything in-between, where the capacity for transition in the future needs to be understood. Mercer’s Analytics for Climate Transition (ACT) helps investors use this analysis to identify not just the losers of today but the winners of tomorrow, enabling them to engage with their managers and capitalize on the transition ahead.
We’ve already had a 1°C increase in average global temperatures on preindustrial averages. According to current science, in as few as 30 years, we could soon be facing a 2°C increase — a climate humans have never experienced and one that hasn’t occurred on earth for millions of years. This is described by the Central Banks and Supervisors Network for Greening the Financial System (NGFS) as society living in a “hothouse world.”3 This crisis puts the need to address transition squarely on today’s to-do-list alongside a 1.5°C global climate ambition and supporting the UN’s “decade of delivery.”
A growing cohort of governments, companies and investors is now actively focused on the net-zero transition and the emissions reductions required. Given different climate scenarios using target dates of 2030 and beyond, there is no single approach to achieving net-zero emissions. Within the finance industry, backed by global initiatives such as the “United Nations Environment Programme Finance Initiative,” investor support is gathering momentum4 in the ”Race to Zero.”
Technology changes supporting net-zero requirements are also in evidence. The energy and utilities sectors that literally fuel our economy are now experiencing real disruption. In 2019, for the fifth year in a row, renewable capacity additions outstripped additions from fossil fuels and nuclear combined. For example, NextEra Energy now has a larger market capitalization than ExxonMobil.
Figure 1. Renewables leader eclipses largest oil major — market capitalization
A transition action plan is a natural next step for investors that have undertaken climate scenario analysis. Mercer’s decade-long investment experience with climate change scenario analysis and modeling, along with its collaboration with climate-change leaders globally — clients we call “Future Makers” — is documented in Investing in a Time of Climate Change — The Sequel (“the Sequel”) and Investing in a Time of Climate Change (2015). These and other industry studies show that it’s in investors’ best interests to transition from our current 3°C temperature increase trajectory, ideally to a 1.5°C scenario. It’s also possible to respond to the urgency and find opportunities that will benefit investors.
Mercer, among others, has undertaken extensive portfolio modeling and identified the potential to capture a “low-carbon transition premium.” Scenario analysis is the foundation of the transition plan because we are asking what companies will need to do now to face the future.
Addressing climate change means we need data and analytics translated by practitioners to help institutional investors identify key risks and work to eliminate them. The data we have access to today, though far from perfect, indicates that investors can support the transition to a 1.5°C scenario and still meet investment objectives.5
Although a 1.5°C scenario presents transition risk (especially for portfolios aligned to a 3°C or 4°C+ world), the data suggests investors can target investment in the many mitigation and adaptation solutions required for an orderly transition. Although there is an active debate about timing, methodology and portfolio implications for institutional investors, one starting point is generally agreed — understanding where emissions are generated now and what capacity companies have to transition and keep ahead of industry changes.
A transition plan takes investors through a process that includes:
Mercer believes strategic transition planning should also recognize short-term flexibility, where needed, to address investment considerations such as market pricing and market timing.
Mercer’s advice and analytics enable investors to assess and rank emissions intensity, transition capacity and green revenues in the portfolio. Central to this assessment is portfolio-wide consideration of the transition capacity to align to a 1.5°C global warming target. It’s best to combine a top-down, total-portfolio view with forward-looking bottom up portfolio analytics such as sector and company exposures. This allows investors to identify next steps and where investments could be allocated in the future so they can engage with managers.
Mercer’s ACT assessment draw on multiple data providers and metrics to assess portfolios across a spectrum from gray to green investments. Because many companies lie in the middle, their capacity for transition in the future needs to be fully assessed and ranked by investors.
The Mercer analysis is designed to provide investors with a portfolio wide view of the emissions reduction needed to meet a net zero target and to plan the changes required to the portfolio in order to transition. The analysis includes geographic, sector, manager and selected stock drivers. The results are intended to be guide investors to assess where emissions reductions could come from, compare different strategies, engage with asset managers and plan for and make portfolio changes to reduce emissions. The goal is to reduce the greys in a portfolio where there is high stranded asset risk, and grow the green solutions and steward the assets that are ‘in-between’.
The purpose of such work is to help investors engage with their managers on how best to position their portfolios for the low-carbon transition. Mercer works with investors to set annual emissions reduction targets aimed at key milestones aligned with IPCC guidelines and based on what’s possible for their portfolios — keeping in mind that some asset classes will take longer to transition than others.
Figure 2. Mercer’s Transition Framework
Transition planning and execution leads to identifying transformational investments — the pursuit of an attractive risk-adjusted return while addressing one or more long-term, global systemic risks — as described in the Mercer and World Economic Forum report.6
It’s up to all of us — investors, companies, governments, individuals — to decide if we achieve a 2050 (or earlier) net-zero target. Now is the time to transition the portfolio and execute on the plan. The data, tools and processes will no doubt evolve. It will take more than simply dividing the portfolio into the grey, the green and the in-between. Rather, investors need to assess the full spectrum of their portfolios and hold those that invest their assets to account when assessing portfolio companies. We believe we now have the tools and adequate, if not perfect, data and analytics to make useful decisions. Above all, there is a compelling reason to transition: the damage ahead if we don’t reduce emissions and stay on course for the net-zero target.
1 See the United Nations Framework Convention on Climate Change (2015) Paris Agreement. In October 2018, the Intergovernmental Panel on Climate Change (IPCC) released a report on 1.5°C and the difference between that and 2°C to illustrate the additional impact that 0.5°C is expected to have and why the Paris Agreement ambition for “well below” 2°C is warranted.
2 As of 30 November, 2019: Please see Important Notices for information about Assets under Management.
3 NGSF Climate Scenarios, available at https://www.ngfs.net/en/publications/ngfs-climate-scenarios.
4 United Nations-Convened Net-Zero Asset Owner Alliance, available at https://www.unepfi.org/net-zero-alliance/.
5 Bril H, Kell G and Rasche A (Eds.). Sustainable Investment: A Path to a New Horizon, Routledge, 2020, p. 50.
6 Mercer and World Economic Forum. Transformational Investment: Converting Global Systemic Risks Into Sustainable Returns, 2020, available at https://www.weforum.org/whitepapers/transformational-investment-converting-global-systemic-risks-into-sustainable-returns.