[Editor's note: This article originally appeared at SocialFunds.com and is reprinted with permission.]
Asserting that "investors cannot simply rely on a best guess as to how the future will unfold when planning their investments," Mercer has published a report that states, "Institutional investors must develop new tools to more effectively model systemic risks such as climate change."
Warning that the quantitative analysis of traditional asset allocation fails to account for the potential impacts of climate change, the report, entitled "Climate Change Scenarios -- Implications for Strategic Asset Allocation," states, "Historic precedent is not an effective indicator of future performance." According to the report, the economic cost of climate policy could lead to as much as a 10 percent increase in portfolio risk in the next 20 years.
The report points out that at present, the short-term horizon of most equity and bond investments prevents investors from factoring in the long-term risks and opportunities relating to climate change. Furthermore, allocating assets to more conservative investment products is unlikely to be helpful, and may in fact reduce returns on investment.
Instead, the report continued, investors should assess qualitative inputs such as investment opportunities in low carbon technologies, the effect on investment of changes to the physical environment, and the effect of policy on the cost of carbon.
"Climate-related policy changes could increase the cost of carbon emissions by as much as $8 trillion over the coming 20 years," Danyelle Guyatt, head of global research for the Responsible Investment team at Mercer, said. "The longer the delay, and the poorer the coordination in implementing the changes, the more uncertainty there will be for investors. The cost of impacts to the physical environment could exceed $4 trillion."
"Our findings had three broad objectives," Guyatt continued. "First and foremost, we wanted to investigate and analyze in detail the potential investment risks resulting from climate change. We also wanted to look at the key performance drivers for many of the leading markets and regions around the world that our clients are invested in. And third, we wanted to identify the scenarios around climate change that will help us better understand and frame climate change as a strategic investment priority."
By "increasing investment in mitigation and adaptation efforts globally," the report finds, institutional investors can both serve the financial interests of beneficiaries and help address climate change. A typical portfolio seeking a 7 percent return on investment, for instance, "could manage the risk of climate change by ensuring around 40 percent of assets are held in climate sensitive assets," according to the report.
While climate-sensitive assets may, in some cases, be more risky as standalone investments, the report continues, portfolio risk can actually be reduced by investment in assets directed toward mitigation and adaptation.