By Alex White, Managing Director, Co-Head of ALM at Redington
From a pure investment context, there are broadly two large tail risks associated with climate change. The regulation needed to mitigate it could (and probably needs to) have a material and immediate impact on certain assets. For example, oil and gas company stocks are unlikely to fare well in a very fast transition.
In the opposite direction, there is a lot more uncertainty around physical effects. But oil, as portable fuel, may become more important in a hot-house world, and may become even more crucial to the UK if the AMOC is stopped and we have Canadian winters.
The assets which fare well in one environment are unlikely to be the same as the assets which fare well in the other. Transition risks and physical risks may well pull your portfolio in opposite directions. And this is before we consider how varied the possible physical effects of climate change could be, on both economies and investments.
There is also a fundamental disconnect between global risk and portfolio risk. Climate risk is a much bigger risk to the world than, for example, leverage management policies. But that doesn't make it a bigger risk to a portfolio.
The assets most beneficial to limiting climate change are often illiquid, and therefore more vulnerable to physical (and probably geopolitical) risks. A solar farm in a poorer, hot, low-lying country such as Bangladesh would be great for the planet but could entail significant risk from rising sea levels. A company selling helicopters to billionaires won’t help the planet, but might do well in that environment.
Looked at another way, from a global perspective, one of the best risk mitigants is for there to be massive investment in green assets. From a portfolio perspective, the best risk mitigant is a generally low-risk, liquid portfolio. The risk to a portfolio is not aligned to, or synonymous with, the risk to the planet. And that means decisions driven by either perspective are unlikely to help the other. However, that doesn’t mean climate risk considerations shouldn’t drive portfolio decisions. So, what actions might you take?
Avoidance risks
Perhaps a helpful lens is what actions would you avoid. Climate change means there’s a higher chance of the world looking materially different than it does now, so bets the world will look the same in a decade should need a higher pay-off.
Illiquidity should be better rewarded in a more uncertain environment. And investments in sectors more exposed, either to regulatory or physical risk, should also need higher payoffs.
In general then, if climate tail risks are higher, the assets to avoid would be low-paying, less liquid, long-term bets that any change would not be too large, especially if those bets were in higher emitting sectors. That describes long-dated corporate bonds – the second largest investment for many DB funds (after LDI).
Put another way, anyone investing heavily into corporate bonds is taking a bet, whether consciously or not, that the effects of climate change won’t be so bad that corporates can’t pay their debts – it’s a bet that things won’t be all that bad.
Clearly, there’s tail risk here, and even just shortening the duration could be a useful mitigant. A lot can go wrong in five years, but a lot more can go wrong in ten.
As an alternative, portfolios could be bar-belled, with lower exposure to higher-risk assets. That risk could also be used impactfully, for example by including green transition, renewable energy or natural capital funds – as long as the overall exposure was managed.
This approach could give a more impactful portfolio with lower exposure to climate tail risk (as it would have lower exposure to tail risk generally). It would also have much larger cash holdings, making it easier to respond to changing markets.
There are often good reasons to hold corporate bonds, and it may not be advisable to rip up the whole portfolio, but it may make sense to tilt the portfolio a little more in that direction. If you want to take a little bit of the sting out of the tail, this is one way to start.
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