Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Global pensions sketchy on net zero
The report, carried out by CREATE-Research and backed by DWS Group, was based on a telephone survey of 50 large pension plans based in North America, Europe and Australasia, collectively managing €3.3 (A$4.9) trillion of assets.
Some 60 per cent of respondents believe the goal of net zero by 2050 is unlikely to be met; 6 per cent of respondents believe it is “very likely” that the target will be met, while 24 per cent responded “somewhat likely.”
That doesn’t mean the COP26 pledges are useless, the report says – simply that they are “the start, not the end, of efforts to get the world on track for net zero.” But a key obstacle is that capital markets are not currently pricing in climate risk “on a scale necessary to redirect capital towards the net zero goal”, leaving pension funds exposed to a number of financial and reputational risks.
“If markets do not price in climate risks on a significant scale while our respondents are making allocations in line with their policy benchmarks, they may come under pressure from their sponsors to change their climate approach – especially if the stocks of oil companies continue to rebound massively, after tanking in 2020,” the report says.
“At a time when many pension plans continue to have funding deficits, they may well be forced to shift their climate strategy down a gear when faced with three sets of challenges: financial, reputational and societal.”
Compounding that are two other factors; many companies are pledging to hit their net zero targets sometime in the distant future without committing to concrete, monitorable action to which they can be held accountable; and left to themselves, capital markets cannot solely “rewire the global economy and society”, as they are constrained by market failure and inefficiency.
“The real problem here is that climate change is a slow-burn issue with indiscernible impacts on a year-to-year basis but with the potential for exponential growth once tipping points are reached,” the report says. “Cognitive psychology shows that humans have difficulty responding to nonlinear relationships. Most markets simply ignore mounting risks until suddenly they are forced into an abrupt repricing as irreversible effects kick in.”
“The role of governments is critical in tackling these two formidable handicaps. A recent survey of global chief executives found that only 18 per cent believe governments have given them the clarity they need to set goals in line with a 1.5°C warming trajectory, according to the UN Global Compact and Accenture study Climate Leadership at the Eleventh Hour.”
To fix that, respondents believe four sets of actions are required. Financial mechanisms for curbing carbon emissions and promoting alternative energy need to be implemented across national economies; financial regulators need to ensure that key players have future-proofed their portfolios for the systemic risks of global warming; a green taxonomy needs to be created to provide consistent definitions and reliable data on corporate climate footprints; and governments need to ensure a “just transition.”
Some 62 per cent of respondents also believe that bubbles might form in climate-related assets due to continuing investor flows, a paradigm that “could end in tears” Ã la the dot.com bubble, and 58 per cent of respondents were concerned about the resulting mis-selling scandal.
“As John Maynard Keynes famously remarked: “Markets can remain irrational longer than you can remain solvent.” Investors too far in front of discounting climate change might find they miss out on years of strong returns before any repricing occurs,” the report says.
