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Systemic climate risk is ‘undiversifiable, largely unhedgeable’ – and emerging right now
One of the biggest risks facing institutional owners today is climate change, with 72 per cent of respondents to the Thinking Ahead Institute’s global asset owner peer study report citing it as one area from which systemic risk might emerge.
But most carbon budgets – which measure how much carbon dioxide is produced by economic sectors to calculate how much those emissions must be cut in the future – are based on a smooth transition to net zero. Those carbon budgets are uncertain, and likely skew lower than what’s embedded in mainstream scenarios, which means the transition will have to be “more transformational, and more disruptive” in order to keep temperatures lower.
“Transition and physical risks are likely to coincide,” Jeffrey Chee, WTW global head of portfolio strategy, told an event in Sydney last week. “The conventional wisdom is that the more transition you do the less physical risk you incur and so they’re assumed to be negatively related. In practice, we expect transition and physical risks to both be material, and investors need to think about them together rather than assuming they’re negatively correlated.”
Beyond a certain level of future temperature increase, we arrive at “significant economic damages” from physical climate risk, which causes system-wide asset losses. And the reality that carbon budgets might actually be zero – or close to it – combined with climate tipping points, means that a wide range of portfolios are exposed to systemic climate risk.
“(There’s) a need to incorporate systemic risk into investment thinking to a greater degree than has been the case in the past… Systemic risks are pervasive, impacting all things in all places, meaning they’re likely undiversifiable, largely unhedgeable, and conventional risk management and asset allocation techniques are difficult to apply,” Chee said.
“They tend to emerge as the result of an accumulation of pressures in the background and manifest through trigger events, like crossing a climate tipping point, and when they do occur the distribution of outcomes tends to be negatively skewed with limited upside and potentially very significant downside.”
Limited upside, significant downside and the difficulty of using traditional asset allocation approaches means the best approach – though perhaps not the most feasible one – is to take action to reduce the likelihood of those bad systemic scenarios occurring.
“But a more advanced way to think about it is, if you think about systemic risks occurring because of the accumulation of pressures in the background, (you can) develop dashboard indicators of – in real time – what is occurring in the background,” Chee said. “Where are those pressures evolving, and what is the likelihood of these scenarios changing over time as these indicators evolve? That gives you an opportunity to think about strategic adaptation of portfolios in response to those changing probabilities.”
But this idea of “system wide change” demonstrates the need to resolve the climate issue in much broader terms than just mitigation. We’ll also need to address biodiversity losses – generally accepted as a systemic risk – societal issues and inequality, and ensure the transition to a circular economy.
“Some level of future warming is already baked in because of historical emissions,” Chee said.
“We will need to do some adaptation from here even if we do manage to keep temperatures to well below two degrees Celsius. The world is a complex, adaptive system; all of these transitions are inter-connected, and we need to recognise that as well.”
“Adaptation can reduce societal vulnerability and mitigate or, in fact, reverse ecological damage. Transition to a circular economy could result in a more inclusive society and also reduce extractive pressure on ecological systems. And it’s generally accepted that improving biodiversity outcomes has just natural benefits to society in general.”
