For long-term investors like GIC, climate change is a key concern given its imminent impact on the value of physical assets and companies over time. Hence factoring this into both our top-down and bottom-up processes is vital to ensuring a resilient portfolio.
At the top-down level, GIC partnered with Ortec Finance and their strategic partner Cambridge Econometrics to quantify how long-term capital market assumptions are affected by climate change drivers by stress testing the portfolio against different climate change scenarios. This highlights areas where there are heightened risks, and focuses our efforts on deeper analysis and mitigating strategies to make our portfolio more climate resilient.
In this report, the main climate change related risks outlined are:
- Timing of climate policies (late, delayed or none)
- Extent of physical risks (based on a best-case 1.5⁰C scenario under Paris Orderly Transition, or a worst-case close to 4⁰C scenario under Failed Transition)
- How markets price in future climate change risks (smoothly over time or disruptively with a sentiment shock)
The three scenarios used are:
- Paris Orderly Transition
- Delayed Disorderly Transition
- Failed Transition
Our analysis shows that these climate change-related risks have a negative long-term impact on global GDP and inflation, due mainly to physical risks (for example, impacts arising from extreme weather events or rising temperatures on assets and businesses). In contrast, transition risk impacts (for example, arising from policy shifts or disruptive technologies such as renewable energy, green hydrogen, electric vehicles) are net positive as policy responses such as the carbon taxes collected are used to reduce income taxes and increase subsidies for clean energy, resulting in a net fiscal stimulus, while low carbon investments boost aggregate demand. However, growth impacts vary across countries and sectors, and also across different scenarios.
Risk assets like equities and real estate are more sensitive to climate change compared to bonds and cash, though equity markets with very low exposures to low carbon electric utilities (e.g. emerging markets) have more potential to outperform in the transition scenarios due to larger room for the sector to grow.
Based on a hypothetical global 60% equities/40% bonds portfolio, projected returns may still be positive in the long run with climate change, but they are meaningfully lower in our three risk scenarios versus a baseline that assumes no further climate related impacts beyond what has already occurred. Long-term investors may be surprised by the underperformance of the portfolio relative to their expectations, and should be prepared to navigate the potential increase in market volatility as a result of climate-related shocks.
Hence, while climate change scenario analysis requires various assumptions and results in a wide dispersion of outcomes, it is still good discipline for investors to be prepared and undertake such an exercise.
Given GIC’s long-term mandate, it is essential to prepare our portfolio for such risks. Climate change scenario analysis plays a central role in this via top-down strategic asset allocation, stress-testing and risk management, and the bottom-up integration of scenario inputs and outputs into our active investment processes.