Asset owners are starting to put a price on climate risks.
The Los Angeles County Employees Retirement Association commissioned investment consultant Meketa to produce scenario analyses for its portfolio. LACERA’s portfolio – currently valued at $74.6 billion – is projected to experience a possible 15 percent net asset value drawdown from the impact of climate-related risks in a below 2C global warming scenario. That is an “ideal world” scenario – the global warming cap that most government signatories to the UN’s Framework Convention on Climate Change are working towards.
Scenario analyses assess the impact of different climate scenarios on the value of its assets and the expected returns of an entity’s investment strategies.
Other institutional investors have also started conducted scenario analyses for their investments. CPP Investments reported “a potential negative impact to the fund’s market value by up to 13 percent in a given year during the next 30 years” in its sustainability report released earlier this Autumn. CalPERS is working on implementing scenario analyses for some parts of its portfolio to support asset liability and risk evaluations, according to an internal memo seen by New Private Markets earlier this month. CDPQ’s real estate business Ivanhoé Cambridge calculates a second IRR counting in carbon prices.
Meketa presented the results of its scenario analyses on LACERA’s portfolio at an investment board meeting earlier this month. The board meeting where these findings were presented is available to rewatch online.
“The point of this presentation is that climate and other scenarios potentially have material economic consequences for the fund – risks and opportunities,” said LACERA chief investment officer Jonathan Grabel. “We’re doing this all in the context of potential value creation and prevention of value destruction of the fund. We’re widening the lens of factors that we evaluate in order to provide the best portfolios for our members.”
Total-portfolio value takes a hit
The 15 percent value drawdown applies to current companies in LACERA’s portfolio, LACERA investment officer Dale Johnson said, if the retirement system maintains its current holdings amid a scenario where global temperatures remain below a 2C increase against pre-industrial levels up to 2050.
The majority of this value drawdown – 11.1 percent – would be due to physical risks, as more frequent and extreme weather events, higher sea levels and degradation of land and natural resources devalue assets. Of the value drawdown, 4.4 percent would relate to transition risks: the consequences of policy and regulatory interventions, which can drive up the operating costs or prohibit certain business activities. Some companies will benefit from transition-related technological innovations, creating a projected value increase of 0.5 percent.
Meketa’s modelling method
In a separate set of analyses, Meketa projected the impact of four more specific climate scenarios on average returns for asset classes.
Meketa developed a network model to map out the relationships between “350 different macroeconomic market climate variables into account” such as oil prices, household energy expenditures, interest rates, inflation risk premiums, Zach Stevens, a senior quantitative analyst at Meketa, told the board. Stevens’ team then applied this model to “104 different asset classes that we model”. “We were able to then project out 10,000 simulations” of different scenarios 30 years in the future. “Each one of these simulations is a way the world could look,” said Stevens.
Stevens’ team selected four scenarios against which to test LACERA’s portfolio: physical risk scenarios, in which global warming is on 1.5C and 3C trajectories, a transition risk scenario, in which a $100 per ton carbon tax is imposed by policy, and a “technology opportunities” scenario, where carbon emissions of electricity production are brought down by 3 percent per year.
Lower returns projections
A 1.5C scenario would lower average returns across all asset classes except investment grade bonds. Over a 20-year annualised return projection, core private real estate and natural resources assets would be hit the hardest: core private real estate returns falling from 6.5 percent to 5.77 percent; natural resources returns falling from 10.27 percent to 9.81 percent. Private equity would fall from 11 percent to 10.43 percent; publicly traded infrastructure would fall from 8.8 percent to 8.46 percent.
The 1.5C scenario is “going to require some pretty aggressive interventions” from policymakers, said Stevens; 2023 is believed to be between 1.2C and 1.5C hotter than pre-industrial temperatures. The majority of the negative impact on average returns, therefore, would stem from transition risks rather than physical risks, said Stevens.
A 3C scenario would negatively impact rates of return from private equity, core private real estate and natural resources in the next 20 years more than other asset classes. Private equity would from 11 percent to 10.67 percent; core private real estate from 6.5 percent to 6.14 percent, and natural resources from 10.27 percent to 9.86 percent.
“This level of temperature rise is more consistent with relatively moderate climate change mitigation efforts, and is far more consistent with the status quo of the trajectory we are on today,” said Stevens. “There is a movement away from transition risk in the portfolio and these specific asset classes; you’re starting to be impacted much more by potential physical risks. We think of that in terms of wildfires and major flooding and how that might decimate real estate and forests. But it can be a lot more nuanced, as you can see how a company is writing down the value of certain [businesses] a lot more.”
The impacts of a 3C scenario will be more severe beyond 2043, said Stevens: “While in the next 20 years, there’s certainly a chance that physical risks become more significant, the likelihood is that by 2100, it’s going to become far more of an issue.”
Pessimism from the board
Board members’ reaction to the presentation was sombre. “I’m very pessimistic,” said board secretary Joseph Kelly. He described discussing climate change with younger family members: “They make statements to me like, ‘I would really have to consider having children’. That’s really significant. There’s a sombre mood [among them] towards the future, specifically related to climate change… The fact is the world is on fire. I think our individual and collective heads are in the sand. I don’t have a positive view of where we are or where we’re going.”
Trustee Jason Green asked about the economic impact of climate-induced migration and limited natural resources. “What happens when there’s no clean water? It does have relevance for the sustainability of our fund.”