Adapting our capital market assumptions to the realities of climate risk

As the momentum behind decarbonisation and net-zero objectives builds around the world, asset owners are increasingly engaged in addressing the investment implications of climate change. The focus thus far has largely been on implementation at the security- and manager-selection levels, but there is a growing recognition of the need to factor climate change into broader investment policy and asset allocation decisions. To help with this process, our Investment Strategy Team, in partnership with our Climate and ESG teams, recently completed a comprehensive effort to integrate climate risks into our capital market assumptions (CMAs).

Finding a way to measure transition and physical risk

Our CMA process follows a classic building-block approach in which the components of total return — income, growth and valuation — are forecast independently. At the heart of the approach is an assumption that macro variables (e.g., GDP, inflation) and fundamental variables (e.g., EPS growth, credit losses) each have a bearing on total return.

With this as our starting point, we needed a framework for thinking about the climate inputs that should be incorporated into the CMA process. We chose to focus on two areas of climate risk:

1. Transition risk includes risks arising from the decarbonisation of the economy, such as the impact of policy/regulatory changes (carbon pricing, subsidies, etc.), technological disruption (the move to renewables, electric vehicles, etc.) and societal pressure and behaviour.
2. Physical risk concerns changes to the physical environment brought on by climate change, including chronic risks (long-term shifts in climate patterns, temperatures, sea level, etc.) and acute risks (risks that are event-driven and increasing in severity, such as floods, hurricanes and wildfires).

Given the complexities and variations in the categories of climate risk, we employed two distinct approaches to estimate their impact on macro variables. For transition risk and chronic physical risk, we followed a scenario-based approach that draws on policy scenarios designed by the Network for Greening the Financial System (NGFS), a group of central banks and supervisors. The output from three different integrated assessment models is available for each of the scenarios, providing some model-risk diversification in estimating potential paths for real GDP and inflation. Figure 1 shows 12 of these paths for US real GDP (left) and 12 for inflation (right). We can see that there is a wide dispersion of outcomes, but generally speaking, real GDP is expected to be lower than baseline and inflation is expected to be higher than baseline, driven by transition risk.

For acute physical risk, we leaned heavily on our partnership with Woodwell Climate Research Center to devise a forward-looking model that integrates physical-risk projections and the likely impact on GDP. We viewed the challenge as analogous to measuring corporate credit losses, in that there are both losses and recoveries to consider. The process we arrived at involved developing country-level assumptions for future extreme climate events (e.g., a 1-in-100-year precipitation event), the associated damages and recoveries, and the potential impact on real GDP.

More on our methodology and the impact of these changes

In our new paper, Integrating climate change into capital market assumptions: our approach and findings, we offer a deeper dive on our climate-aware CMAs, including our fundamental asset-class methodology. We also compare the results with our regular CMAs and highlight several findings, including the greater impact on equity (versus fixed income) and on emerging market equity (versus developed). Ultimately, we think integrating climate-related inputs into a CMA methodology is likely to alter asset allocations. Even if the changes in CMAs are modest, they may impact rank-order preferences for asset classes and the relative attractiveness of risk assets themselves. One final point: climate change is dynamic and uncertain, and asset owners will need to periodically revisit their asset mixes as policy evolves and climate scenarios unfold.