Climate risk has caused significant challenges for life insurance financial risk modelers. There is a lot of noise in the market, with emphasis on either very precise or very complex modelling. However, it is important to also look at the broader, systematic impacts on financial markets exposures; such as yield curves, inflation, credit spreads, risk premia, and asset class returns.
How do you find the balance and a sufficient level of granularity in your modeling? How do you select and assess the impact of different climate models? Are there risks we are missing? We have created a series of short articles to help those responsible for climate modeling in the actuarial, risk, and strategic asset allocation functions of a life insurance company. These articles begin to address and simplify the complexities of climate change in processes such as the ORSA, stress testing, and strategic asset allocation.
In the fifth of the series of six articles, we explore the impact of physical and transition risk on asset returns.
Analyzing and Attributing Climate Change Impacts on Asset Returns
Climate change is an emerging global risk with the potential to impact both sides of an insurer’s balance sheet. Physical risks are categorized as ‘acute’ or ‘chronic’, and their transient versus systemic and non-diversifiable nature differentiate them (respectively). Whilst environmental changes caused by increases in average global surface temperature drive physical risks; decarbonization policies and trends are the main drivers of transition risks. Policy inaction increases physical risk, whilst action increases transition risk, creating a conflict know as ‘the tragedy of the horizon’.
Transition costs arise due to implicit or explicit carbon pricing and investment into alternative technologies and energy sources. These costs are accrued to reduce vulnerability to the physical risks of climate change. There are also opportunities to benefit from the economic upsides associated with increased dependence on greener energy sources and practices, for example carbon sequestration and capture. Whilst climate risk is commonly decomposed into these two risk categories (physical and transition) for attribution purposes, there is often a complex inter-connection between the two. Accounting for that balancing act is the subject of this article.
Figure 1 presents a climate scenario for which transition costs are the main risk. This Net Zero 2050 scenario assumes prompt policy action to reduce emissions; implying heavy investment and higher rates of carbon pricing imposed over the short term. The results shown are relative to a counterfactual scenario, which does not assume transition and/or physical damage costs.
Figure 1: Compared against counterfactual, we see Net Zero 2050’s Cumulative Nominal Impact on the returns of a Diversified Multi Asset Portfolio (DMAP) denominated in US dollars
Negative values indicate that the market returns are suppressed relative to the counterfactual scenario. Physical risks are slower to manifest and lower in relative terms due to the effective mitigation measures. The physical costs could be characterized as modest, slowly, and smoothly increasing in the short to medium term before staying under control out to 2100. An important dimension in climate informed financial analysis is the long time frames which arise due to cumulative drags, delayed responses, and a sophisticated interplay between the diverse risk sources. This is far removed from the more familiar point in time instantaneous shocks that financial institutions consider in their risk management frameworks.
Figure 2: Compared against counterfactual, we see Net Zero 2050’s Cumulative Nominal Impact on a multi asset diversified portfolio of US dollar denominated investment
Figure 2 shows that for transition risks, it is possible to take a step further and decompose transition impacts into 1) abatement, investment in mitigation/adaptation technology; and 2) climate inflation, due to the rise in energy prices, driven by taxation, and which drive broader consumer prices increases. This more detailed decomposition produces the same overall impacts as in Figure 1 but demonstrates that the costs associated with different risk drivers can potentially offset each other. They do not all have a negative impact; nor are they necessarily persistent in their contribution. This potentially gives rise to windows of opportunities.
Figure 3: Compared against counterfactual, Current Policies’ Cumulative Nominal Impact on DMAP USA returns
Figure 3 shows a Current Policies scenario. Compared to the Net Zero 2050 scenario, markets are likely to under – perform in the long term under Current Policies. This is driven almost entirely by ongoing global warming and much more significant levels of physical damages, which will be experienced as a long, slow, and steadily increasing drag on earnings.
To conclude, being able to decompose the climate risk exposures following more ambitious pathways (such as Net Zero 2050), not only allows for a reduction in physical damages costs by assuming some transition costs, but it also allows for trade-off between the different cost sources. In the context of Figure 2, some of the abatement losses are balanced by gains attributable to inflation.
Returns attribution helps to unveil some of the complex dynamics which could take place under different climate pathways and can help differentiate the impact on asset returns from different components of climate risk.
For more insights on this topic, listen to our podcast series.
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