Mercer are one of the largest financial consultancy companies in the world. Owned by the global financial firm Marsh & McLennan, they provide advice to asset owners, such as large corporations, foundations, universities and pension funds.
In 2015, Mercer published a highly influential 100 page report ‘Investing In a Time of Climate Change’. The report aims to help asset owners and investment managers, who move asset owners investments around, understand better how to consider the impact of carbon risk on their portfolios.
Over a year after the report’s release, we wanted to consider what relevance it held for UK councils taking action on carbon and climate change risks.
What does the report say?
In the report, Mercer states that “climate change is an environmental, social and economic risk, expected to have its greatest impact in the long term. But to address it, and avoid dangerous temperature increases, change is needed now. Investors cannot therefore assume that economic growth will continue to be heavily reliant on an energy sector powered predominantly by fossil fuels.”
The main questions addressed by the report are:
- How and when will climate change affect the risk and returns of an investment portfolio?
- What risks and opportunities to investments are created by climate change, and how do we manage these considerations to fit within current investment practices?
- How can an investor become resilient to climate change?
The report says that the decisions investors make could result in four possible outcomes:
- Transformation: a strong climate change action plan puts us on a path that keeps global warming within safe levels (defined at 2oC above pre-industrial levels this century).
- Coordination: policies and actions are aligned and cohesive, limiting global warming to 3°C.
- Fragmentation (Lower Damages): limited climate action and lack of coordination results in a 4°C or higher rise in the global temperature.
- Fragmentation (Higher Damages): same limited climate action as the previous scenario, but assumes that relatively higher economic damages result.
Quantitatively forecasting climate risks and investment outcomes at different levels of financial systems the found that:
- Annual returns from coal could fall by anywhere between 18% and 74% over the next 35 years, with effects more pronounced over the coming decade.
- Conversely, the renewables sub-sector could see average annual returns increase by between 6% and 54% over a 35 years.
- Diverse portfolios are best placed to protect investors from negative financial returns, especially under a 2°C scenario.
- Portfolios will also need to consider greater material risks that will arise under a 2°C plus world. For example, under a 4°C, scenario, chronic weather patterns (long-term changes in temperature and precipitation) pose risks to the performance of many financial assets.
- Key risks will come either from structural change during the transition to a low-carbon economy, where investors are unprepared for change (i.e. still invested in the carbon economy and unprepared for the low carbon economy), or from increased physical damage, for example from events like extreme weather.
The report’s main recommendations are:
- Asset owners (such as local council pension funds) should put in place an integrated governance approach that enables them to build capacity to monitor and act on shorter-term (1–3 years) climate risk indicators as well as on longer-term (10-year plus) considerations.
- This will require asset owners to develop investment policies that clearly incorporate climate risks.
- Once a clear policy is in place, asset owners should develop new risk assessments, develop new ways to focus their investments (for creating new ‘mini-portfolios’ that invest in the low carbon technologies) and improved management and monitoring.
Why does the report matter?
The report was a clear acknowledgement from a well known global financial firm that climate change poses material financial risks to investment portfolios.
Moreover, Mercer states that action is needed now, and that even though climate risk is more complex and longer-term than most investment risks, uncertainty about the future should not be a barrier to action.
The findings reinforce the efforts of divestment campaigns as they clearly demonstrate that:
- The prospects for investment in coal are abysmal.
- The long-term outlook for renewable energy is safe and healthy.
- Lack of investments in low carbon infrastructure now will amplify the material financial risks associated with climate change later.
- Unprepared investors will lose the most.
- Investors that diversify away from fossil fuels and invest in “alternative asset categories”, including renewable energy, low carbon infrastructure, social housing, and green bonds will be better prepared for climate change impacts than investors that do not.
Essentially, the report argues that the “transformation” scenario is possible but only if investors take an active role in realigning their investment policy with effective climate action. Otherwise, we are headed for one of the financially, socially and environmentally disastrous “fragmentation” scenarios.
This conclusion supports the case for reinvestment in the just low carbon transition. A key shortcoming of the report, however, is that the modelling does not acknowledge or account for the need for the transition (and investments) to be just and democratic. Thus, the report doesn’t go far enough but nevertheless is a useful resource that supports the case for divestment from fossil fuels and reinvestment into low carbon solutions.