Unhedgeable Risk How climate change sentiment impacts investment Dr - PowerPoint PPT Presentation

1 Unhedgeable Risk How climate change sentiment impacts investment Dr Jake Reynolds, Executive Director, Sustainable Economy, CISL Dr Scott Kelly, Research Principal, Centre for Risk Studies #RewireEconomy

2 CISL: A unique Cambridge institution 30 years of building Business and leadership capacity to policy engagement tackle global challenges • Sustainable finance (banking, insurance, investment) 60 staff in Cambridge, Brussels, Cape Town • Natural capital (incl. carbon) • Equality and wellbeing Patron: HRH The Prince of Wales Independent research Global network of Executive and 7,000 senior executives graduate education

3 Title here Focus Mandates for sustainable investing Metrics for investment impact Understanding consumer demand

4 A question tackled by an interdisciplinary team  Commissioned by CISL and the ILG  Collaborative effort of three Cambridge research teams  Centre for Risk Studies (CRS)  Centre for Climate Change Mitigation Research (4CMR)  Cambridge Judge Business School (CJBS)

5 Cumulative emissions and the “tragedy of the horizon”

7 The nested model of finance and investment Inflows and outflows from the economy

9 Unburnable carbon and the carbon bubble Shell: Mountains BP: Best Knowledge Shell Energy Scenarios: New Lenses BP Energy Outlook 2035: http://www.shell.com/global/future-energy/scenarios/new-lens- http://www.bp.com/content/dam/bp/pdf/Energy-economics/energy- scenarios.html outlook-2015/Energy_Outlook_2035_booklet.pdf Meeting 2°C target requires 60% cut in fossil fuels by 2050

10 The analytical challenge  Estimating economic damages is problematic  Significant uncertainties  Future economic productivity  Climate sensitivity  Catastrophic climate change and tipping points  Human behaviour  Sensitivities and assumptions  What is included / excluded in the analysis  Timing of climate policies

11 Recent reports on the financial impacts of climate change July 2015 Aug 2015 June 2011 1. Mercer, 2011. Climate Change Scenarios - Implications for Strategic Asset Allocation. http://www.mercer.com/services/investments/investment-opportunities/responsible-investment/investing-in- a-time-of-climate-change-report-2015.html 2. Mercer, 2015. Investing in a time of climate change (update). http://www.mercer.com.au/insights/focus/invest-in-climate-change.html 3. The Economist, 2015. The cost of inaction.

12 Structural methodology

13 Extreme events “plausible and highly unlikely”  Scenarios are not predictions  Scenarios are stress tests for risk management purposes  These are not forecasts of what is likely to happen  These are hypothetical: Illustrate a 1-in-100 year event in a particular threat class  Used for ‘what - if’ studies

14 Development of sentiment scenario

15 Defining the sentiment scenarios Representative Concentration Pathways (RCPs) Socio-economic reference pathways  Total radiative forcing from GHG causing climate SSP1 SSP2 SSP3 SSP4 SSP5 change 8.5 Forcing level (W/m 2 ) X Shared Socioeconomic Pathways (SSPs) 6.0 X X X X  Range of future socioeconomic, technology and emissions scenarios X X X X X  Reference scenarios upon which policy targets can 4.5 be modeled X X X X 2.6 Shared Climate Policy Assumptions (SPAs)  Climate change policy designs + how targets are SPA1 achieved  GHG emissions coverage, accession, cooperation SPA2 ons …

16 The process begins by defining the sectors to be considered

17 Damage functions are used to estimate impacts on sectors at different temperature change values

18 Estimating GDP@Risk 70 Crisis GDP Trajectory Trillion US$ 65 GDP@Risk: Cumulative first five year Global loss of global GDP, GDP relative to expected, resulting from a 60 catastrophe or crisis GDP@Risk Impact 55 Recovery 50 2012 2013 2014 2015 2016 2017 2018 2019 2020

19 Scenario assumptions Scenario: Two Degrees Scenario: Baseline Scenario: No Mitigation Trends typical of recent decades Focus on rapid economic growth World making good progress towards continue with mild progress, if any, dependent on fossil fuel with little sustainability w/ rapid improvement to towards reducing resource and attention to climate change adaptation; cleantech development energy intensity no room for mitigation which lead to belief that global warming is accelerating Regulations: Coordinated level of global past the point of no return Regulations: Delays in global cooperation for mitigation: global $30/ton climate policy action with no carbon carbon tax imposed, increasing in future. tax and fossil fuel demand remaining Regulations: Higher fixed investment unchanged for fossil fuel extraction and subsididies Market Reaction: Moderate shift in market sentiment due to uncertainties to future energy resources and structural change as Market Reaction: Negligible shift in Market Reaction: Drastic shift in market energy consumption is reduced and market sentiments; expectations of sentiments due to large uncertainties divestment from fossil fuel takes place future economic activities remain regarding climate outlook and future unchanged economic activities

20 Scenario assumptions Scenario: Two Degrees Scenario: Baseline Scenario: No Mitigation Regulatory assumptions: Regulatory assumptions: Regulatory assumptions: - No carbon or oil tax - No carbon or oil tax - $100/tonne CO 2 of carbon tax to - World fossil fuel energy - 50% increase in world fixed reflect the strength of climate policies aimed at reducing greenhouse gases supply/production remains investment for energy extraction (GHG) emissions unchanged - Fossil fuel-dominant energy - Carbon budgets set at 20% on existing investments remain unchanged reserves - No technological advances to - 80% more investments in low-carbon renewable energy sources technologies - No further investment (or subsidies) for fossil fuel extractions

21 Sentiment scenario summary table Matrix Axis Parameters Two Degrees Baseline No Mitigation Future temperature increase Low Moderate High Climate impacts Extreme weather events Low Moderate High Population Growth Low Moderate Low Socio- Resource consumption Low Moderate High economic development Fossil fuel demand Low Moderate High Fossil fuel price High Low High Environmental Green technology High Moderate Low Policies Climate policies High Moderate Low

22 Global macroeconomic impacts Summary of Effects of Sentiment Scenarios Baseline (Reference) Two Degrees No Mitigation Macroeconomic Losses Min. GDP growth rate 3% 0.3% -0.1% Global recession duration Nil Nil 3 Qtrs GDP@Risk (US$Tr) - 8.9 19.1 GDP@Risk (%) - 2.2% 4.7%

23 The long-term view 250 Global GDP output (US$ Tn) 200 150 100 50 0 2015 2020 2025 2030 2035 2040 2045 2050 Long Term Impact of Scenarios with Respect to Baseline to 2050 (GDP@Risk) Scenario No Discount Rate 3.5% Discount Rate 6% Discount Rate Two Degrees 6.5% 4.5% 3.2% No Mitigation -19% -16% -14%

24 Aggregate vs. sectoral analysis  Multiple portfolio structures considered  Portfolio rebalancing to maintain correct proportions  Sectoral impacts of particular relevance for equities  Uses physical impacts data for sectors and regions

25 Within model variation Climate Countries Asset classes Economic Sectors impacts Health Care/Pharma Energy / Oil and Gas Heat wave United States Fixed income Flooding United Kingdom - 10Y gov bonds Technology (renewables) Transport Storms Germany - 2Y gov bonds Construction Real Estate Agriculture Consumer Retail Japan Equities Consumer Services Basic Materials China Corporate bonds Financials Telecommunications Brazil Commodities Industrials

26 Four portfolio structures Conservative High Fixed Income Commoditie Commodities Cash s 1% 4% Equity 1% Equity 12% 40% Fixed Fixed Income Income 59% 84% Balanced Aggressive Commodities Commodities 3% 5% Equity Fixed 50% Income Fixed Equity 35% Income 60% 47%

27 Impact on equity markets Two Degrees No Mitigation 40% 80% (Nominal, % change Q-on-Q) (Nominal, % change Q-on-Q) 60% 20% Equity Value 40% Equity Value 0% 20% -20% 0% -20% -40% -40% -60% -60% -80% -80% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Yr1 Yr2 Yr3 Yr1 Yr2 Yr3

28 Impact by sector Impact by sector, No Mitigation: emerging vs. developed markets Emerging Markets

29 Impact on fixed income No Mitigation Two Degrees 5% 5% (Nominal, % change Q-on-Q) (Nominal, % change Q-on-Q) Fixed Income Total Returns Fixed Income Total Returns 0% 0% -5% -5% -10% -10% -15% -15% -20% -20% -25% -25% -30% -30% -35% -35% -40% -40% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2016 2017 2018 2016 2017 2018

30 “ Unhedgeable Risk” Summary of portfolio performance (short-term impact) Portfolio Structure Baseline Two Degrees No Mitigation High Fixed Income +0% -10% -23% Conservative +1% -11% -36% Balanced +1% -11% -40% Aggressive +1% -11% -45% Summary of portfolio performance (long-term impact after 5 years) Portfolio Structure Baseline Two Degrees No Mitigation +4% -3% -4% High Fixed Income Conservative +12% +9% -26% Balanced +16% +17% -30% Aggressive +21% +25% -45%