In a previous article we discussed the merits of setting interim targets on the road to decarbonisation.  When setting such targets, a forward-looking view of the potential decarbonisation trajectory of both the market and your portfolio is vital.

As the broader economy transitions to a lower-carbon world, an element of decarbonisation will naturally occur in insurers’ portfolios. Why is this? Because high-emitting firms will become a smaller component of equity markets and corporate bond indices, as the energy transition moves towards its end point. We need to ask, what are the effects of different decarbonisation levels along this timeline and how will these chime with insurers’ own targets?

If we can do this, we can predict the expected decarbonisation at the portfolio level and decide what further actions need to be taken to meet insurers’ own individual targets. In turn, it is vital that insurers understand how physical climate change and the transition to cleaner forms of energy might affect the investment returns of the companies and markets they invest in.

The importance of climate scenario analysis

Climate scenario analysis can play a pivotal role in understanding decarbonisation trajectories at the portfolio and market level.

Assessing the expected decarbonisation trajectory and the impact of that trajectory on a portfolio is not a straightforward task. Which pathway should you place reliance on and what is the impact on your portfolio as a result?  We think climate scenario analysis can provide a guide.

Our climate scenarios approach considers a range of both bespoke and off-the-shelf scenarios, applying our expert judgement to assess the probability of each outcome. We are motivated by the view that a rigorous and transparent methodology is essential for making sound investment decisions, encouraging positive change at the companies we invest in and achieving valued outcomes for our clients.

There are three features that differentiate our climate-scenario framework from that of most other asset managers, allowing us to fully integrate the results into our business strategy:

1. Bespoke scenario design – Climate scenarios are typically taken ‘off the shelf’ from outside agencies. Although this allows us to contrast and compare, such scenarios often involve unrealistic assumptions about policy uniformity across regions and sectors. As a result, they aren’t all that useful when it comes to investment integration and product development. By relaxing these assumptions, we can build more plausible scenarios that better inform our assessment of climate risks and opportunities.
2. Macro and micro integration – Investment integration also requires a rigorous process for translating climate scenarios into financial impacts for every investment in our portfolios. Drawing on the expertise of our external partner – Planetrics – we do this in three stages:
1. Our scenarios are converted into direct economic shocks, like carbon taxes or physical damages, and indirect shocks that alter energy usage and the supply and demand of different products over time.
2. We then model the effects of these potential shocks on firms’ asset value streams. We look at companies’ ability to react to shocks in terms of abatement or adaptation, and the nature of competition in their industry. In terms of the latter, we look at the ability to pass on any higher costs to consumers or gain market share at the expense of more impacted competitors.
3. Lastly, we generate impairment estimates for individual securities using standard asset-pricing models, which can be aggregated at sector, regional and portfolio levels.

3. Probabilistic assessments – The financial implications of climate change and the energy transition will be determined by the evolution of regulation, policy and technology. However, these drivers are difficult to forecast over long time horizons. We must take this uncertainty into account and update our analysis accordingly as new information becomes available. We do this by:
1. Specifying a wide range of plausible scenarios (see Figure 1)
2. Assigning probabilities to each scenario based on the political environment and economics of mitigation
3. Pooling the results so that we can analyse how asset prices respond to the probability-weighted mean outcome, as well as tail outcomes
4. Updating our scenarios and their probabilities on an annual basis

Figure 1: Our bespoke scenarios allow for policy variation across geography and sectors

Source: Planetrics, September 2021

The scenarios use two different energy systems models which embed different assumptions about energy systems and the technology pathways that shape their evolution: REMIND and MESSAGE-GLOBIOM (M-G). Current pledges are based on Nationally Determined Contributions (NDCs)

Prudent risk management and regulatory requirements

We have spoken about climate scenarios in the context of supporting insurers on their net-zero journeys. However, there are several further significant drivers that require insurers to become increasingly familiar with climate-scenario modelling.

In our recent ‘Sustainable investment in European Insurance’ survey, European insurers told us that risk management and regulation were among the key drivers of their sustainable investment practices, as shown in Figure 2 below.

Figure 2:  Main drivers of sustainable investment in insurance by country and business line

Figure 2: Main drivers of sustainable investment in insurance by country and business line

In conclusion

Whether driven by a net-zero objective, prudent risk management or regulation (or indeed all three), insurers can benefit significantly from familiarising themselves with climate-scenario analysis. For more about this topic, see another recent article “Climate scenarios: a rigorous framework for managing climate financial risks and opportunities”.  

In the next instalment of our four-part series on insurance investing and sustainability, we’ll be discussing frameworks to help insurers decarbonise their portfolios.