Traditional environmental, social and governance (ESG) analysis has tended to focus on fundamental or “bottom-up” factors. However, we believe that the systemic nature of climate risks demands an expanded “top-down” approach that informs broad asset allocation decisions as well as security selection.
In this paper, we provide a framework for integrating climate-related risks into strategic asset allocation (SAA).
In our view, the positive results we find when we integrate climate risks into SAA suggest that investors may be exposed to potential downsides, and missed opportunities, if they fail to take them into account.
Executive Summary
- We use a Climate Value at Risk (“Climate VaR”) model to estimate the potential impact of climate change on the present value of securities, which we then aggregate up to the benchmark index level to use as inputs into the strategic asset allocation (SAA) process.
- Ex post Climate VaR adjustment to an SAA optimization lowers the efficient frontier: for a given unit of volatility, estimated return is lower relative to the optimization that does not take climate-related costs (and gains) into account.
- Climate VaR is widely dispersed across different asset classes and sectors—some investments appear to be considerably more at risk than others, suggesting potential opportunities to enhance efficient frontiers by integrating Climate VaR ex ante into the SAA optimization process.
- An SAA optimization that fully integrates Climate VaR ex ante can raise the efficient frontier, relative to the optimization that receives an ex post Climate VaR adjustment to its estimated returns.
- Including low carbon indices into the SAA optimization that fully integrates Climate VaR ex ante can additionally reduce a portfolio’s financed carbon emissions without impairing its estimated risk-adjusted return.
- Investors can integrate additional climate metrics, such as carbon intensity or carbon footprint, as constraints in the optimization process; the wide variation of financed emissions between asset classes makes it possible to set those constraints within a wide range, and helps to minimize impairment of estimated risk-adjusted return.
Efficient Frontiers: With and Without Climate-Adjusted Optimization
Source: Bloomberg, JP Morgan, MSCI. Data as of December 31, 2021. Allocations and changes in allocations are rounded to whole numbers. Carbon Intensity and Carbon Footprint data are calculated on Scope 1 and 2 emissions. Indices used: Bloomberg Barclays Indices for U.S. Government/Agency Debt, U.S. Corporate bonds, U.S. Large-Cap Equities and Small-Cap Equities; MSCI Indices for EAFE and Emerging Markets Equities; JPM EMBI for Emerging Markets Sovereign Debt; JPM CEMBI for Emerging Markets Corporate Bonds; MSCI ACWI Low Carbon Target Index; MSCI USD Investment Grade Climate Change Corporate Bond Index; MSCI USD High Yield Climate Change Corporate Bond Index. Past performance is no guarantee of future results. Please note that estimated returns data is based on NB’s capital markets assumptions and are provided for information purposes only. There is no guarantee that estimated returns will be realized or achieved nor that an investment strategy will be successful, and may be significantly different than shown here. Investors should keep in mind that the securities markets are volatile and unpredictable. There are no guarantees that historical performance of an investment, portfolio, or asset class will have a direct correlation with its future performance. Net returns will be lower.
