Climate aware startegic asset allocation
The need to take climate change into account as a structural factor of performance
Academic research, as well as the lessons of experience, demonstrate that long-term asset allocation is the main source of performance, far ahead of tactical allocation or investment selection. However, with the problem of global warming linked to greenhouse gas emissions, the concept of “Tragedy of the horizon” has highlighted the necessary consideration in the construction of portfolio of a very long duration event, of the order of 80 years, time necessary for the associated damage to materialize fully. Simultaneously, the community of central banks acknowledges that climate change poses potentially systemic risks to financial stability that could materialize in “green swan” events.
Consequently, traditional backward-looking probabilistic approaches would not be able to assess climate-related risks properly. Historical data are certainly not sufficient to define a long-term asset allocation. They are even partially counterproductive, because they are supported by irrelevant economic and monetary fundamentals. Alternative approaches based on a green taxonomy may also prove insufficient as they only offer a static view of the reality they depict. New forward-looking approaches are therefore needed. Such scenario-based methodologies seek to set up plausible hypotheses for the future without attributing a probability of occurrence to each of them.
Strategic asset allocation must take into account the transition of economies to a decarbonized economy, the only scenario capable of avoiding devastating global warming, by positioning itself on investments that generate performance and lower risk. But other, less positive, scenarios have to be considered too. This is the subject that the Climate Aware Strategic Allocation aims to cover. In addition, this transition may be induced and accelerated by promoting the financing of traditional industries, the development of transitional facilitating activities or of disruptive innovations. This is the subject of Investing in Climate by selecting ad-hoc investments within each asset class once the allocation has been completed.
In more details, Climate Aware Strategic Allocation is based on three pillars: expected returns derived from a consistent economic scenario, risk measures, volatility and correlations, and an algorithm for optimizing risk-adjusted returns. The idea is to use an essentially forward-looking scenario-based approach to implement the strategic asset allocation.
The scenarios translate the more or less intense efforts of the global economy to mitigate carbon emissions and adapt economic structures to warming while taking into consideration productivity, demographic trends, the relative energy intensity of the economy and the carbon content of energy production. The economic and scientific community agrees on five so-called Shared Socioeconomic Pathways (SSP), determined by the degree of mitigation and adaptation. They range from a virtuous scenario corresponding to the compliance with the United Nations Sustainable Development Goals in the context of enhanced international cooperation to an extreme scenario of regional rivalries abandoning any ambition in the field of climate. The purpose of this study is to deduce what strategic asset allocation is optimal for each SSP.