This paper aims to help the growing number of investors that have committed to or are considering the Divest-Invest pledge as a means of addressing climate change risks, by assessing the potential impacts of aligning a portfolio with the pledge from an investment risk-return perspective. Although there are many different ways an investor can manage climate change-related risks or reduce portfolio exposure to carbon, this paper focuses specifically on the approach adopted by Divest Invest signatories — namely, divesting from fossil fuel reserve owners and reinvesting in climate solutions (that is, positively allocating capital to areas aligned with the transition to a low carbon economy).
The paper considers the following key questions:
- What financial impact does investing in fossil fuel-free or sustainable investments across different asset classes have under a climate change scenario consistent with a +2˚C outcome (the baseline goal of the Paris Agreement)?
- If a transition to a low carbon economy does occur, do these assets exhibit a “Low Carbon Transition (LCT) premium,” and if so, what is the best way to measure it?
Prospective Scenario Modeling
To understand the impact of fossil fuel divestment or investment in climate solutions on portfolio risk/return, practitioners naturally first turn to the historical record, though the question remains as to the extent to which past data can be relied on to make long-term predictions regarding the future impacts of climate change — a phenomenon that has not yet fully manifested and has no comparable proxy in history. It is also unclear to what extent markets are currently pricing climate change into valuations and what potential large changes in policy, technology and weather patterns may unfold over the coming years and decades. Given these challenges, it is helpful for investors to utilize a scenario framework to look forward and ask “What if?”
This research leverages and relies upon Mercer’s climate change modeling framework described in detail in the 2015 report Investing in a Time of Climate Change.
We employ this modelling framework to estimate the return impact on sustainable iterations of core asset classes, including US and international equities, investment grade credit, infrastructure and private equity.
These asset classes are analyzed as part of the following three portfolio approaches, each of which has been modeled after the typical asset allocation of a small (<$101 million) US foundation:
- No action taken to address stranded asset risk (Base Portfolio)
- Divest from fossil fuels in public equity (Divest Portfolio)
- Divest from fossil fuels in public equity and at the same time invest in assets with a sustainability focus (Divest Invest Portfolio)
We then run these portfolios through our asset allocation model under two scenarios and compare the results:
- The first scenario is based on our standard US capital market assumptions. We refer to this scenario in the report as the Efficient Market scenario, because it presumes climate change is already fully priced by markets and no opportunity exists for investors to add alpha from a low carbon economic transition.
- The second scenario applies our Transformation scenario, which estimates the impact of a low carbon transition resulting in a +2˚C climate outcome (and assumes this shift is not currently being priced by markets). This scenario involves sufficient climate policy action and technological advancement to create divergent performance between sustainable assets and their non-sustainable counterparts.