Mark Jeavons and Tim Manuel (pictured) are part of the Responsible Investment team at Aon
Man-made climate change is one of the biggest threats facing our world today. Governments have made commitments to reduce greenhouse gas emissions to limit its damaging effects. To meet these commitments, more aggressive policy action and a rapid shift away from fossil fuel use will be necessary. This will likely cause considerable disruption, increasing costs and reducing growth globally, while raising the risk of a global recession.
The UK is one of the global leaders in tackling climate change. It signed the Climate Change Act (2008) which set legally binding targets to reduce carbon dioxide (CO2) emissions by at least 80% by 2050 (from 1990 levels). By 2016, the UK is just over half way there, at 42% below. To meet the 2050 target though, emissions will need to fall by 3% each year, needing more challenging measures. Globally, the position is worse with substantial action required. The world and the UK are actively working together towards tackling climate change. However, the question to ask is: will it be enough?
Pension funds, as long-term investors, could find themselves exposed under many of the potential future scenarios around climate change. The long-term effects of un-tempered climate change are likely to be damaging, but the economic transformation required to deal with the challenges could also cause pain in the near term for those that are unprepared.
The Paris Climate Change Agreement aims to strengthen the global response to the threat of climate change by limiting the global temperature rise to well below 2°C above pre-industrial levels. The scientific consensus is that keeping the global temperature rise below this level will help avoid the worst effects. Every country in the world, with the exception of the US, has now signed up to this agreement. The Intergovernmental Panel on Climate Change has shown that if emissions continue on their current trend, global warming is likely to be more than 4°C above pre-industrial levels. This is well above the danger limit and would likely put our planet and society at risk from more severe climate change effects before the end of the century.
To remain within the target would require us to emit no more than 720 billion tons of CO2 worldwide for the rest of this century. With the world emitting around 40 billion tons of CO2 every year, this means that at current levels we have less than 18 years before global temperatures hit the danger limit.
This leaves little time to put in place effective policies to reduce carbon emissions sufficiently to avoid the calamity scenario. Global emissions need to start falling quickly in order to have a realistic chance of limiting the worst effects of climate change. This means more ambitious goals than those set out in the Paris agreement, including the international regulation of carbon emissions and a rapid shift away from fossil fuels in favour of renewable energy sources.
Under the ‘green scenario’, where global collaboration manages to act to address the challenges, there is still the likely threat of a shock from climate regulation changes that could lead to large losses across pension funds’ portfolios in the near term. The implications of the alternative ‘climate change calamity’ scenario may avoid some of that near-term pain, but does not bode well for future generations or investors’ returns.
The risks from climate change are much greater over the long run than over the next decade. However, the window for limiting emissions and avoiding disastrous change is narrow. Under both scenarios there is scope for economic pain at some point on the road, either near or far.
Tackling climate change is a Herculean task, which requires efforts of communities, companies and individuals alike. The actions (or inaction) of governments worldwide will have ramifications for society and the global financial system.
Pension funds, insurers and other financial institutions will need to consider how likely they are to be impacted by climate change and decide how they will manage the risks and future challenges over multiple timeframes.
Scenario analysis can be used to help trustee boards and corporate treasurers to consider a range of climate change outcomes, and to better understand how their assets and liabilities are likely to be impacted. This analysis can be used to stress test investment strategy and make informed funding and investment decisions. This allows for better planning for future conditions, which will hopefully lead to a brighter future.
