Green indices reduce the carbon footprint of investment portfolios, but their added value is currently limited in terms of managing the financial risks of climate change. Only in the event of a disorderly climate transition would there any demonstrable outperformance.
This is the view of Willemijn Verdegaal (photo), co-head of Climate & ESG solutions at Ortec Finance, who also told our sister publication in the Netherlands Fondsnieuws the return expectations in the current ALM models for pension funds are too optimistic. “The models are often based on data from the past, so climate risks are not taken into account. Climate change, however, has a major impact on the economy and financial markets.”
Ortec Finance does take the risks of climate change into account in its scenario analyses. The consultancy recently also examined green benchmarks, as many pension funds are considering using such low-carbon indices to achieve their climate goals. Three climate scenarios were examined: an orderly transition to meeting the Paris climate targets, a disorderly transition and no transition.
Disorderly scenario
“In a delayed disorderly transition, we take measures too late to limit global warming to well below two degrees Celsius,” explains Verdegaal. “This will take financial markets by surprise, possibly resulting in severe shocks. Investors, for example, will quickly downgrade CO2-intensive companies. The real economy could also be hit hard, for example by the collapse of the oil and gas sector or parts of the transport sector. Due to the broad economic impact, ‘green’ sectors will also suffer.”
Only in this scenario do green benchmarks clearly outperform traditional indices. “In the disorderly phase, the outperformance will be around 1 percentage point per year. After the transition to a sustainable economy is completed, the difference quickly decreases,” says Verdegaal. The main reason for the outperformance is that green indices are less exposed to stranded assets. “However, they are not completely immune to the high volatility during the chaotic phase. Moreover, they do not offer protection against physical climate risks, such as extreme weather.”
In an orderly scenario, she says, there is hardly any difference in performance between green and grey indices. “Due to the gradual transition, the composition of traditional benchmarks will also slowly change.”
In absolute terms, all benchmarks will lag behind a traditional “climate uninformed” model, in which climate risks are not taken into account. Verdegaal: “The financial return in each climate scenario will be lower than is taken into account in the current ALM models. Physical climate risks are unavoidable and will depress the returns of both green and grey indices in the long run.”
Conclusion
According to Verdegaal, green benchmarks are mainly suitable for reducing the carbon footprint of an investment portfolio. “In a financial sense, they have no added value in the case of an orderly transition or when no transition takes place and the earth continues to warm up. In a disorderly transition, there is some added value and they perform better than grey indices”, Verdegaal concludes.
“Because climate change brings physical risks anyway, the returns are lower than most investors’ current expectations. But for the grey benchmarks, of course, disappointing returns also await.”