Climate change presents an unparalleled risk that will profoundly affect investment portfolios. The world is in the process of transitioning to a low-carbon economy, which has significant disruptive potential for companies and the value of their associated securities.

In light of this, Carbon Delta has entered into a collaboration with Ortec Finance and Lombard Odier Investment Managers to create a holistic solution to embed climate risk and opportunity across the investment value chain.

The working group met in April to discuss the initial framework for embedding climate risk and opportunity across the investment value chain. The group also included Achmea IM, MN and PME Pension.

Climate as a systemic risk

The potential impact of climate change cannot be overstated. According to research conducted by Ortec Finance and Cambridge Econometrics, failure to transition to a low carbon economy could result in a temperature increase of 4°C. In turn, this would likely create a significantly negative impact on global equity returns. On the other hand, an orderly and rapid transition could boost equity returns significantly.

Typically, managing climate risk in investment portfolios happens at a company level using tools such as carbon footprinting. This has an undeniable impact, but is inadequate when we consider the systemic nature of climate risk and the different ways it can unfold. What is required is a holistic process that captures a much broader information-set about climate risk and opportunity into asset liability management (ALM) and strategic asset allocation decisions, and into the portfolio construction itself.

According to Lisa Eichler, Co-head Strategic Climate Solutions at Ortec Finance: “The fact is that climate change is a key systemic risk and this stands to have a negative impact on investor returns. It cannot be diversified away and can only be effectively countered by integrating it into the full breadth of the investment process.”

Ortec Finance recently partnered with Cambridge Econometrics to develop a new methodology for embedding climate risk into top-down macro-economic modelling and scenario sets. Ortec Finance integrates this information into their systemic climate risk aware ALM in order to show how the different potential global warming scenarios would affect an investors’ investment parameters.

But this is just the beginning.

Willemijn Verdegaal, Co-Head Climate & ESG Solutions, at Ortec Finance says: “The best outcome for investors comes from integrating top down and bottom up climate risk analysis in a consistent manner. This means using cutting-edge data on climate risk and opportunity, and embedding that information throughout the investment process.”

The importance of data

Cutting-edge data is central to this process of mapping out future paths of climate risk. Carbon Delta employs a Climate Value-at-risk® (CVaR) methodology that estimates forward-looking costs to companies, as well as their ability to benefit from technological innovation. This is done by estimating the potential upside revenue a company could derive based on its stock of low-carbon patents. This data has been incorporated in both Ortec Finance’s ALM and in Lombard Odier’s approach to portfolio construction.

David Lunsford, Head of Development & Co-Founder of Carbon Delta, said: “The idea behind our CVaR is to aggregate the risks and opportunities that may arise from climate change at the company and security level. This gives investors a more informed forward-looking view, which can enhance their understanding of a company’s sustainability on a long-term basis.”

Integrating climate into investment portfolios

Foort Hamelink, who is responsible for integrating ESG in bespoke portfolios at Lombard Odier Investment Managers (LOIM) said: “Investors are increasingly aware of the risks presented by climate change, but it is also important to note that the transition to a low-carbon economy will present significant opportunities. We can develop a better idea of which companies are better positioned to thrive and prosper as the transition to a low-carbon economy unfolds by incorporating climate risk data into company assessments.

“We fully agree, furthermore, that this is best achieved by embedding climate-related information across the whole investment process,” Hamelink continues. “Consistency in the approach to data is important, which is why we are embedding Carbon Delta’s CVaR metrics into both the ALM and the portfolio construction. Importantly, this approach can be applied to passively-managed strategies and is applicable across all asset classes.”

LOIM has developed a strategy for implementing low-tracking error portfolios that ‘tilt’ portfolio holdings using LOIM’s proprietary ESG/CAR, and on carbon metrics, including data derived from Carbon Delta’s CVaR.

Closing the loop

The next stage of the process is for Ortec Finance, Carbon Delta and LOIM to analyse how the new portfolio diminishes exposure to the underlying risk drivers identified in the ALM. Consistency of data is an important aspect underlying this process so all parties are working from the same independent data points, on a macro-economic, sectoral and company level. As a result of this analysis, the risk parameters at the ALM level are also expected to improve.

Anna de Jong-Wakley, Head of Sales and Solutions for Benelux, at Lombard Odier Investment Managers, says: “Investors need a transparent and effective means of identifying climate risk and incorporating that information into their investment portfolios. Our collaboration is key to helping mitigate climate risk, capture investment opportunities and build more resilient portfolios.

“Our work also has the effect of reducing the probability of extreme climate scenarios unfolding,” de Jong-Wakley continues, “which will deliver a positive impact for investors, and for society as a whole. We have formed this collaboration out of a shared urgency to move the needle when it comes to climate change and helping to facilitate an orderly transition.”

Join Lombard Odier Investment Managers for the opportunity to hear more about the approach to integrating sustainability at the whole-portfolio level at our seminar, “the sustainability storm”, at Kasteel Woerden in July on 4 July. Click here for more information.

This collaboration is open in nature and other potential participants would be very welcome to join. If you would like further information, please contact Anna de Jong-Wakley at LOIM, Willemijn Verdegaal and Lisa Eichler at Ortec Finance, and Roman Kübler at Carbon Delta.