Applying climate scenario risk analysis to DB pension plans

Defined benefit plan sponsors are undoubtedly familiar with scenario risk analysis, but applying that concept to their portfolio’s climate risk is a whole new ballgame.

Plan sponsors will need to use these risk analyses to get a handle on how exposed they are to climate change risks and opportunities decades into the future, said Alyson Slater, senior director of sustainable finance with the Global Risk Institute during the Canadian Investment Review’s 2020 Defined Benefit Investment Forum in December.

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“Whether or not we take strong policy action and try to restrict [carbon] emissions, or whether we don’t really restrict the emissions at all and we allow the worst physical impacts of climate change to hit us — either way there are going to be risks and opportunities for us in the financial sector under any of those scenarios,” she said.

“I think we’re used to looking at that three- to five-year horizon in our planning. [Climate scenario risk analyses] are looking at that 30-year horizon . . . so [it’s] very big picture, very complex.”

In 2021, the policy environment around climate change will change dramatically, with U.S. President-elect Joe Biden promising to re-sign the Paris Accord and the U.K.’s Conference of Parties 26 agenda doubling down on an attempt to get all parties to agree to net-zero carbon emissions by 2050, along with tabling a financial sector plan, she said.

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For financial sector companies, this policy backdrop presents pressure to understand both the carbon emissions they’re enabling through assets they invest in and how those emissions impact investee companies’ long-term financial stability and prosperity in the face of climate change, Slater noted.

Employing scenario risk analysis for climate change isn’t necessarily about getting concrete answers as it is about building knowledge and capacity. “The idea is more to . . . try out methodologies and datasets, see what works, what doesn’t. I think it’s all about opening eyes and stretching minds to what the changing climate really means for us from the financial sector perspective.”

Investors can use climate science data from the International Panel on Climate Change to translate information on phenomena like droughts and sea-level rise into financial analysis and the International Energy Association’s energy scenario analysis, which looks at the projected energy mix decades into the future, she advised. Investors can also create carbon pricing scenarios to determine which of their investee companies can absorb a substantial hike to the cost of carbon.

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As a first step, plan sponsors should figure out the goal of such an analysis and what tools might help them reach it. Slater cited the example of the OPSEU Pension Trust, which conducted a scenario risk analysis to understand how climate risks could affect the fund’s asset allocation by looking at potential warming scenarios. For example, what if the earth keeps to a 1.5-degrees Celsisus warming scenario through heavy policy action, or a three-degrees pathway with medium policy action, or a four-degrees pathway with very little policy action and plenty of physical risk?

“They were able to run this over their portfolio . . . just to understand what this looks like and how we have to treat the data to get it into a usable format,” she said. “[They] did conclude that not experiencing the worst of climate risk would be better than experiencing that four-degrees scenario and that there may be more opportunities out there in terms of that transition than we normally look at. We’re mostly focused on the risk, but the opportunities of a changing energy base, for example, and how that permeates through the markets could be a larger opportunity than we’ve [realized].”

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Climate scenario risk analyses are expected to garner plenty of attention in 2021, with the Bank of England planning to use its 2021 biennial exploratory scenario to look at climate risk, with multiple U.K. banks and insurers participating. “It’s a departure from your traditional sorts of stress testing, it’s more a learning exercise so we can understand and start to build the skills from both the regulatory side and the banks and insurance companies for understanding climate risk and how we could apply that to our portfolios.”

At home, the Bank of Canada partnered with the Office of the Superintendent of Financial Institutions on a pilot project to use climate change scenarios to assess the risk to the financial system related to a transition to a low-carbon economy, with six insurers and banks participating, noted Slater. “The rules of the game are changing.”